Are Serco shares a good investment?

Serco Group is a FTSE 100 listed support services and outsourcing company.  It has over 100,000 employees, international operations and provides a wide range of operational and process related  services.  Recent contract wins include ground maintenance in Canterbury, operation and maintenance of a new Bus Rapid Transport System in Indore, India, and an extension to continue running the Docklands Light Railway.

Shares in Serco Group currently trade at around 560p.

Financial results

Any investment in shares should be seen as a long-term commitment.  The standard advice is to have a time horizon of five years or more, and I think that’s sensible.

Since you should be expecting to hold your shares for five years or more, it makes sense to look at the long-term financial results of the company, rather than just what they’ve done in the last year or two, as you may still be holding the shares five or ten years from now.

Growth – Serco’s growth rate is about 18% a year over the last decade.  In comparison, the companies that make up the FTSE 100 have grown on average by about 4% a year over the same period, so Serco’s growth rate is some 350% higher than average.

There is an element of industrial “wind at their backs” when it comes to this growth rate though.

I own shares in MITIE, Mears and Interserve, all of which are in broadly similar support services and outsourcing businesses.  Each of these companies has seen rapid growth over the last decade and more, partly due to the outsourcing boom which has taken place in that time.

This means that much of Serco’s growth is probably driven by being in a growth industry, rather than being driven by some general superiority over its peers.

Consistency – Serco is top of the class in terms of consistency, with a 100% track record of profitability and dividend payments, and a 100% record of growing sales, earnings and dividends in every single year.  By comparison, the FTSE 100 companies as a whole have only hit these targets 74% of the time.

Debt – Debt levels at Serco are somewhat high, but given the consistent and growing nature of the company, this may not be a problem.

Debt interest payments (£28 million) are around 11% of recent profits.  While I prefer it to be less than 10%, I certainly wouldn’t call that excessive.

Total interest bearing debt (£880 million) is about four times profits, which is close to, but below my maximum allowable level of five.

Cash generation – Dividend income is one of the most important sources of returns, and it’s worth checking that the dividend is sustainable in the long run.  One way to do this is with free cash flow, and in the last decade Serco generated about four times more free cash flow than it paid out in dividends, which is a healthy margin.

Overall then, Serco is large, prosperous, internationally diverse and cash generative.  It’s exactly the sort of defensive investment  I would add to the UK Value Investor Model Portfolio, but only at the right price.

Current valuation

No company is worth an infinite price, so there must be some consideration of how much value you’re getting for your money.  Valuation, in most cases, is the most important part of the investment puzzle, so it’s critical that you pay a sensible price.

Price to earnings – The price to earnings ratio with the share price at 560p is 15.6.  That’s relatively high, but not outlandish.  In the last decade, Serco has earned an average of 19.4p per share, and the price today is 28.9 times that amount.  This ratio of price to 10 year average earnings (called PE10) is a handy way to compare the share price to a stable measure of the company’s earnings power.

A PE10 of 28.9 is quite high, and I’d prefer to see it under 20.  In comparison the FTSE 100’s PE10, with the index at 6,250, is 13.7.

However, to some extent it’s worth paying up for above average growth and consistency, so a company with a consistent growth record is usually worth some premium (but not too much), on the assumption that growth will continue into the future.

Dividend yield – The historic yield is currently 1.5%, so shares in Serco are definitely a growth investment rather than an income investment.  A smaller yield may be acceptable, as long as the company has high earnings (giving the possibility that dividends may be raised quickly), or more growth and consistency than average over the long-term.

A low growth business combined with a low yield may not provide the returns you’re looking for.  Again, in comparison the FTSE 100 has a yield today of 3.5%, which means an immediate income some 130% higher than that from Serco.

Conclusion

Serco is a business growing faster than average, with more consistency than average.  It has somewhat high debt levels, but not too high for my liking.  The problem is the price.

At 560p it is priced at a premium to the FTSE 100, in other words, to the average large business.  That’s fine in itself, because it’s probably a better company than average due to its above average growth and consistency.  But the premium is too steep, for me at least.

Serco is currently ranked at number 56 on the UK Value Investor Stock Screen.  This screen ranks every FTSE 350 stock with a consistent dividend history, and it ranks them on growth, yield, value and consistency.  Ranked number 56, Serco is ahead of the FTSE 100 (effectively a giant conglomerate) which is ranked at number 79 out of a total of 155.

If I were to add Serco to a watch list, I would set the alert for 300p.  At that level it would have a yield of almost 3%, a PE of 8, and it would rank in the top 20 on the UK Value Investor Stock Screen.

Combined with Serco’s high growth and high consistency, a price that low would create a very compelling opportunity.  Unfortunately it would probably take some pretty bad news to get the shares to that level, which is why investing is simple, but not easy (as Richard Oldfield of Oldfield Partners would say).