Broker tips: First Derivatives, Serco, Diploma, Electrocomponents

The company's 2019 full-year results last Wednesday revealed "strong" revenue growth of 17% and adjusted EBITDA "slightly ahead" of expectations, leading Berenberg to increased its 2020-21 estimates for adjusted EBITDA by 8-9%, respectively, in line with management guidance.

However, the German bank said there were still some concerns.

Berenberg noted that revenue growth slowed to 13.7% in the second half of the year to its lowest level since 2015, while EBITDA margins declined 40 basis points year-on-year.

"With both needing to improve in FY 2020 to meet guidance, it suggests there may be less headroom to guidance compared to previous years," said Berenberg's analysts.

In addition, Berenberg noted that First Derivatives generated only around £6m worth of free cash flow in 2019 - on around a 3% margin, bringing its cumulative FCF since 2011 to about £24m, compared to the £800m increase in the group's market cap over that same time frame.

On the flip side, valuation multiples in the sector had re-rated and the broker expected group EBITDA margins rising back by 40 basis points by the end of the financial year 2021.

But given the above concerns and "lofty valuation", while revising its target price higher, Berenberg retained its 'hold' rating on First Derivatives.

RBC Capital Markets upgraded Serco to ‘outperform’ from ‘sector perform’ on Wednesday, lifting the price target to 150p from 140p as it said the risk/reward is now in favour.

The Canadian bank said it had lifted its forecasts to account for Serco’s acquisition of US defence supplier NSBU earlier this month, arguing that the risk/reward looks favourable over the next 12 months.

RBC said the acquisition looks sensible. "The US Navy looks like a growth market, the deal adds capability for Serco, there are synergies from sharing the fixed overhead and the deal appears to be well priced (8x EBITA) and should be accretive to earnings," it said.

In addition, it noted that the UK now becomes a smaller proportion of the group and given 80% of contracts are cost-plus, the risk profile is relatively low.

RBC said it expects free cash flow to improve markedly from £23m in 2019E to £83m in 2020E and £103m in 2021E.

"This reflects the growth in the top line, margin improvements from leveraging the platform and the significant fall away of onerous contract provision usage (£45m in 19E to £15m in 20E). In addition, cash tax should remain low - Serco has recognised a £20m deferred tax asset in the UK with a further £151m as yet unrecognised.

"This free cash flow should provide options for further M&A and to re-instigate the dividend."

JPMorgan Cazenove initiated coverage of Diploma and Electrocomponents on Wednesday at ‘overweight’ and ‘neutral’, respectively, as it argued that both are "high-quality operators compared to most other distributors".

On balance, however, JPM said it prefers Diploma for its M&A record, lack of cyclicality and consistency of results.

"This is reflected in the group’s FY1 price-to-earnings ratios with Diploma on 22.7x and Electrocomponents on 15.6x," it said.

It noted that since 2005, Diploma has generated an earnings per share compound annual growth rate of about 15%, with approximately a third of this being organic.

As far as Electrocomponents is concerned, JPM said that following a period of underachievement, the company has undergone management changes and a dramatic turnaround in fortunes. In particular, revenue growth has accelerated and operating margins have increased by around 500 basis points.

Part of this improvement is due to market trends, rather than company-specific factors, JPM said, adding that the market backdrop us now beginning to deteriorate.

JPM set a 1,678p price target on Diploma and 591p on Electrocomponents.