ShoreCap downgrades Serco to ‘hold’

Shore Capital downgraded Serco on Wednesday after the outsourcer said last week that it had lost its long-running Australian immigration detention centres contract and estimated that changes to employer national insurance contributions would increase labour costs by £20m a year.

The broker, which cut its rating on the shares to ‘hold’ from ‘buy’, said that while it’s disappointing that Serco has lost the contract, it is waiting "to understand the reasons for the loss" and noted that AsiaPac remains a strategic market for the company.

Ex-immigration services, Shore Capital said it expects the growth strategy to continue.

"The lost profitability due to the NIC increases is more challenging, in our view," it said.

ShoreCap said Serco is unable to recoup additional NIC costs under its UK Government contracts, which tend to be cost+ based.

"Until contracts/frameworks end/roll-over, these higher costs will have to be borne, with a cost of circa 100+ basis points to Serco’s UK margins (previously in the 4.0% range).

"We expect a cost of c.200bps to Serco’s return on invested capital, in FY26F, now at 13.9%."

Shore said that as contracts reach renewal, without price increases to reflect additional costs, business with the UK Government will be "unattractive".

"Higher ‘risk-based’ pricing may be unattractive to UK Government clients - we expect a smaller market for services in future," it said.

It added that ultimately, the Government will have to pay more for essential services delivery.

"In FY25F, the ending of the Merseyrail franchise JV in FY28F comes into our forecast period (c.£120m/revenue); we don’t expect Serco to rebid this," Shore said.

"Work in North America for Serco represents c.49% of Group revenue, with a significant presence in Defence & Security and citizen (healthcare admin) markets."

The broker said it was awaiting specific implications from the Trump administration for these activities, if any.

Shore’s forecasts for FY24 remain unchanged. However, taking Australia and NICs together, it cut its revenue forecasts for FY25 and FY26 by 3% and 4%, respectively. It also reduced EBIT estimates by 11% and 13%, respectively.

Shore said its FY25 adjusted earnings per share forecast falls by 14% to 15.1p and by 16% to 16.2p for FY26.

"Whilst we still see long-term opportunity for outsourced services to Government, the medium-term outlook feels to have tightened somewhat; noting lower capital returns and potentially higher risk; we await to see how opportunities develop," it said.

"We also feel that strong exposure to UK Government is likely to be seen as a negative issue for a period."