Serco is ideally positioned for Government budget cuts

Serco

528p -3

Questor says BUY

UK public debt is ballooning out of control. This means that whichever political party wins next year's election, it will have no choice when it comes to public spending – it has to be cut or there will be dire consequences.

The Confederation of British Industry's (CBI) Blueprint for Balancing Budget and Supporting Economic Growth report, released last month, suggested that the current government has been overstating economic growth prospects for the next few years. The CBI calculated that an additional £120bn needed to be taken out of current spending to balance the budget for 2015-16. This will be no easy task – and the private sector will have a substantial role.

"The skills and experience necessary to achieve reform in the delivery of public sector services, such as change management, process re-engineering, culture change and communication, are specialised and rare throughout the economy, but can be found, to a greater extent, in the private sector," says Ian McCafferty, CBI chief economic adviser. "The public and private sectors will need to work closely together if these much-needed reforms are to be delivered."

This is why Questor is bullish on the prospects for the outsourcing industry as a whole – whatever government gets elected next year, although it seems likely that there will be a higher degree of outsourcing if the Conservatives gain power.

The public sector has to become more efficient. What's more, many of the services offered will have to increase future capacity to meet projected needs as the population grows.

Serco is ideally positioned to be able to capitalise on its trend. The company describes itself as "improving essential services by managing people, processes, technology and assets more effectively".

The company has already won contracts to deliver the Government's Flexible New Deal, in which it will train jobseekers across Wales, the Midlands and Manchester. This is unlikely to be scrapped whichever party gets the keys to Number 10 next year.

Other contracts Serco holds include operating London's Docklands Light Railway, maintaining the UK's nuclear weapons, and running the National Physical Laboratory. The latter means it is responsible for the atomic clock that tracks Greenwich Mean Time.

Last week's trading update was positive. Serco said it had secured £1bn of contracts so far in the second half, bringing the total for the year to date to £4.5bn. This strong order book provides excellent visibility of revenues. In the US, Serco said it had won contracts worth about $700m (£416m). The company also said it expected to meet current full-year forecasts.

Serco should show strong growth in the future – that's why the shares are trading on such a high rating. The December 2009 earnings multiple is a heady 19 times, falling to 16.3 times next year. The yield, at 1.1pc, is very unimpressive – however, there remains significant scope for the payout to be increased as the dividend is covered by earnings more than four times. Questor would like to see further progress on the dividend next year.

The shares were first recommended at 455.9p on September 2 and they are up 16pc since their initial recommendation. Despite the high rating, the stance remains buy because prospects for the outsourcing sector look solid.

Cineworld

148¼p -5¼

Questor says BUY

As the recession deepened, more and more people visited the cinema as it was regarded as a cheap night out. The trend was helped by a string of major film releases such as Harry Potter and the Half-Blood Prince and Ice Age 3.

Cineworld was a beneficiary of this trend but there have been worries about prospects in 2010, when the company will be up against strong comparables. Some analysts have also been concerned that Saturday and Sunday TV – citing the success of The X Factor and Strictly Come Dancing – means that people are less likely to go to the cinema at the weekend.

However, although 2010 may be tougher than this year, Cineworld could benefit from the move to 3D films.

Cineworld is the market leader in 3D films and next year's release schedule in this format is strong – including James Cameron's Avatar, Tim Burton's Alice in Wonderland and the next film in the Saw horror franchise.

There is even talk of previous blockbusters such as Titanic being reworked in 3D and re-released.

Revenues at Cineworld rose 6.5pc in the 43 weeks to October 23, the company said in a recent update, with revenues from the box office jumping 10.9pc.

Customers also spent more on items such as popcorn and other refreshments. Retail revenue rose 5pc in the quarter, against a 0.1pc rise in the same quarter last year.

The shares were first recommended at 120p on May 15 and they are now 24pc ahead of their recommendation price. Trading on a December 2009 earnings multiple of 9.6 times, some may argue that the valuation is pretty full.

However, Questor is always focused on dividend payments as, over the long term, this is what really drives the increase in valuation of an investor's portfolio. With the shares yielding a relatively secure 6.5pc and the future looking steady, the stance remains buy.