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I’m bullish on this growth stock despite profit warning sending shares 18% lower

Image: The Motley Fool Editorial.

For companies which have endured a difficult period for a number of years, the turnaround process is never easy. While it is always possible to put together what appears to be a sound strategy, the reality is that there will inevitably be periods of difficulty as the company seeks to recover. Reporting on Wednesday was a company that appears to be in such a situation, but which could deliver high returns in the long run.

A difficult year

The company in question is outsourcing specialist Serco (LSE: SRP). Its performance in 2016 was disappointing, with revenue declining by 13%. This included an 11% organic decline from net contract attrition and an 8% reduction from disposals, partially offset by a 6% currency benefit. Without the impact of positive currency translation, its performance would therefore have been even worse.

As expected given falling sales, underlying trading profit moved 15% lower. While this was disappointing, Serco made progress in improving its business during the year. It is making headway with its five-year plan, and its performance in 2016 was in line with the guidance the company provided at the time of its first-half results. It has been able to reduce operating costs by £450m, with the value of its pipeline of new opportunities up 30%.

Future prospects

Serco stated in its update that it is around half-way through its transformation plan. It expects 2017 performance to be in line with previous expectations, with the market anticipating a decline in earnings of 53% in the current year. The process of restructuring the business will be a painful one which could cause further volatility in the company’s share price in the short run. As such, today’s 18% decline in Serco’s valuation may not be its lowest ebb.

However, in the long run Serco appears to have significant growth potential. It is forecast to record a rise in its bottom line of 66% next year, which puts its shares on a price-to-earnings growth (PEG) ratio of just 0.5. This indicates that it offers a wide margin of safety, which may equate to high capital growth in the long run. Certainly, there is likely to be some disappointment ahead as the size and scale of its turnaround is relatively large, but in the long run it could prove to be a strong performer.

Sector inspiration

Within the support services sector in which Serco operates, G4S (LSE: GFS) has been able to deliver a successful turnaround. Arguably, its performance was never as challenging as that of its sector peer, but G4S nevertheless endured a tough period. The scandal involving prison tags hurt the company’s reputation and may have led to a difficult period. However, it is now performing relatively well and is due to report a rise in its earnings of 16% this year, followed by 9% next year.

Clearly, G4S is a lower-risk option than Serco. Its business is performing well and it does not require a transformation programme. However, its PEG ratio of 1.4 also means there may be less upside than for its struggling sector peer. While both stocks could be worth buying, Serco seems to have the more enticing risk/reward ratio at the present time.

A big mistake?

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.