Jefferies downgrades Serco to 'hold,' citing profit headwinds, limited growth

Investing.com -- Jefferies has downgraded Serco Group (LON:SRP ) to "hold" from "buy," reflecting a cautious outlook on the company's near-term earnings momentum, in a note dated friday. 

Shares of the public services provider were down 2.4% at 06:32 ET (11:32 GMT).

The move comes amid a combination of challenges that have been weighing on Serco’s performance, including headwinds from its immigration contracts and UK National Insurance, which are expected to continue impacting results.

As per Jefferies, despite the company's strong positioning in key markets, including US defense, the company's larger contracts may not be enough to counterbalance the pressure. 

Specifically, the loss of the Australian immigration contract, anticipated reductions in UK immigration services, and the expected decline in US CMS contract revenues are expected to have a significant impact on Serco’s profits. 

These headwinds, alongside the UK National Insurance issue, are projected to result in a combined profit shortfall of over £55 million in the 2025-2026 period—roughly 20% of the company’s group profit.

While Serco is working to mitigate these challenges with cost reductions and productivity gains, the analysts at Jefferies suggest that the company may struggle to meet its guidance of £260 million in profits for FY25. 

In fact, the expected earnings trajectory for the company between FY24 and FY26 is largely flat, with no profit growth expected over this period. 

This marks a shift from earlier expectations, with the analysts now estimating a decline in earnings per share for FY25-26 by 13-15%, in line with the broader consensus.

Serco’s guidance for FY25 also reflects this muted outlook, forecasting flat organic growth, following a 3% decline in FY24. 

Although this includes significant headwinds from large contract losses, the analysts caution that the ongoing volatility and uncertainty surrounding the company’s contract renewals make it difficult to forecast where sustainable growth will settle. 

Although Serco has a substantial bid pipeline, with contracts valued at £10.2 billion, win rates for these contracts have declined in FY24, indicating a limited growth recovery for 2019.

Jefferies does see some potential upside for Serco in the form of its £500 million surplus capital, which could be deployed for mergers and acquisitions over the next year. 

If the company opts to pursue M&A opportunities, this could be accretive to earnings per share by as much as 12-15%, particularly if Serco leverages its balance sheet to move towards the higher end of its management’s target leverage range.

Despite the potential for growth through M&A and buybacks, the near-term outlook remains subdued.

The new price target of 175p based on a revised 7% free cash flow yield indicates that while there is still some upside potential, the risk-reward profile is less appealing.

Source: Investing.com