Shares in outsourcing group Serco (SRP) rally 10% to 133p, their biggest one-day gain this year, after it announces the acquisition of US ship and submarine design company Naval Services Business Unit (NSBU) for $225m.

The deal, which is being financed through a mix of new shares and debt, is expected to be completed in the second half and to add to earnings straight away.

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NSBU is a provider of naval design, systems, engineering and production as well as lifecycle support services to the US Navy, US Army and Royal Canadian Navy. In the 12 months to September 2018 it reported revenues of $336m compared with Serco’s $453m of North American Defence revenues last year.

MAJOR US FLEET EXPANSION

NSBU has an order book of $600m and a new business pipeline of more than $2bn, but the big attraction for Serco is the huge expansion in the US Navy’s ship-building plans over the next decade and beyond.

From a current fleet of 280 ships, the Navy wants to have 355 ships in service by 2035 which is a substantial increase from the 2017 plan of 308 ships. This means the ship-building budget needs to grow from just over $20bn per year in the period 2020-24 to between $26bn and $28bn per year the following decade.

As Serco highlights, the plan represents the largest increase in US naval capability since the Reagan Administration in the 1980s.

INCREASED REVENUE DIVERSIFICATION

The deal immediately gives Serco greater scale in the US, taking its share of revenues from the Americas from 20% to 26% of the group total and taking the non-UK share of revenues close to 70%. It also takes the share of Defence revenues up from 30% to 35% of the group total.

As well as the 355-ship target, the US Navy is investing heavily in ‘next-generation’ unmanned surface vehicles and unmanned underwater vehicles which is an area where NSBU also brings skills and experience.

On top of design and engineering revenues, life-cycle support services are an ‘evergreen’ source of income. As a rule, for every $1m spent on building a naval ship, $2.3m is spent on maintenance and modernisation. The US Navy’s baseline ‘sustainment cost’ is forecast to be $24bn in 2020, rising to $30bn in 2024 and $40bn by 2034.

NEW ERA OF EXPANSION

Today’s deal is Serco’s largest acquisition for many years, having spent most of the post-crisis era focusing on operational improvements and generating positive free cash flow which it managed last year.

The company is increasing the number of share in issue by 10% to raise £130m and taking on an additional £75m of debt to fund the deal, which will take its gearing to 1.5 times net debt to earnings before interest, tax, depreciation and amortisation (EBITDA), well within its target range of one to two times.

In 2020, the first full year of ownership, NSBU is expected to contribute $370m of revenues, $28m of Ebitda and $27m of trading profits, which include some $3-4m of cost savings from integrating it into Serco’s existing US business.

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Issue Date: 23 May 2019