Why I’d Dump Serco Group plc As It Surges 10%+ & Buy G4S plc Or Capita PLC Today

The trading update released today by Serco (LSE: SRP) did little to convince me that its stock is a fair buy at this price, in spite of a 14% surge in early trade. In fact, I’d rather choose G4S (LSE: GFS) or Capita (LSE: CPI) if I were to invest in the outsourcing sector. Here’s why. 

Distressed Asset

warned in June 2014 about the perils of investing in Serco, and ever since the stock has lost 60% of value. It currently trades at 130p but I am not interested, although opportunistic trades may find a compelling argument to buy into it — a change of ownership, for instance. 

Management said that trading “in the year to date has been a little better” than it anticipated, confirming guidance for the year, according to which revenues will likely to be around £3.5bn, trading profit will hit £90m, while earnings before interests, taxes, depreciation and amortisation is expected to come in at about £160m — these figures are consistent with half-year revenues “of not less than £1.7bn”, and trading profit “of not less than £45m.”

As its restructuring continues, Serco also noted that its indebtedness is going down, and “taking account of other non-trading movements, including cash exceptional costs as previously indicated, net debt at 30 June 2015 is anticipated to be approximately £350m (31 December 2014: £682m).” 

A rights issue has helped it fix its balance sheet, but “free cash outflow for the 2015 financial year as a whole is expected to be approximately £150m.”

I need to see a positive free cash flow yield before suggesting that the business is sustainable. 

G4S & Capita 

G4S is a more valid alternative, although its financial are not completely reassuring and I doubt that capital appreciation will be meaningful over time.

Its stock is up 4.7% over the the last 12 months, while trading multiples based on earnings, cash flow and book value suggest that its stock is fully priced right now. Moreover, a high forward dividend in the region of 3.6% signals risk rather than opportunity, and I am not comfortable with its net leverage position based on its cash flow profile. 

It’s certainly a safer bet than Serco, but it may not be worth the pain, I’d argue — and there are better options, such as Capita, whose stock has risen 7% over the last 12 months and 14% since the turn of the year.  

Its operating and net margin double those of G4S and are also much higher than Serco’s, which is one element I like, while its net leverage is more manageable, and that is reflected in a lower dividend yield, which stands at 2.6% on a forward basis. 

Trading multiples do not point to a bargain trade, though, and that’s one of the reasons why I’d probably look elsewhere for value. 

For instance, I'd certainly consider a transport company mentioned by our Motley Fool analysts in this free investment reportIts balance sheet is solid, and its stock price has risen 15% in the second quarter -- but forward p/e multiples in the region of 14x/12x suggest that upside could be much higher into 2016 and beyond. Furthermore, if you are after a solid yield play, consider that its forward dividend yield is almost 3% and is properly financed and covered.

I flagged this stock some time ago; it has now drawn the attention of analysts at Barclays, HSBC and UBS, who raised their price targets by 10% in recent days. So, download our free report right now and find out more about your next trade!

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