The Investment Column: Outsourcing expert Serco set to benefit from scope and flexibility

Royal & Sun Alliance; Dunelm
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The Independent Online

Our view: Buy

Share price: 453.25p (-1.75p)

The support services group Serco has identified potential orders worth £27bn – enough to keep it busy for the next 10 years based on its current workload. Of course it has to win the contracts first, but that is not proving a problem: it is awarded 50 per cent of new bids and 90 per cent of rebids.

The company's portfolio of contracts spans defence, prisons, railways, the armed forces and nuclear power. The order book stands at a record £14.7bn after a successful year gaining new business overseas.

Contracts won include work on anti-terrorism systems for the US, the operation of an Australian prison, and a deal to run the Dubai Metro, while at home it will manage a new immigration centre and develop a robotic system to move goods around a hospital.

Serco is a member of a consortium aiming to take charge of the decommissioning of Sellafield in Cumbria. Analysts will have to look again at their forecasts if it is successful. Figures of £500m have been mentioned for the work.

Last year's profits reflected the new business gains, particularly in the US, and rose 17 per cent to £123m. If anything the credit crisis could benefit the group as stretched finances of both the public and private sector accelerate the drift to outsourcing of essential services as a cheaper alternative to increasing their own direct labour costs.

Serco's scope – it now services 10 major business sectors in 30 countries – gives it the flexibility to re-direct resources if there is a softening if any one market or region. With strong organic growth acquisitions are unlikely, unless they offer strategic benefits not otherwise available within the group. Serco already has 91 per cent of current year revenue under its belt, with 76 per cent for 2009 and 63 per cent for the following year.

The shares have remained well up with events, moving in a narrow band over the past year, and although they currently sell on a pricey 21 times current forecasts for 2008 remain attractive. Buy.

Royal & Sun Alliance

Our view: Hold

Share price: 142p (+0.5p)

In case anyone had wondered, Royal & Sun Alliance is not a bank. It has no holdings in monoline insurers, credit-backed bonds, US municipal bonds or US sub-prime residential securities.

But, of course, what RSA – as it now wants to be known – does have is exposure to floods, fires, even earthquakes, bad drivers and other natural disasters.

What RSA is hoping is that markets will begin to decouple insurers like itself from other financial stocks such as banks and realise that they are a much better investment risk.

But while RSA has some control over events, it cannot as yet control the weather. So those floods in the UK last year gave it a soaking, leaving a bill of £120m.

Despite the claims, however, RSA managed to lift its operating profits by 4 per cent to £814m, better than expected, while its combined operating ratio – the key measure of costs to premiums – edged up to 94.9 per cent, much in line with expectations.

Net written premiums were up 6 per cent at £5.8bn, reflecting a strong performance from its international business – mainly Scandinavia, followed by Canada – which achieved above average growth. There was also an encouraging result from its fast-developing business in emerging countries, although it did decide to pull out of Venezuela with a loss of £13m.

Group underwriting profits fell 10 per cent to £278m, pulled back by the UK, which managed a profit of £65m despite the floods. Although competition remained tough in the UK it was able to push through rate rises of 3 per cent on property and 8 per cent in motor. The new tougher approach to writing potentially unprofitable lines meant it walked away from £350m of business.

The investment performance was solid, with a 4.4 per cent improvement in its portfolio, compared with 4 per cent last time.

The shares, selling on 8 times expected earnings, offer little excitement while financial stocks remain out of favour. Hold.


Our view: Buy

Share price: 154.5p(+9.5p)

Dunelm proves it is possible to be a retailer in the UK without losing your shirt. The company is among the top 10 retailers operating in the homewares market – selling bedding, cushions, curtains, bathroom products and kitchenware. There are 88 stores, most the size of a B&Q shed, where shoppers spend an average £30 a visit.

Starting life from a market stall, the firm has remained loyal to its roots and keeps it simple, offering the widest choice of merchandise at the best possible price. First-half profits grew by a quarter to £27m on sales of £197m, while operating margins nudged up to a healthy 14 per cent.

Dunelm believes there is scope to roll out up to 150 stores, underpinned by data showing that the homewares market is growing at 3.4 per cent a year. Sales during the first half grew by 4.9 per cent, but there are ominous signs of a slowdown, with current trading just 0.9 per cent higher.

One explanation could be a weaker housing market, although the counter-argument is that people often spend on home improvements when they are unable to move.

The shares have been caught in the retail sell-off over the last year, down 36 per cent, but staged a mild rally yesterday, to sell on a little over 9 times current year forecasts. That looks cheap.