MIDAS SHARE TIPS: Defence role boosts profits at Serco

You don’t have to have a particularly long memory to associate Serco with outages, fines and fraud.

But despite previous breaches, the outsourcing company continues to find work in recession-resistant markets such as immigration, defense and the Orwellian-sounding “Citizen Services” sector.

The company has come a long way since it was founded in 1929 to provide services to the cinema industry, before switching to sound equipment for the British War Office during the Second World War.

Now you’ll find it running a diverse selection of projects, including maintaining the UK’s air defense radars, running six prisons and managing the ferries between Orkney and the Shetland Islands.

These examples are just the tip of Serco’s sizable iceberg, which also includes controversial areas such as the detention of asylum seekers and the former Covid Test & Trace system.

Like it or not, the company is rarely out of the news. To give just one example, this week the Serco-run Yarl’s Wood asylum seekers’ center in Bedfordshire was the subject of a report highlighting an ‘increase in violent incidents’ due to a lack of progress in cases.

But while Serco is not the investment for those who like to keep their holdings out of the spotlight, it compensates by being a defensive stock for tough times like these. At the end of last month, it upgraded its earnings outlook as many of its services are in high demand.

Mark Irwin, the group’s CEO, said governments around the world look to Serco to help with the “complex and difficult challenges they face.”

One of the group’s strong performers is the newly acquired European immigration service provider ORS. This helps to make up for the winding down of much of Serco’s Covid work, which boosted revenues during the pandemic.

Analysts raised their earnings targets for the company following the update, with RBC’s Andrew Brook saying there is now “high visibility for 2023” and raising his earnings per share (EPS) forecast for the year by 7.5 percent.

Peel Hunt’s Christopher Bamberry raised EPS targets by seven percent, saying the company is “well positioned to meet current macroeconomic challenges.”

While there is optimism for 2023, that doesn’t mean Serco couldn’t surprise negatively next year.

Brook, at RBC, notes that some of the contracts the company manages will expire in the coming years, and there is still some uncertainty about the Australian immigration contract Serco has.

Serco’s longtime shareholders have had a rough time. Serco shares were 459p in 2013, before a Serious Fraud Office investigation and fine sent them tumbling down. Today they are 156p, down 12 percent over the past 12 months.

That puts them at a relatively undemanding valuation of 11 times earnings in a higher-rated industry, and with a two percent dividend yield to boot. The company also has the advantage of being cash-generating, meaning its balance sheet is strong.

The company is well positioned to benefit from anticipated increases in government spending on immigration and defense in many parts of the world, which appears to give it an advantage.

Midas verdict: Serco is not without risk. The loss of Covid-related work has forced it to replace it with other contracts, and it is not always easy to make up for the shortfall.

If the company loses the Australian immigration contract, due for renewal this year, it could depress earnings, while Asia-Pacific revenues are expected to be lower.

The company’s tendency to work in high-profile and controversial areas such as immigration has also led to scandals in the past, something extremely bad for stock prices.

However, there is no suggestion that current management is likely to lead the company into this kind of trouble, as former CEO Rupert Soames is credited with resolving any issues at the company, leaving it in stronger shape.

At 156p, the shares are a buy.