Serco slips as UBS cuts rating by two notches

Investing.com -- Shares of Serco Group (LON:SRP ), the British outsourcing and public services company, fell over 4% on Friday after UBS analysts downgraded the stock by two notches to "sell" from "buy," citing stalled earnings growth and mounting headwinds. 

The downgrade comes alongside a reduced price target of 140p, down sharply from the previous 220p, reflecting UBS's concerns over the company’s ability to sustain growth in the coming years.

As per UBS, Serco, which has seen a significant turnaround over the past seven years, is entering a period of flat earnings growth, driven by slowing contract momentum and tighter government spending. 

The brokerage expects earnings per share to remain flat over the next three years, with key contract expirations and limited new order wins expected to weigh on financial performance.

The report flags that Serco is facing a slowdown in contract momentum, with revenue declines anticipated from three of its largest contracts in the next two years. 

UBS’s revised order intake model suggests that the company would need to achieve historically high win rates to meet consensus expectations for organic growth and profitability. 

However, the analysts remain skeptical about Serco’s ability to surpass these benchmarks in the current economic environment.

UBS also pointed to a period of margin consolidation for the company. While Serco has made strides in improving profitability on existing contracts, the analysts caution that further gains could prove challenging, given rising cost pressures and a tightening fiscal environment. 

Contractual profitability improvements in smaller deals have reportedly plateaued, further limiting upside potential.

Serco’s US defence business was cited as a bright spot, with a solid performance track record. 

However, UBS notes that this division remains relatively small compared to key peers and is unlikely to offset broader pressures across the company’s portfolio, particularly in regions outside the US, where performance has been weaker.

The downgrade comes amid broader concerns about government spending trends, a key driver of Serco’s revenues. 

With the company trading at roughly 10 times its expected 2025 enterprise value to EBITA, UBS notes that Serco is in line with its mix-weighted peer group. 

However, the analysts argue that this valuation does not adequately reflect the company’s weaker earnings outlook, especially compared to peers projecting earnings growth of 5-8% over the same period.

The revised price target of 140p is based on a discounted cash flow analysis incorporating the revised growth and margin assumptions. 

Despite an upward adjustment in Serco’s 2024 EPS forecast due to better-than-expected trading, cuts of 10-15% to 2025-26 estimates underscore the pressures UBS foresees.

Source: Investing.com