Turkey of the week: risky business with rose-tinted rating
By
Paul Hill Sep 18, 2009
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According to Alistair Darling's Budget, the government is set to spend £175bn more this year than it will receive, propelling the nation's debt to a record £1trn. So after the 2010 election, the country will be in serious belt-tightening mode, with everyone facing higher taxes and reduced public services.
Nobody knows where the axe will fall, but the bulls are convinced that outsourcers such as Serco will be a major beneficiary. That's based on the government achieving the necessary savings by handing over control of its in-house operations to third parties in order to reduce costs.
That's fine up to a point, yet by 2011, I expect the trend to end. That's because, due to the huge size of the deficit, the government (which accounts for 64% of Serco's sales) will need to be far more radical. Many capital expenditure projects (such as defence, hospitals, schools) will be chopped altogether, along with hefty decreases in civil servant headcount.
Serco (LSE: SRP), tipped as a BUY by Collins Stewart
What's more, there will be a big drive to close any discretionary services, and downsizing even of activities that are deemed essential. Such an austerity drive won't just be confined to these shores either, because in North America (24% of sales) states such as California have slashed budgets, some even to the point of not buying school books.
For the moment, the sector is on cloud nine, with Serco bagging £2.1bn of new contracts in the six months to June and building up a record £16.7bn order book. Alongside a number of high-profile contracts, such as operating the Docklands Light Railway and London's bike-hire scheme, the firm already runs prisons, performs back-office IT functions, manages air traffic control towers and trains soldiers.
Yet regardless of almost universal support from the City, I'm not a fan. The shares are priced to perfection, trading on a 12.5 times 2009 operating profits (Ebita) multiple, while only paying a frugal 1.3% dividend yield. While the City may be expecting sales growth of 10% for the next three years, I suspect actual results will undershoot.
The outsourcing arena has become much more competitive, with a range of aggressive suppliers such as Capita, IBM, Accenture, Xchanging and Bunzl entering the fray. The resulting price pressure will squeeze Serco's profitability and lead to lower contract renewal (currently 90%) and bid win rates. And with a new political party in power, there is likely to be a temporary hiatus in 2010. Indeed, it may even cancel or shrink some previously awarded contracts, reducing order books and severely testing the company's saintly reputation in the City.
Sure, Serco is a well-run group that delivers predictable and consistent returns. All the same, this late-cycle business is also exposed to contractual and economic risks that simply haven't been factored into a rose-tinted rating. I value the shares at about 375p, or 25% below today's price.
Recommendation: too expensive, SELL at 498p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments
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