Market Commentary - Housing, Infrastructure, Construction and Services
Serco is the only HICS sector stock to provide news today. The company has delivered half year numbers in line with earlier statements about performance first indicated on 25th May. Morgan Sindall topped the HICS league table again yesterday with a 4.5% rise to 638p. G4S had a bad day, falling 2.4% to 179.9p as a large broker produced a sell note having a good swing at the FX rate impact of recent changes, margin potential, scope for a dividend hack and high net debt.
Serco is the only HICS sector stock to provide news today. The company has delivered half year numbers in line with earlier statements about performance first indicated on 25th May. Operating profit, underlying, was £65.2m in the period, in line with the earlier statement that it would be not less than £65m, boosted by one-off factors on the period. The one-offs are the result of good management and some contract running longer than expected. There are two bits of news in the release this morning that will aid sentiment. The first is that future workload might be in better shape than expected as the company won £0.9bn of signed contracts in the period (excluding its share of the AWE contract of £0.7bn for the next three years) and the pipeline is over 10% higher at £7.3bn. The second is that costs are now £550m lower on an annualised basis compared with the first half of 2015. The key issue therefore is when and how will shareholders see the benefit of those efforts. More below.
Morgan Sindall topped the HICS league table again yesterday with a 4.5% rise to 638p. Management are doing the usual “Dog and Pony” show that is required post results and clearly convincing folk of their case. The numbers speak well in any event but seeing the white of management’s eyes is a necessary part of the process. Guidance suggests that a consensus at 75p of EPS this year has upside risk and as we pointed out yesterday, a return to “norm” sector margins (driven by better risk assessment and management) provides the potential to nearly double current levels of earnings.
G4S had a bad day, falling 2.4% to 179.9p as a large broker produced a sell note having a good swing at the FX rate impact of recent changes, margin potential, scope for a dividend hack and high net debt. There is no doubt that the turnaround of one of the world’s largest private sector employers is taking time. But all of that ignores the fundamental strengths of the company in its markets, the progress made to date and the potential to get the balance sheet back in order. The potential for a cut in the dividend is at the heart of the current “scare” and with the company holding the final payment for 2015 level earlier this year it is an easy topic to pick out. In the absence of cash generation from disposals the company has limited scope to raise the pay-out but equally has no pressing need to reduce it either.
Serco has been keen for some time not to raise expectations and today re-iterates previous guidance that the good performance, in financial terms, in the first half (compared with 2014 and 2015) is likely to be weaker in H2 and that the outlook for 2017 is unchanged. Revenue of £1.49bn in the period is a tad higher than expected given FX rate moves and several contracts being prolonged and the retention of the Environmental Services operations. The key areas in the last two years have been operating costs (already mentioned), the balance sheet (which is now back in shape with net debt at £120m, 0.5x EBITDA) and improving performance sufficient to retain client loyalty and build for the future. The latter will take time to emerge but from the evidence today of new work wins and the pipeline that looks to be in shape as well. The corporate renewal programme also seems to be working and while the company’s work is such that it attracts attention the reports of incidents have been very few. Furthermore substantial investment has been made in the infrastructure of the business (IT, procurement, benchmarking/experience sharing) that could lead to further performance improvement. The company state that there may be potholes and with over 500 contracts geographically spread it can never guarantee smooth passage on all of them, all of the time. That will not alter but what is clear is that the demand for outsourced work from the public sector is still positive.
The statement contains much detail, all of which is as expected and hints that the shareholders getting some return is at the front of management’s efforts. The company states that it will not pay a dividend but confirms that it is committed to resume payments as soon as it can. The problem remains that operating cashflow is impaired by the onerous contracts; free cash flow was a small inflow of £1.5m which is an improvement on last year as working capital cycles are now more normalised but is not yet sufficient to share with investors. We suspect that the company might be in a position to say something more positive about dividend size and timing by the middle of next year but 2018 is probably the earliest shareholders will see some reward. The progress towards becoming a £3bn+ pa revenue company making 5-6% margins appears to be on track.
Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.