Questor share tip: Serco a sell ahead of rights issue

Serco
343.8p-60.7
Questor says SELL

SERCO’S fall from grace has been rapid and painful for investors. The company issued its third profit warning yesterday and said it would need a rescue rights issue just two days before the arrival of new chief executive Rupert Soames. Any recovery now looks as though it will take much longer than first imagined, sending shares sharply lower, and we are struggling to see any attractions here.

The outsourcing group, a former stalwart of the FTSE 100, has seen a huge destruction of value during the past 12 months. The company was valued at about £3.4bn when the shares reached a decade-long high of 683.5p on July 8 last year, but having slumped to 343.8p yesterday, a share price that is approaching the lows of the 2008 financial crisis, the company was worth £1.59bn.

It is easy to say that the advice we are leaning towards here is to buy high and sell low. However, with the very real prospect of a rights issue on the horizon we feel it is necessary to ensure that good money is not thrown after bad.

The recovery at the outsourcing group will now take longer than expected. When Serco released its annual results last month, the full-year profits had fallen by more than half from £281m, to £107m. There was good reason for this; the investigation into the botched prisoner tagging contract and subsequent loss of work cost Serco dear. However, the market consensus was for a speedy recovery in pre-tax profits to £187m in the current year.

Serco said yesterday that things were looking worse than they had originally thought and “ may in turn require a material downward revision to expectations”. That is a profit warning to you and me. The update was high on impact, sending the shares more than 20pc lower, but light on detail.

Analysts from Liberum thought the “shock statement” meant the margins on long-term contracts could slip by about 1pc. That doesn’t sound much. But Serco is a low-margin business and reported an adjusted operating margin of 5.6pc in its latest annual results. So a small 1pc slip in profit margin on £5.1bn of revenue could see up to 20pc knocked off the profits, say Liberum. And that would equate to pre-tax profits of about £150m for the current year, down from previous expectations of about £187m.

Falling profitability isn’t the only problem; paying fines is costing cash and that is sending the debt levels much higher. The amount of spare cash that Serco made fell from £181m to £84.8m last year. The level of net debt – total debt less cash – increased to £725m at the end of last year, and that could rise again to around £800m in the current year. That makes the equity position look risky when the net asset value of the company is £1.1bn, and £1.3bn of that amount is made up from the value attributed to acquisitions made during the past decade.

Serco also has some major contract rebids within the next nine months, the biggest of which is the Australian Immigration contract, responsible for 9pc of revenue and even more in terms of profits due to the high margins. A decision is due in December. The outsourcer has previously had a strong retention rate on contracts, but could struggle given the negative press.

Serco shares are rated on P/E ratio of 13.5 times adjusted earnings per share of 24.5p (after today’s profit warning). The company has falling margins, rising debt and revenue risk, so even after today’s sharp correction we cannot recommend supporting a rights issue. Sell.