Its time to bet on a bounce for Serco (LSE: SRP) and G4S (LSE: GFS), the bulls argue. Those in the bear camp, meanwhile, point to further downside. Whos right? Here are a few things you should know about both companies.
Performance, Opportunities & Risks
Serco stock is down 21% since 27 June, when I noted that downside was about 50% based on the fair value of Sercos assets. Meanwhile, G4S stock has lost only 2% of value, but this doesnt mean that G4S is a better investment than Serco.
On the one hand, the UK outsourcing market offers opportunities for well-managed companies as efficiency and cost reduction measures are being sought in the public sector. On the other hand, the industry is faced with several headwinds, including regulatory and impairment risks.
Moreover, in spite of recent weakness in the shares of some of the major players, the UK outsourcing sector is not particularly cheap, either. The outlier is Capita (LSE: CPI), which is finding it easier to grow its business as rivals struggle. Capita stock isnt attractive at its current price, however, given that it trades at 2x and 13x forward revenue and forward adjusted operating cash flow, respectively.
Serco: A Takeover Target?
Sercos revenue are unlikely to grow for a long time. Operating profitability may hold up under a best-case scenario, but even then earnings per share will unlikely grow significantly over time. The shares are incredibly expensive based on most trading multiples, in my view. Of course, investors may take the upbeat view that after a plunge of 43% in Sercos stock price this year, Serco may become a takeover target. In fact, with a market cap of 1.5bn and an enterprise value of 2.1bn, Serco could easily be swallowed by a larger player such as Denmarks ISS.
First problem: there arent many competitors that could pay up in this market. Second problem: trade buyers are also struggling to create value right now and M&A doesnt seem the most likely option in this environment. Third problem: private equity firms wouldnt be able to lever up Sercos balance sheet to justify the return on investment.
Dilution risk should also be a real concern for Serco shareholders, while it remains unclear how the company will manage to stick to its generous dividend policy in the near future.
G4S: Forecasts & Downside
Admittedly, G4s is in better shape than Serco. Thats reflected in the relative valuation of its shares.
Forecasts for revenue and operating profit are encouraging, but G4Ss balance sheet is stretched, and although a cash call has provided a boost to G4Ss liquidity profile, net leverage will likely remain problematic for some time. Investors betting on G4S would do so hoping that management will deliver, but a cut in the payout is a distinct possibility. On 27 June I estimated a 23% downside, and I still expect more pain for shareholders
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.