“The company’s combination of steep valuation and vulnerable finances have conspired to make the first half of 2014 a time to forget for its shareholders.” That is how we concluded an article back in May on former market darling Serco’s fall from grace – and investors in the troubled services business are unlikely to remember the second half of the year with any great fondness either.
November saw Serco issue its fourth profits warning of 2014 alongside the news it was writing down the value of its assets by £1.5bn – of which about a third related to various onerous commitments it has agreed to fulfil over the coming years. The group also announced it would be looking to raise £550m in a so-called ‘rescue rights issue’, which comes on top of the £160m it raised from investors in a placing in May.
The latest reduction in forecast profits also means the group is set for some uncomfortable discussions with its banks – in order to “negotiate amendments to the operation of covenants” – so former Aggreko boss Rupert Soames, who was brought in as chief executive early this year, clearly has his work cut out as he seeks to steady the ship and repair Serco’s balance sheet.
This article is not meant in any way as a ‘we told you so’ – honestly – but to explain why at present we have no interest in owning Serco at its current share price of 166p (closing price on 05/12/14). After all, with the share price having fallen from a high of 683p in July 2013, regular visitors to The Value Perspective might be forgiven for thinking the company might present a compelling proposition for us.
That it does not comes down to the importance of focusing on movements in value rather than just movements in price. On the basis of price alone, that 75%-odd collapse over the past 18 months is indeed interesting to us – but only as a signal to take a closer look at what has happened to the company to assess its valuation and the associated investment risks.
There are three reasons such a big share price fall has yet to result in a valuation we find compelling. The first is the starting point because, as we suggested in that earlier article, the market used to think Serco was a wonderfully consistent growth business and so valued it at a considerable premium to the average business in the market. A sizeable share price fall was therefore required just to unwind this premium rating – let alone lead to an attractive valuation in miserly, value-focused eyes such as ours.
The second is the normalised level of profits to which we apply these valuation multiples. Through a variety of imprudent growth, optimistic expectations and flattering accounting, Serco’s historic sales, profits and profit margins were higher in the past than they are likely to be in the future when the business is run on a more sustainable basis.
Management warn revenues could fall as low as £3bn to £3.5bn in 2016 – from £4.8bn in 2014 – as contracts expire without being replaced and Serco sheds unprofitable parts of the business to focus on its profitable core. This may be the right thing for management to do but the change in scale needs to be borne in mind when thinking about the profits it is reasonable to expect Serco to make at the end of its recovery process in three to five years’ time.
The final issue is simply the cash the business will burn as it restructures itself and works through some of those onerous contracts, the longest of which is set to run until 2022. These three things combined explain why Serco’s share price has been able to fall such a long way and yet not give the company a recovered valuation three to five years out that looks attractive enough to compensate us for the risks of being involved.
None of which means, of course, that we are correct in our view or that Serco will not go on to be a profitable investment from here. Nor does it mean there are no circumstances where we would be happy buyers of the shares – all else being equal, at or below a particular price, we would be. However at The Value Perspective we are always focused on what we are getting for our money and, despite the grim-looking share price chart, what we would currently be getting is not something for which we would be happy to pay the current share price