Questor share tip: Is Serco 12-year low a major buying signal?

Serco
133.3p +9.8p
Questor says AVOID

OUTSOURCING group Serco [LON:SRP] saw its shares soar more than 8pc higher yesterday after touching a 12-year low at the end of last week, so is now the time to buy?

In March, Rupert Soames, who joined last year, outlined his strategy to turn the company around. The plan was unveiled alongside a deeply discounted rescue rights issue to bolster its balance sheet. The company needed to identify problem contracts, repair its finances, then shrink to a more manageable size.

When Mr Soames took control, he issued a “bring out your dead” call for management to review all the troubled contracts, which led to an annual pre-tax loss of £1.35bn.

The contracts also blew a hole in the balance sheet, which was plugged by the an equity raising of £555m, with £450m being used to reduce the company’s debt burden.

Having completed the first two tasks, Serco is now concentrating on reining back its overseas presence, starting with pulling out of India.

Serco acquired Indian-outsourced accountant and call centre business Intelenet in 2011 in an attempt to diversify away from its core UK defence market and into the emerging markets private sector. The company paid a premium, splashing out up to $630m (£385m) to buy the business from private equity owner Blackstone.

The division is now up for sale with a price tag of between $450m and $500m. Blackstone looked at buying it back but has since dropped out, and now only private equity rival CVC is left in the race. Joe Brent, analyst from broker Liberum, thinks the price could ultimately fall as low as about $310m (£200m).

Serco’s shares have tumbled from a peak of 558p in July 2013 to just 117p on Friday last week, in the process dumping the company out of the FTSE 100 index.

It expects £90m trading profit in 2015 on revenues of about £3.5bn, and analysts from broker Liberum have pencilled in pre-tax profits of about £60m, giving earnings per share of 8.2p.

The company has given no guidance for 2016, but Liberum expect pre-tax profits to fall to £42m, on revenue of £3.18bn, giving 4.2p in earnings per share in 2016.

The big problem that Mr Soames is grappling with is that outsourcers agree to deliver a level of service at a fixed price for a number of years. If the costs rise faster than anticipated, then the profit can be wiped out very quickly and the company can then find itself locked into a loss-making contract for years.

The company received another knock last week when its prisoner transport contract in Western Australia was put out to tender. Serco had been running the five-year contract since 2011, and a possible extension was not taken up.

Serco may have accepted its past sins, but it still has a difficult future. The order book at the end of the year stood at £12.6bn, a drop of £1bn on the same point last year. The loss of a big contract to operate Northern Rail, which is due to end in January 2016, will see £250m knocked off the revenue next year.

It is in the middle of a multi-year restructuring, refocusing on being a lower profit margin company that delivers services for the UK government. The shares still hold a lot of risk for investors given that revenue and profits will fall for the next two years.

The shares also pay no dividend and debts will continue to rise even though the rescue rights issue went some way to plugging the gaps. The cash raised from selling the Intelenet business would have been useful so any cut-price deal would be a blow.

We said Serco was a “classic falling knife share” at 362p in July last year, and reiterated our advice to avoid the shares at 183.7p on March 12. We need to see some more stable profit figures before changing our view. Avoid.