Should you trust struggling Serco?

After Serco Group's criminal tagging contract scandal last year, the outsourcing firm's profits have been battered along with its market value, which has halved since last summer. But at these low levels, are the shares worth buying? It all depends on new management's ability to restore confidence. It will not be easy.

In the six months to June, operating profit was nearly all but wiped out, falling 92% to £9.9 million, and Serco posted a reported pre-tax loss of £7.3 million. Earnings per share crashed from 17.18p to a 1.27p loss this year. Strip out a host of one-off charges and operating profit still fell 65% and by 74% at the pre-tax level.

"The challenges have been numerous," admitted new chief executive Rupert Soames. "Costs increased particularly to improve performance on operationally-challenged contracts; previously higher-than-average margin work reduced in volume or was lost on re-bid; and we have won less new work."

But Soames does seem to be making progress. Free cash flow rose to £52 million, dividend per share was flat at 3.1p and net debt fell has fallen by £166 million since December to £559 million. Full year revenue guidance was maintained at £4.6 billion and operating profit should be at least £155 million. After previous profit warnings, this can only be reassuring for investors, with confidence in the company's outlook improving further with the draft of new leadership.

As part of Serco's restructuring - total cost in the first half was £14.5 million - Soames has coaxed another employee from Aggreko, its interim chief executive and Soames' former lieutenant Angus Cockburn, who will be Serco's new finance director. While this restructuring has been taken well by investors, it's worth remembering that many employees jumped ship after the scandal broke.

"It's going to take time to heal these wounds and restore confidence and trust and as always actions will speak louder than words," said Soames. But the company has split analysts, with Investec maintaining its 'sell' recommendation as it remains to be convinced that Serco can meet its guidance. It also reckons another rights issue is on the cards.

Analyst Andrew Gibb said: "Whilst the Corporate Renewal Programme and Strategy Review are proceeding to plan, there is clearly much work to be done. The fact that out of the 40 major contract opportunities going into 2014, the group has lost eight and secured just two, highlights its poor win rate. With the value of new larger bids falling to £8 billion from £12 billion six months ago, the turnaround will be slow."

He does see potential in Serco's turnaround story, but stresses that it will not be "an overnight success." Gibb warns that "there appears to be more downside risk, as the Strategy Review digs deeper into the broad contract base", lowering his target price to 290p.

However, JPMorgan keeps its 'neutral' rating on the stock. "On the positive side, we believe that after a difficult year, some stabilization may have been reached, with new management joining and an improved relationship with the UK government.

"The balance sheet position also now looks much better. On the negative side, the earnings risk for full-year 2015 is probably still negative, given recent contract decisions and the shares looks quite fully rated at 18 times 2014 price/earnings to Capita (Overweight, 18 times) and Babcock (Overweight, 15.8 times) both of which have more earnings stability. Babcock is our current top pick in the Business Services sector."

Serco has just started on the long road to recovery and no-one expects it to be easy. But the firm has performed in line with adjusted guidance and investors are clearly chuffed, with the shares up 5%. Downside seems limited from here, but the outsourcing expert cannot recover if it does not win back trust (and business). Both will be hard won.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.