Exit XChanging

Shares in outsourcing group Xchanging were torpedoed last month when the company warned that 2010's profits would be hit by a spree of one-off charges. The warning not only threw up concerns over trading, but also over the viability of the group. So when it reported those results last week, acting chief executive Ken Lever - the group's founder and chief executive, David Andrews, quit following the profits warning - set out a four-part plan to transform the business. Certainly, action is needed. But there are serious concerns that Xchanging's challenges will overwhelm the business.

To understand Xchanging's problems it is important to understand how the business works. Essentially, it takes over the running of other companies' cost centres - such as HR and insurance claims management - and attempts to run them for less money, using its expertise in offshoring, its management systems and economies of scale. Such deals are organised as a joint venture, where Xchanging and its clients split the cost savings between them.

The joint ventures create some issues. For one thing, the more that Xchanging successfully cuts the running costs of its joint ventures, the more it erodes the potential for future gains. This means it needs a regular flow of new contracts to keep growing, but new contracts have been scarce recently. What's more, depressed economic conditions have meant there is less work for many of its joint ventures.

Some City analysts have also criticised the group for the way it accounts for the cost of setting up joint ventures. Much of the set-up costs are capitalised, meaning they are recorded as an asset on the balance sheet, which will be written off over time, rather than a cost in the income statement, which is incurred immediately. This practice, coupled with a recent decline in cash flows, meant the City was sceptical about Xchanging even before the profit warning.

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When it warned, Xchanging took an impairment charge of £110m, much of which related to its disastrous acquisition of an IT and business process outsourcing company called Cambridge. This has increased concerns about Xchanging's financial position because one of its debt covenants relates to the group's net worth, which is based on its net asset value. True, Xchanging's balance sheet has net cash (see table), so you might wonder why there is any concern about debt. Unfortunately, much of that cash is tied up in joint ventures and broker Peel Hunt estimates the group has net debt to the tune of £47m. However, earlier this month management said it had £45m headroom on a covenant that says net worth must exceed £175m.

Even so, borrowing covenants could still hamper Xchanging's transformation because it plans to exit underperforming businesses and that could prompt further write downs. That means the group may have to restructure its finances before it can make progress, incurring further costs and possibly raising the cost of its debt. The restructuring may also incur its own costs. Xchanging has not put a number on this, but broker Espirito reckons it could be a £15m charge to profits.

The widely perceived financial weakness of Xchanging could also hamper the group's aim to restore growth. Customers may be reluctant to set up a joint venture if they think their potential partner is financially weak. What's more, some of Xchanging's joint ventures can be terminated and there are fears of partners defecting. And the group has said that a venture it had set up with SIA-SSB is proving challenging to integrate - triggering fears that Xchanging has had to relax terms in order to win new business.