Strategic review given headroom with placing
Serco Group (LONDON:SRP) placing of 49.9m shares (approximately 10% of shares in issue) to raise £160m is designed to provide headroom to conduct a thorough strategic review of the group. This follows the IMS, which identified a further knock-on impact from 2013’s difficulties and reflected a more cautious approach to contract risk. With downgraded expectations and a greater than normal H2 profit bias (1/3:2/3 split), the group was likely to be uncomfortably close to covenants at the half-year point. The capital raise removes this danger and allows new CEO Rupert Soames to conduct a thorough nine-month strategy review, the outcome of which will determine the future direction, size and appropriate risk/reward profile of the group.
IMS highlighted further headwinds and caution
The IMS highlighted several key factors that led the group to reduce 2014 operating profit guidance from £220-250m to £170m: specific contract assumption changes; downward margin trends due to mix; and a weaker H1 outlook. H1 profit is forecast at £55m (including £20m non-recurring headwinds) and the group anticipates H2 performance uptick driven by improved contract performance, cost initiative benefits and modest business wins. This followed a contract-by-contract examination of forecast outturn and risks, with additional haircuts applied to provide extra contingency. As a result, we feel that the £170m target should be achievable.
Strategic review will leave no stone unturned
The completed equity placing of 49.9m shares at a price of 320p/share has raised £160m and will provide headroom versus covenants while the group undertakes a thorough root-and-branch strategic review, expected to take nine months. This will probe several key areas: market and competitive position; margin trajectory; organisation; and the optimum balance sheet structure. The duration of the review appears generous, although Rupert Soames made it very clear that a thorough job was preferential to a knee-jerk reaction that could harm medium-term prospects.
Valuation: Caution welcome, but still early days
Shares are down 13% since Monday’s announcement that a downgrade and potential placing was on the cards. Post placing, we anticipate consensus EPS will reduce to around 19p/share, implying a rating of 17.9x CY14 EPS, largely in line with peers Babcock and Capita. While the road to recovery will be long and challenges remain, a combination of market opportunity, management caution and a focus on returns lead us to believe there is scope for a lasting improvement.
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