Serco Investment Case

Having exited our commercial exposure in recent years, Serco is now focused almost entirely on delivering services to governments.  We are a trusted partner of governments, combining people, processes and technology to achieve our purpose of delivering superb public services.

• We operate in five areas of government service: Defence, Justice & Immigration, Transport, Health and Citizen Services, and deliver them in the UK, Continental Europe, North America, Asia Pacific and the Middle East.

• While being a focused and specialist B2G business, we think it beneficial and a competitive advantage, to diversify our exposure to individual governments and sectors.

• Increased resilience: Demand in any one sector or from a particular government can be changeable. Being diversified by sector and geography reduces the risk when demand reduces in a particular area and positions us well to capitalise on opportunities in areas where demand is strong. The overall effect is our diversification reduces volatility, making our business more resilient.

• Competitive advantage: Governments across the world face similar challenges, and we believe that we can gain competitive advantage and deliver value to customers by operating internationally.

• Most companies operating in our market are heavily focused in either a particular sector, or within a geography; in our market, Serco is a rare beast, operating among five sectors and four regions.

We estimate the total annual value of government services in our target segments and geographies that could be provided by the private sector is around £300bn, of which around £100bn is delivered by private companies. Key aspects of our market are:

• The supply-side is fragmented; as a leading international supplier, our market share within our existing footprint, at around 3%, is small, although it is larger in some specific segments within certain sectors.

• We estimate market growth is 2-3% as a weighted average across our geographies.

• There is significant opportunity for growth, given that around two-thirds of the services that could be provided by the private sector are currently self-delivered by government.

The business of providing services to government is attractive in the long term for a number of reasons:

1. In many areas of public service provision, private companies, properly managed, can deliver services of higher quality and lower cost than governments can themselves.

2. Governments will continue to face relentless pressure to deliver more and better public services, at lower cost, and that this will lead them to focus relentlessly on value for money and the quality of service provision. This pressure comes from what we call the ‘Four Forces’ comprising:

• the unavoidable increase, at rates above GDP growth, of demand for public services across important areas of government. Examples are the pressures on health and social care driven by ageing populations, and growing prison populations;
• the need to reduce public debt and expenditure deficits;
• rising expectations of service quality amongst public service users; and
• the reluctance of voters and corporate taxpayers to tolerate tax increases.

3. Its enduring nature compared to other markets. All around us we see markets being disrupted and long-established business models being fundamentally challenged by technology. While some areas of government will benefit from the ability to manage massive data and will find new ways to interact with citizens, which we are responding to, we also believe that there will be a continuing and enduring need for the kind of frontline services Serco provide. We are confident that in thirty years’ time, sick people will still go to hospitals, and when there they will have their rooms cleaned and food served predominantly by humans. That when people break the law they will be sent to prison where custody officers will look after them; and that complex defence infrastructure such as near-space radar will still be maintained predominantly by human beings, who will need to be security cleared, again by other human beings.

4. Although a national government can wield the power of a monopoly purchaser in their own country, every country has a government (or multiple governments if you consider state and local bodies too), and with an international footprint together with a range of service offerings, agile suppliers can move to where the demand is and where they can get a fair return for the risk they take on. In a market with low barriers to both entry and exit, suppliers can move, but governments cannot.

We set out several years ago that we believed annual revenue growth of 5%+ and a trading margin of 5%+ should be deliverable in the longer term. Between 2017 and 2020 we delivered 10% three-year compound revenue growth and 33% compound growth in Underlying Trading Profit.

The medium- and long-term outlook is currently harder to predict as the lasting impact of Covid-19 is still uncertain. But we have already started the task of considering the changes and opportunities that may arise and intend to present our conclusions in the second half of 2021. Our initial view is that Covid-19 will put even more pressure on governments to provide more and better services for less, and this is positive for our market. There is likely to be an impact on the mix of demand for services provided by the private sector to governments and our business model, which is designed to be agile, is well-suited to this.

We therefore see no reason to change our view that in the long-term Serco should be able to grow its revenues by, on average, around 5% a year, and deliver trading margins of 5%.

For several years our cash flow was negatively impacted by onerous contracts. Having now almost completely worked through these, our business should be strongly cash generative. Although it may vary in any one year, we expect cash conversion of 80%+ on average.

We have a clear set of capital priorities; our target financial leverage is 1-2x net debt to EBITDA and with that strong balance sheet in place we will use cash for investment in the business to generate organic growth, to fund bolt on acquisitions and to pay dividends to our shareholders.