Questor: Serco is getting back on its feet and profits are gaining momentum. Hold

Questor share tip: a first dividend from the firm since 2014 and improvements in margins suggest that investors can afford to be patient

Russ Mould 3 March 2020 • 5:58am

A Serco flag — There seems (thus far) to be limited risk to the Serco's supply chain from the coronavirus Credit: Darren Staples/REUTERS

More than three years after our initial analysis of Serco, the support services group, the investment case is moving on from a turnaround story to one that offers growth potential.

Last week’s full-year results showed a return to organic sales growth, record order intake of £5.4bn and a bulging £14bn order book. Improved profits and good cash conversion also helped management to recommend a 1p-a-share dividend, the first distribution of any kind since 2014.

This could provide a springboard for further improvement in 2020 and beyond. Rupert Soames, the chief executive, has said he expects 20pc growth in underlying operating profits to about £145m.

That implies a margin of 4.2pc: better than the 3.6pc achieved last year but still below the 5pc-6pc range of which analysts feel Serco is capable if revenues flow as planned, cost control remains good and the sales mix shifts further towards America and defence-related businesses.

If a 6pc margin could be achieved it would mean huge increases to current earnings forecasts, which would help to assuage any concerns over valuation. A forecast price-to-earnings ratio of 20.4 for 2020 cannot be described as a bargain, especially for a business with a 3.6pc historic operating margin, and even if the dividend nearly doubles in 2020 the yield is still just 1.3pc.

But the potentially substantial earning uplift, if all goes well, could see the forecast earnings multiple drop to the low-to-mid teens, a far less forbidding prospect, especially as further reductions in debt are planned.

As this column regularly notes, lower debt means less risk and less risk can mean a higher earning multiple. If profits are growing at the same time, substantial capital gains can result.

There are still risks. One is that currency movements are currently proving unhelpful. In addition, Serco has acquisitions to digest and it still manages a complex book of large long-term contracts where any blunders could prove costly in terms of profits and reputation (and therefore future business flows) – something to bear in mind as 40pc of 2020’s forecast revenues come up for extension or re-tender in the next three years.

But earnings momentum appears to be gathering, there seems (thus far) to be limited risk to the firm’s supply chain from the coronavirus and the prospect of higher profits, lower debt and increased dividends could reward further patient support.

Questor says: hold

Ticker: SRP

Share price at close: 150.2p

Update: DCC

Market shakedowns such as the one witnessed in recent weeks as a result of the coronavirus crisis are a reminder of the importance of valuation.

Paying lofty multiples to gain access to an appealing narrative or a firm’s profit stream, cash flows and dividends can lead the unwary investor into trouble, even if the fundamentals of the stock in question do not necessarily come under pressure.

Such considerations prompted this column to steer clear of DCC, the energy, healthcare and technology distribution specialist, about two years ago. The firm has done little wrong since, embellishing its record of long-term profit growth by supplementing organic momentum with select acquisitions.

May’s full-year results should also see DCC add to a record of increases in its annual dividend that stretches back to 1999. And yet the shares have now fallen by about a fifth since our initial study of the company and valuation is the most likely explanation.

The shares were trading on 20 times forecast earnings and a yield of 2pc at their autumn high – a big premium and a big discount respectively to the FTSE 100 even though analysts expect earnings to grow at a low single-digit rate in each of the next two years.

The current forecast earnings multiple of around 14 is more like it, but there is no need to get involved just yet.

Questor says: avoid

Ticker: DCC

Share price at close: £55.54