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Are Serco Group plc And G4S plc Doomed?

Labour will mount an assault on big outsourcing companies if it wins the election, reducing their role in delivering the government’s back-to-work programme and exploring a plan to force them to pay all workers above the minimum wage in exchange for Whitehall contracts,” the Financial Times reported this week.

More bad news for Serco (LSE: SRP) and G4S (LSE: GFS) — both outsourcing groups should engineer a way to disappear from investors’ screens.

Management Buyouts

g4sThe solution? A management buyout would be one obvious option if the two businesses were financially sound — but they are not. Their cash flows are problematic. High leverage is an issue, particularly for G4S, which paid £135m in interests last year. Its operating profit came in at £142m.

Additional risks include: restructuring charges, impairment of goodwill, legal settlements, merger and related restructuring charges, other “unusual” items, and asset write-downs. They all had a big impact on the performances of Serco and G4S in 2013. Will 2014 be any different?

Dividend Cuts 

Serco stock is falling. Revenues are falling. Margins are under strain. Its reputation is in tatters. Net leverage is still within covenants only because Serco raised new equity capital earlier this year. Another cash call should not be ruled out.

sercoVery simply, Serco is a business in disarray. Forget about estimates for P&L items, its cash flow statements tell the story of a company that: a) is struggling with working capital outflows; b) will likely need divestments to keep up with debt repayments; c) will soon have to cut its payout ratio.

There is no reason why Serco should stick to its dividend policy. The same applies to G4S. “G4S dividend policy is to grow dividends in line with underlying earnings growth,” G4S states on its website. G4S dividend stood at £130 in 2013, but net losses were £362m.

Last year, Serco paid out £51.5m, i.e. more than 50% of its net income.

Downside Risk

In early May, Serco asked the backing of private investors to raise fresh equity for £160m. If its dividend policy remains unchanged, Serco will give shareholders back a third of that amount this year — and that capital will be taxed. Dear me.

Its bankers — the placing was led by BofA Merrill Lynch and JP Morgan — should have advised their client to cut the payout and raise less than £160m, which meant a hefty dilution for shareholders. Serco’s share count grew by about 50 million new shares to bring the total number of shares outstanding to 537 million. 

Based on the fair value of its assets, Serco has a 49.9% downside. After a large cash injection in 2013, G4S recorded a drop in earnings before interest taxes depreciation and amortisation (EBITDA), so its net leverage shot up to 4.6x from 3.4x in 2012. Even assuming bullish estimates for EBITDA growth, G4S’s debt position will remain problematic for some time. Based on the fair value of its assets, downside is 23.3%.

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Alessandro doesn't own shares in any of the companies mentioned.