Investment View: Serco's super growth makes it worth the risk


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The Independent Online


Our view: Buy

Price: 544.5p (+0.5p)

Credit Serco with this: it runs one part of London's publictransport system that actually works. Perhaps that's because the trains on the Docklands Light Railway don't feel the need for a bonus on Boxing Day: They don't have drivers.

In the meantime, the company yesterday told investors that everything remains on track. Serco has sold out of a couple of operations – one providing education software and the other data hosting – for £6m. So the sales will generate a £25m loss.

That's not too clever. Handy that the news could be slotted into a pre-close update in the last full trading week before Christmas. Perhaps that's being cynical, though, because the generally positive tone sent the shares higher.

It is also worth noting that gains on disposals earlier in the year will cancel out the loss and a £5m donation to a new charitable foundation (bless 'em, full of Christmas spirit) announced yesterday.

So the forecast £270m of pre-tax profits for 2012 won't be significantly impacted by one-off charges.

On the face of it, Serco should be finding the going rather difficult. More than £9 out of every £10 it generates in revenue derives from governments, and while it has been branching out into the private sector, the public sector will still be its mainstay for some time to come.

Fortunately, its operations are global. And, what's more, some embattled governments with big deficits (like ours) have been outsourcing an increasing number of services.

That helps to explain why the group won £4.2bn of orders in the first half, against £2.5bn in the previous year. At the half year the company boasted a £19.4bn order book, with a further pipeline of £31bn of "identified opportunities" worldwide.

The group has since won £1.4bn of contracts, bringing its year-to-date total to more than £5.6bn.

It is worthy of note that when The Independent looked at this company this time last year its order book stood at £16.6bn. That's some growth.

Serco appears to be winning in the current tough climate, although it hasn't all been plain sailing. The US, in particular, has proved tough, although Serco is hardly alone in being a British company that has struggled stateside. However, it has won a $70m (£43m) contract to upgrade military vehicles, while the company's US Army career-transition services contract and its patent-office classification contract have seen expansions worth around $100m combined.

If there is a downside to Serco it isn't so much in the company's ability to win new work, it is in the potential for some of the jobs it has won to blow up in its face. When government contracts go bad, the negative publicity can be brutal.

While ministers and civil servants who muck up contract negotiations tend to be first in line, companies holding badly negotiated state contracts which don't work well for the end user can suffer too and damage outsourcing's reputation generally.

Providing a sprawling range of services across a huge range of sectors, Serco executives need to be on the ball to ensure all is well at a time when it is growing very quickly.

If they needed an example of what can go wrong, they might like to pop over to G4S for a sit-down with Nick Buckles about the disastrous Olympic security contract – remember that?

G4S has still to recover from the reputational damage, and even through its shares look cheap (10.3 times next year's forecasts with a prospective yield of 3.7 per cent) I'd steer clear until it has proved it is clear of the fallout.

For its part, Serco has the £175m Compass asylum-seeker support services contract which has started full operations. Imagine the Daily Mail's glee if something goes awry with that one.

That said, Serco is probably worth the risk. If it proves able to effectively manage the new business it is putting on at a rate of knots investors will be well rewarded.

The shares are hardly expensive by historic standards. They trade on 12.3 times 2013 forecast earnings, with a forecast yield of 1.8 per cent, which is acceptable enough given the rate at which the company is growing. Serco's shares have been drifting downwards in recent weeks. I'd take that as a buying opportunity.