The trading update released today by Serco (LSE: SRP) did little to convince me that its stock is a fair buy at this price, in spite of a 14% surge in early trade. In fact, I’d rather choose G4S (LSE: GFS) or Capita (LSE: CPI) if I were to invest in the outsourcing sector. Here’s why.
Distressed Asset
I warned in June 2014 about the perils of investing in Serco, and ever since the stock has lost 60% of value. It currently trades at 130p but I am not interested, although opportunistic trades may find a compelling argument to buy into it — a change of ownership, for instance.
Management said that trading “in the year to date has been a little better” than it anticipated, confirming guidance for the year, according to which revenues will likely to be around £3.5bn, trading profit will hit £90m, while earnings before interests, taxes, depreciation and amortisation is expected to come in at about £160m — these figures are consistent with half-year revenues “of not less than £1.7bn”, and trading profit “of not less than £45m.”
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As its restructuring continues, Serco also noted that its indebtedness is going down, and “taking account of other non-trading movements, including cash exceptional costs as previously indicated, net debt at 30 June 2015 is anticipated to be approximately £350m (31 December 2014: £682m).”
A rights issue has helped it fix its balance sheet, but “free cash outflow for the 2015 financial year as a whole is expected to be approximately £150m.”
I need to see a positive free cash flow yield before suggesting that the business is sustainable.
G4S & Capita
G4S is a more valid alternative, although its financial are not completely reassuring and I doubt that capital appreciation will be meaningful over time.
Its stock is up 4.7% over the the last 12 months, while trading multiples based on earnings, cash flow and book value suggest that its stock is fully priced right now. Moreover, a high forward dividend in the region of 3.6% signals risk rather than opportunity, and I am not comfortable with its net leverage position based on its cash flow profile.
It’s certainly a safer bet than Serco, but it may not be worth the pain, I’d argue — and there are better options, such as Capita, whose stock has risen 7% over the last 12 months and 14% since the turn of the year.
Its operating and net margin double those of G4S and are also much higher than Serco’s, which is one element I like, while its net leverage is more manageable, and that is reflected in a lower dividend yield, which stands at 2.6% on a forward basis.
Trading multiples do not point to a bargain trade, though, and that’s one of the reasons why I’d probably look elsewhere for value.
