Spotting top turnaround buys isn't always easy. How do you know whether a company will be able to return to past glories?
Former FTSE 100 member Serco Group(LSE: SRP) is a good example. It announced a £1.5bn contract this morning to run what will become Australia's largest prison. Operations won't start until 2020, but this 20-year contract is the kind of long-term deal that chief executive Rupert Soames hopes will attract investors.
Mr Soames has done a good job of stabilising the business and Serco's latest results showed an improvement in underlying earnings and revenue. But the group's profit margins remain very much lower than they used to be. In 2012, the company reported an adjusted operating margin of 6.4% on turnover of £4.9bn. Last year, the equivalent figures were 2.7% and £3bn. Adjusted operating profit has fallen from £314.8m in 2012 to just £82.1m last year.
The company is expected to achieve adjusted earnings of 2.7p per share in 2017, rising by 33% to 3.5p per share in 2018. But even using next year's earnings, the shares still have a hefty forecast P/E of 33 and a prospective dividend yield of just 0.4%.
If Serco can rebuild its profit margins, then earnings could rise rapidly and the stock could look cheap at current levels. But the outsourcing sector is under a lot of cost pressure at the moment. The firm's guidance suggests to me that it could be several years before margins improve.
Although I believe Serco does have the potential to deliver a strong recovery, I think this may take longer than expected. I'm not convinced the shares are a compelling buy today.
A contrarian buy?
Small-cap stocks aren't always very closely followed by City analysts and fund managers. As a result, they can sometimes offer much greater value for investors who are willing to do their own research.
One potential value pick that's appeared on my radar is agricultural feed and fuel supplier NWF Group (LSE: NWF). This business has grown steadily over the years by buying independent local firms and combining them into a larger group, with significant cost savings.
However, demand for the firm's products fluctuates depending on weather conditions and commodity prices. It's also a very low-margin business, with a five-year average operating margin of about 1.5%.
NWF had a slow start to last year, and the shares have fallen by 23% so far in 2017. However, today's year-end trading update confirms that trading conditions have improved as the year progressed. Results for the year ended 31 May 2017 are expected to be in line with market expectations.
That leaves the stock looking fairly cheap, on a forecast P/E of 9.9 and with a prospective yield of 4.4%. Although the group's growth prospects are probably limited, today's update confirms that infrastructure upgrades last year have now been completed and may help to provide incremental growth opportunities.
Last year saw heavy investment, which has limited the group's ability to generate free cash flow. But historically NWF has been strongly cash generative and operated with low levels of debt. This could be a good, cheap income stock to tuck away for long-term gains.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.