value and opportunity

Serco Plc, the British outsourcing company, used ro be a stock market favourite for a long time. Especially in the 2000s, Serco was able to increase its profit ~10 fold from 0,04 pence per share in 1999 to around 40 pence in 2012.

Then however, a little bit similar to Royal Imtech, problems and some scandals piled up and culminated in an accounting bloodbath for 2014. Serco showed a total loss of 2,09 pounds (!!) per share, eliminating pretty much all profits made from 1999.

After raising a smaller amount of capital last year, Serco announced a large 1:1 capital increase at a sharp discount in early March, the rights have been split of on March 31st. Serco wants to raise some 500 mn GBP with the majority being used to lower the outstanding debt (currently around 600-700 mn).

Looking at the stock chart, Serco shareholders have suffered a big loss, especially compared to competitor G4S which, despite relatively similar problems, has recovered well:

Normally, I would not look at a “turn around” case like Serco at all, but in this case it might be different. The difference is the new CEO, Ex Aggreko CEO Rupert Soames:

Soames surprised everyone in early 2014 when he left Aggreko after leading the company for 11 years and with great success. For anyone who has read an Aggreko annual report, one knows that Soames was not only a succesful CEO but also a very good communicator. I can highly recommend to read those reports as they are very interesting.

Before asking for shareholder money, he actually said that he will not take his guaranteed bonus for 2014 which I found was a very good gesture.

After enjoying the Aggreko reports I decided to look into the 2014 annual report and especially the “CEO Letter” from Soames to see what he has to say.

I was positively surprised by the openness how Serco’s problems were adressed, both from the Chairman and Soames himself. It is the classic tale of too much growth through acquisitions combined with a lack of integration and bad execution. Other than at Royal Imtech, it doesn’t involve outright accounting fraud.

One rarely gets to read such a good description of the problems of a company and the historic context (page 9 of a turnaround case. This is then followed by a clear change in strategy, namely to focus on Government services and get out of “private” contracts altogether. Overall the strategy section looked very well thought out and not unrealistic to me.

Further in the report, I found this interesting statement:

Historically, the key metrics used in forecasts were non-GAAP measures of Adjusted Revenue (adjusted to include Serco’s share of joint venture revenue) and Adjusted Operating Profit (adjusted to exclude Serco’s share of joint venture interest and tax as well as removing transaction-related costs and other material costs estimated by management that were considered to have been impacted by the UK Government reviews that followed the issues on the EM and PECS contracts). We believe that in the future the Group should report its results (and provide its future guidance) on metrics that are more closely aligned to statutory measures. Accordingly, our outlook for 2015 is now expressed in terms of Revenue and Trading Profit. The revenue measure is consistent with the IFRS definition, and therefore excludes Serco’s share of joint venture revenue. Trading Profit, which is otherwise consistent with the IFRS definition of operating profit,adjusts only to exclude amortisation and impairment of intangibles arising on acquisition, as well as exceptional items. Trading Profit is therefore lower han the previously defined Adjusted Operating Profit measure due to the inclusion of Serco’s share of joint venture interest and tax charges. We believe that reporting and forecasting using metrics that are consistent with IFRS will be simpler and more transparent, and therefore more helpful to investors.

This is something whcih I haven’t seen before that actually a company is going back from “adjusted” reporting to statutory which I find is very positive.

Another good part can be found later in the statement from the CFO (by the way another Aggreko veteran) regarding the implementation of ROIC:

A new measure of pre-tax return on invested capital (ROIC) has been introduced in 2014 to measure how efficiently the Group uses its capital in terms of the return it generates from its assets. Pre-tax ROIC is calculated as Trading Profit divided by the Invested Capital balance. Invested Capital represents the assets and liabilities considered to be deployed in delivering the trading performance of the business.

I always like to see return on capital as an important measurement for businesses and implementing this is clearly a great step forward.

Another interesting fact from the Renumeration report: Both new board members have significantly lower salaries than the old, outgoing board members. Soames has a 800 k base salary, Cockburn 500 k. both pretty reasonable numbers.

However the big problem for me is that I know next to nothing about the business of Government outsourcing. So for me it is at this time very difficult to assess how attractive the stock is and how long it will take to recover.

The current management is clearly a good one but I am not sure if the underlying business is a good one as well. Especially those long-term contracts do seem to contain significant risks. Page 50 and following pages in the report provides  a very good view in great on what can go wrong with long dated contracts. In many cases, Serco was locked into fix price contracts and costs went against them without having a chance to do anything about it.

On the other hand, the 1,5 bn write-off for sure is conservative and one could/should expect that it contains some “reserves” which might be released in coming years.

Deeply discounted rights issues in general

Another word of caution here: A couple of discounted rights issues I looked at in the past were actually not very good investments.

Severfield was a good one with around +50% outperformance against the Footsie since the rights issue in March 2013. KPN even outperformed the Dutch Index by ~+62% in the two years and Unicredit even more than 70%.

On the other hand, Monte di Pasci underperformed by -70% against the index since their rights issue  and Royal Imtech by -45%. EMAK finally performed more or less in line with the index over time after the capital increase.

So overall, the score of outperformers to underperformers would be 3,5:2,5. With Royal Imtech it was pretty easy to see that it would be difficult, as there was a significant accounting fraud involved. BMPS also looked like a big problem as the rights issue was to small and another one is in the making.

So the question is clearly: Is Serco more like Severfield/KPN or Royal Imtech ? For the time being I would rather look at Serco more positively, mostly due to management.

Not surprisingly, analysts hate Serco. the company has one of the lowest consensus ratings within the Stoxx 600. This alone is not a reason to buy, but at least might explain a potential under valuation. A final note: Soames might not be a bad choice for running a Government outsourcing company. His ancestry should ensure some viable contacts at government level:

Rupert Soames can just remember his grandfather, Sir Winston Churchill. His earliest memories are of playing cowboys and Indians with Britain’s wartime prime minister – and of not being allowed to attend his state funeral. He was six at the time and furious: “Watching it on TV was a very poor substitute,” he once said.

His family has long been part of the political establishment: his father Christopher was the last governor of southern Rhodesia, now Zimbabwe, who served in Margaret Thatcher’s cabinet and was also a European commissioner, while his brother Nicholas is a current Tory MP.

Summary:

Overall, the Serco case does look interesting. A brilliant management team is trying to turn around a troubled Government contractor with a transparent and plausible strategy. On the other hand, the business is a difficult one or at least I do not have a lot of knowledge about this sector so I need to digg more into it.

So for the time being, I will watch this from the sidelines and maybe try to learn more about this sector in general.