Stephen Rawlinson
30 June 2017 · 2 min read

Market Commentary - Housing, Infrastructure, Construction and Services 30th June 2017

Serco has released its trading update today and Interserve has told us that FD Tim Haywood will leave the business at end November. Serco’s top team is however, being cautious in its approach. In conclusion on Serco, management is doing what it said it would do. However, it is taking longer than they and many others might prefer as there appears to have been many weak contracts in the portfolio.

Kier’s site visit to Reading created a positive impression on us. The sector moves yesterday were mainly down, only Mears and Homeserve were in positive territory with rises of 3.5% and 0.5% respectively.

Serco has released its trading update today and Interserve has told us that FD Tim Haywood will leave the business at end November. Serco’s main news is the high level of order intake which at £2.4bn YTD is at a high level. Albeit that £1.5bn is for Grafton prison in Australia. The company point out that with the £1.6bn of new work won in 2H’16 the 12 month run rate is a record level. We are not hearing industry remarks that the work has been won at the wrong price so the mid term future is looking more secure. The company also states that it is trading in line with expectations for revenue and trading profit in 2017, which are £3.1bn and £65-70m respectively. In terms of numbers the pre-close statement shows all other aspects to be as expected with net debt between £150-200m at year end.

Serco’s top team is however, being cautious in its approach. It is handling a turnaround in an international business with some poor contracts with a long duration. On the international issue the headline numbers have benefitted from currency translation and FX remains volatile. The company indicates that its guidance is subject to swings in FX. In terms of the longevity of the contracts the transformation is taking time because the company cannot simply walk away from the bad deals of its predecessors and maintain credibility with the customers. The benefits of geographic diversity and long term earnings stream will be evident in the future but, more time to reshape is needed and it was never promised to be quick fix.

The company also states that the environment in several markets has become more unpredictable. The comment is vague regarding markets and territories. We may get a more specific indication of that reference later today. We are hearing from several services companies with UK exposure that the post 8th June election decision making in HMG has slowed; the Queen’s Speech was focussed on Brexit as we know so the business of government on other matters may have stalled. That is not necessarily a bad thing if contracts are extended but only if they are if they are profitable. Shareholders may need to make stronger noises if they are unwilling to subsidise taxpayers on long term loss making contracts.

In conclusion on Serco, management is doing what it said it would do. However, it is taking longer than they and many others might prefer as there appears to have been many weak contracts in the portfolio. The upside will emerge, as the contract win rate attests. Organic revenue fell 8% in the first half as old contracts are worked through and the new ones will take their place so the required churn is happening; the revenue decline at constant FX is masked by the decline in the value of sterling. The share price closed at 118.5p last night and EPS this year will be round 3p. Serco’s position as one of few companies able to handle large scale, complex services contracts to the public sector provides it with a differentiated position in its markets. There is a substantial requirement for such skills, so, strategically the company is well placed, based on the simple dimensions of track record on contract delivery and demand. Of course, there are other elements as well but the core strengths and appeal exists and are being improved. The sunny uplands of £3bn pa revenue from long term contracts and margins at 5-6% are still on the horizon, but it looks like 2019 is the earliest they will be fully noticeable.

Tim Haywood’s departure from Interserve is to be expected as new CEOs brought into difficult situations need to have fresh blood in the role, usually somebody they have chosen. It’s one of the “rules” of the game. New CEO Debbie White arrives on 1st September and the release tells us that a new FD is being sought. The main problems at Interserve are in Construction and the new CEO’s background is in services so the new FD may need to have some knowledge of building contracting to be complementary. Negotiating complex construction contracts post event is an art in itself.

Kier’s site visit to Reading created a positive impression on us. The site was near to Reading’s football ground, just by the M4 motorway. The site itself was less important than the formula for development the company uses, of which this site is one example of many. It takes risk when buying sites but, its knowledge of construction and willingness to de-risk projects with the early sale of land and developments, makes each situation relatively low risk/high return. The only substantial risk might be at the macro level. The sites are usually a mixture of retail, commercial and very light industrial. If the economy is heading for a dip then clearly there is some risk, especially around consumer spending. Kier can adjust somewhat to that but not insure against it completely. This part of Kier had a very strong 2H we suspect, based on the evidence shown in the slides yesterday and will have delivered around £25m of operating profit in the year ending today after £6.9m in 1H. The share price at 1229p at close last night and with 108p of EPS expected this year does not shout out as particularly cheap. However, the company has reaffirmed the 2020 Vision of 10% CAGR and based on the evidence yesterday the Property division is capable of making its contribution, in full.

The sector moves yesterday were mainly down, only Mears and Homeserve were in positive territory with rises of 3.5% and 0.5% respectively. Companies keep telling us that life is tough and while earnings forecast are being maintained few are rising. The main loser was G4S as it fell 2.7%, possibly due to FX as sterling strengthened against the US$ yesterday but also as there is a retrace of recent strong increases. The stock is now back in the FTSE100 and the trackers may have been boosting he price in the short term as they sought to be weighted accordingly. The other key element yesterday was the companies sensitive to interest rates and big infrastructure had a tough day, Costain, Balfour Beatty and Morgan Sindall all slipped by more than the average; they fell by over 2% in each case so the move is not substantial but the pattern in recent weeks is towards one step forward and two back. Given the current uncertainties it’s no surprise that investors might be nervous.

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