Share tipster Paul Hill picks the worst tip from the week’s press and brokers’ reports. This week: 2006 may have been a good year for this outsourcing group, but trouble lies ahead.
Turkey of the week: Serco (SRP), tipped as a BUY by UBS
Serco is one of the UK’s top outsourcing groups, making 74% of its turnover here. It also has units in North America, Europe, Australia and the Middle East. Activities range from facilities management, projects and IT systems, to the creation of new businesses. It maintains buildings, runs scientific establishments, operates railways and detains offenders. About 90% of its income comes from the public sector.
The basic model is for customers to outsource non-core activities. Serco then streamlines and integrates these within its larger operations, meaning cost savings for the client and better customer service. It’s win-win for both parties, and unsurprisingly the market has become crowded with suppliers, such as Capita, IBM and Accenture. Serco’s high-profile contracts include running the Docklands Light Railway and providing engineers for the US Postal Service.
After an excellent 2006, where revenues (£2.5bn) and earnings per share (16.6p) rose 13% and 42% respectively, Serco last week said it had made a good start to 2007 – signing or being appointed preferred bidder for £1bn of contracts. The board is also confident of delivering double-digit growth, widening margins and meeting City hopes. This confidence was underpinned by contract retention rates of 90% and a huge £13.9bn order book at the end of December.
Serco is well run and delivers predictable and consistent returns, which cuts its cost of equity and pushes up its rating versus the market. But there are serious risks to be considered. In particular, delays to new contracts, the mispricing of agreements, negative press coverage (eg Jarvis’s role in the Potters Bar rail tragedy) or the loss of a major customer could seriously damage the company’s credibility in the City. Furthermore, even though Gordon Brown had the air of someone who had pots of cash in March’s Budget speech, the reality couldn’t be more different. After years of massive spending, the purse strings are finally being reigned in. Public spending is set to slow from a current growth rate of over 3% a year to an average of 2% until 2011. The pinch will be felt across all government departments and no doubt extend into the outsourcing sector.
So how much is Serco worth? 2007 earnings per share is seen coming in at 19.3p, rising to 22.0p in 2008. On the fundamentals, I would value the shares on a 2007 p/e ratio of about 20, generating fair value of around 390p per share – or 30% below current levels. I believe it is now time to take profits.
Recommendation: Take profits at 511.5p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments