Saddled with around £1trn of debt, the government’s finances are in a dire state. That’s bad news for suppliers to the public sector, as evidenced by the recent liquidity squeezes and subsequent collapses of Rok and Connaught. But one area that is expected to hold its own is outsourcing. That’s because, irrespective of pricing pressure, any knock to profits should at least be partially offset by volumes gains as the government continues to farm out activities to third party operators, such as Interserve.
Interserve’s businesses include running services for schools, prisons and hospitals, maintaining the sentry boxes at Buckingham Palace, and cleaning British law courts. And it is still winning new work. An example is the coveted three-year £200m facilities management contract with HSBC, covering its 1,600 retail and 120 office sites across Britain. The government accounts for about 35% of turnover, with the rest coming from private clients, such as Sainsbury’s, Thames Water, Toyota, and BP.
What’s more, the group sports a £4.5bn order book, providing excellent revenue cover of 90% and 60% for this year and next. Its exposure to the Middle East is a further attraction. Indeed, the firm makes 40% of its earnings from the region, and in an upbeat statement on 16 November, CEO Adrian Ringrose said that this is only going to go up.
Interserve (LSE: IRV)
As for the numbers, the City forecasts 2010 revenue and underlying earnings per share of £1.9bn and 38.5p respectively, plus a 9.2% yield. True, Interserve is not for widows and orphans. Nevertheless, I think the chances of the dividend actually being cut are slim – the payout is twice covered and the proforma net debt of £75m represents only 1.1 times EBITDA. Better still, Ringrose said that the firm is “trading in line with expectations” and is anticipating a “stronger” second half year.
Personally, I would rate the stock on a ‘through-the-cycle’ EBITA multiple of eight, assuming a sustainable margin of 3%. After adjusting for the £75.8m pension deficit (net of tax), debt and £67m PFI portfolio that delivers an intrinsic worth of approximately 295p per share.
On the downside, investors need to be aware of the usual dangers associated with managing large, multi-year contracts, collecting debts in the Middle East, and future austerity measures. All the same, given that rivals such as Capita and Serco are rated on p/e ratios of more than 15, Interserve looks a well-priced play on future growth in outsourcing. The next trading update is scheduled for 11 January.
Recommendation: SPECULATIVE BUY at 191p (market cap £252m)