Why Servcorp needs to spend big to defend itself against competitors

Key statistics: ASX: SRV

Closing share price 28.08.18: $4.095

52-week high: $6.040

52-week low: $3.810

Most recent dividend: 13c

Annual dividend yield: 6.44% Franking: 25%

Servcorp: Result 2018

Servcorp's competitor, WeWork, is frantically adding new floors, and burning billions of cash in the process. That's making life hard for Servcorp, as it's not easy sourcing new office space and winning customers when the competition's not interested in making money.

WeWork's strategy has more than a scent of unsustainability about it. Servcorp may be the industry's most efficient operator but WeWork's march will continue as long as investors stump up the money, and that could be years.

How Servcorp responds is the most important issue facing the company today.

In the US, Servcorp generated a pre-tax loss of $9.4m as expected. We're expecting continued losses, and higher expenditure on refurbishments, for the time being.

Conditions were also difficult in Singapore and Saudi Arabia, with each region experiencing a meaningful decline in profitability. Together, the three were the main culprits behind Servcorp's 5% decline in total revenue to $314.4m, and its 34% fall in pre-tax profit to $32.1m.

Despite the challenges, management still thinks Servcorp can carve out its own niche in the co-working space, targeting the older demographic with a premium offering of better technology, and even soundproof spaces.

Encouragingly, Servcorp has the resources to defend its turf, with $93m of net cash and a business still spinning off $18m of free cash flow each year. Management has been tested by difficult operating conditions before, such as the post-tech-bubble fallout in the early noughties.

But they're going to have to spend up to defend themselves. Capital expenditure is expected to pick up to $50m-$60m in the coming year as more floor space is dedicated to co-working and the general look and feel is refreshed. Floor capacity is expected to increase 7.5% to 6040 offices in the 2019 financial year, which points to a light year of free cash flow.

Given the low barriers to entry in the co-working space, and the cyclicality of the business, we're still concerned that the price isn't low enough to compensate for the risks. As a result, we're keeping our price guide as is, and we continue to suggest you HOLD.

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