Gamble of the week: A healthy British supplier

The fortunes of UK suppliers to the public sector vary hugely. The likes of Rok and Connaught have hit the corporate graveyard, and Mouchel is in bad shape. By contrast, support services and construction group Interserve (LSE: IRV) is in rude health.

Last Tuesday, the firm released a pre-close trading statement saying that it had bagged £1bn of new orders in the first half of the year, as it seeks to become one of the biggest providers of government services. New work was won from the Ministry of Justice, Alliance Boots, Sainsbury’s, and West Yorkshire Police, from whom a £150m contract was secured. This all comes despite the challenging backdrop of sticky inflation and government cutbacks.

Other opportunities are piling up too. The company is bidding on three out of nine prisons that are being privatised, along with tendering for probation services in a joint venture with Durham Tees Valley Probation Trust. Furthermore, it is shortlisted against Serco and Virgin for a groundbreaking deal to provide social services in Devon.

The pennies are also being tightly managed – CEO Adrian Ringrose notes that “trading has been underpinned by strong cash generation” and that “the recent partial disposal of its interest in University College London Hospitals will generate £35m in cash”.

Meanwhile, its support services arm is on target to hit margins of 5% by 2013, compared to 3.6% in 2011. And although the board’s recent full-year guidance was unchanged, I suspect this could be an expectations management exercise. I think upgrades later in the second half of the year are possible if the positive momentum continues.

One key risk is that many of the newest contracts are now much larger and more complex than previous deals. So they include terms on payment by results, which tie a proportion of earnings on prison contracts to a range of variables, such as prisoner rehabilitation rates. Nonetheless, a £4.5bn order book (as at December) provides excellent income visibility. And the firm’s exposure to the fastest expanding regions of the Middle East and the rest of the world (35% sales) is an extra bonus.

The City is forecasting 2012 revenue and underlying earnings per share (EPS) of £2.3bn and 44.7p respectively, with a 5.5% dividend yield (twice covered). I rate the stock on a through-the-cycle EBITA multiple of eight, assuming a sustainable profit margin of 4%. After adjusting for the £56m pension deficit and £44m of net debt (0.7x EBITDA), I get an intrinsic worth of about 410p per share.

Investors need to be aware of the usual dangers associated with managing large multi-year contracts, collecting debts in the Middle East and the government’s austerity drives. But with rivals such as Capita and Serco rated much higher, Interserve looks a good bet on the ongoing expansion of outsourcing. Interims are due out on 15 August.

Rating: BUY at 330p (market cap £420m)

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