A year can be a very long time in the markets – just ask Serco. Until this time last year, the services business was a market darling, having grown very quickly over the preceding decade due to its exposure to UK public sector outsourcing. When the government did not have the know-how – or occasionally the stomach – to cut costs, Serco could be relied upon to step in.
The market was optimistic about the company’s prospects and, for a number of years up until early 2013, its share price traded on a valuation that reflected this rosy outlook. Since then, however, Serco has experienced a number of bumps in the road, including an investigation by the serious fraud office into allegations it had charged for ‘tagging’ criminals who were actually in prison or did not even exist.
At the same time, the company has seen a significant amount of change in its management. when that happens – and especially with businesses where long-term contracts play an integral part – there will always be scope for things to go wrong or for new management to take a different view to their predecessors on the profitability of individual deals. Partly as a result of the above, the company also won few new contracts, which adds a further headwind to future prospects.
This has seen Serco’s profits expectations downgraded quite considerably and now, with its profit-to-debt ratio having reached an uncomfortable level, the company has had to come to the market to raise some new equity. This is in spite of the fact a newly appointed chief executive, former Aggreko boss Rupert Soames, has only just formally taken his seat at the board table.
Indeed, the equity placing document contained some interesting wording to the effect that the deal was only being done to buy the new CEO enough time to formulate a new strategy. In other words, it was no more than an interim measure to make sure the business had a degree of financial stability whilst Soames got the measure of things, and there was nothing to rule out Serco returning to the market for more money further down the line if the new CEO felt it necessary.
You will not be surprised to discover we believe there are a number of value lessons to be drawn from this tale of woe – the first being it is a graphic illustration of why we avoid businesses that trade on rich valuations. For long periods this can appear to be a poor strategy, but the danger of a high valuation multiple is that if anything happens to impede the progress the market has priced in, that valuation premium can disappear very quickly.
As this often coincides with a fall in profit expectations you can end up seeing a very meaningful and very swift drop in the share price, which is why the value perspective looks to do the complete opposite and buy companies where valuations and thus expectations are depressed. Not only can these stocks absorb a lot more bad news but also, if things actually turn out to be better than the market expects, they can then see a meaningful uplift.
Another value lesson – particularly in the context of ‘growth’ companies – is that, once that profit outlook starts to change, things can unravel very quickly indeed because that is not what the business or it employees are used to dealing with. Things going even a little bit wrong can send ripples – very quickly and at times quite savagely – through the business and its financials, and it can be difficult to change the mind-set of the company from one of rapid growth to one of stabilisation and recovery.
It is because businesses can see their financial prospects change so quickly that, even if all looks to be going swimmingly, we prefer to focus on businesses with strong, sensible balance sheets. Serco’s combination of steep valuation and vulnerable finances have conspired to make the first half of 2014 a time to forget for its shareholders.