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Out of the rubble: How outsourcing reinvented itself

Government contractors are starting to woo investors again – but has the sector really turned its back on a disastrous decade?
December 5, 2022
  • Mitie follows Serco in showing signs of recovery
  • Accounting failures cast a long shadow

The history of government outsourcing is not so much chequered as plain bad. The sector is a graveyard of corporate disasters, dominated by the headstone of Carillion, which famously fell into liquidation in 2018. The construction giant is in good company: property services group Connaught went into administration in 2010, followed by Interserve nine years later, and several others – including Capita (CPI) and Kier (KIE) – have narrowly avoided similar disasters. 

Something different has happened over the past couple of years, however. Shares in downtrodden Mitie (MTO) – which spans facilities management, property management, and healthcare services – have more than doubled since March 2020, and are now ahead of pre-pandemic levels. In contrast to profit warnings and turnaround plans, investors have been enjoying share buybacks and profit upgrades.

Serco (SRP) – the scandal-ridden outsourcer best known to the average Briton for winning the UK Test and Trace contract – has had an even longer winning streak. Shares have doubled since 2016 and the group has boosted its profit forecasts multiple times since the pandemic struck. 

All of which raises the question: have outsourcers really changed their ways, or is this a false dawn for a battered sector?

 

Murky past

In order to tell the industry’s fortune, it’s useful to understand what went wrong in the past, both for businesses and for investors. Mitie – which generates 60 per cent of its turnover from government contracts – is a useful test case.

The group’s share price started falling in the summer of 2017 and didn’t really stop until autumn 2020. The shares were set on their giddy descent by a series of profit warnings which culminated in a £183mn loss in the year to 31 March 2017. The loss was largely the result of the disposal of the group’s home healthcare business, which was sold in March 2017 for the grand total of £2. To add insult to injury, Mitie actually paid the buyers £9.5mn to cover the cost of the turnaround plan.

In the case of Mitie – and several of its peers – the loss was preceded by audit failures. Over £107mn of goodwill was attached to Mitie’s troubled healthcare arm, which actually went on to bank a loss on disposal of £30mn. This massively warped the value of Mitie’s balance sheet, particularly given that goodwill was the group’s single largest asset at the time. Mitie’s former auditor, Deloitte, was slapped with a £1.5mn sanction in April for the “material uncorrected misstatement”, but the failing has cast a long shadow.

Serco’s past is no prettier. Having over-diversified, the outsourcer became bogged down in lengthy, under-performing contracts which dragged it into a loss – much like Lakehouse, the failed fixer-upper of council houses. Operational problems were far from the only problem, however. The group also ran into trouble with the Serious Fraud Office (SFO), and was fined £19mn plus costs for understating the profitability of a prisoner tagging contract between 2010 and 2013. 

Two former Serco executives eventually ended up in Southwark Crown Court, but were acquitted after disclosure failings by the SFO caused the trial to collapse.

 

Brighter future

Both Serco and Mitie have been under new management for several years – Serco chief executive Rupert Soames, in the post since 2014, is to step down at the end of 2022 – and have endured lengthy periods of rehabilitation. The question is whether this has made enough of a difference. 

“I think the industry has improved substantially over the last eight years,” said Numis analyst David Brockton. “Cultures within organisations have improved immensely, internal controls have improved, and current management teams have learnt from the problems of the past. I’d never say the risk of future transgression is zero, but they are in a significantly better position.”

Others seem to agree with him. Private equity firms had steered clear of outsourcers for a decade. However, in July, Clayton, Dubilier & Rice announced the acquisition of two facilities management businesses for €2.7bn (£2.3bn). Analysts at Jefferies estimate that the sale implies an EV/Ebitda multiple of about 11. (Mitie and Serco currently trade on multiples of 5.8 and 5.7 respectively).

The new-found interest coincides with tangible improvements in the sector. Mitie’s net debt is almost 70 per cent lower than it was back in 2018, despite its purchase of Interserve’s facilities management arm for £120mn in 2020. Meanwhile, it is actually producing cash again – in the years up to 2020, it was sucking in cash for operations, as opposed to generating it. Cash flow did take a hit in the six months to 30 September 2022, however, which management blamed on the replacement of Covid contracts and the need to grow acquisitions. This is worth keeping an eye on.

 

 

Serco has been on a similar journey. Analysis by Jefferies shows that the group’s free cash flow yield has been climbing steadily since 2015 and is expected to reach 10 per cent by 2024. Adjusted net debt has fallen by 27 per cent in the six months to 30 June 2022, to just £164mn. 

Once again, there’s a caveat. Serco’s adjusted figures do not account for lease liabilities, which now exceed its borrowings by almost £100mn. On a statutory basis, with lease liabilities included, net debt only fell by 8 per cent, and is still high at £596mn. 

 

Cheerful order books

Balance sheet quibbles aside, outsourcers are certainly proving resilient. Although they were boosted by the pandemic, when governments roped in all the help they could get, things are still going strong. Mitie’s order book was up at the half-year mark, as was Serco’s. The latter is particularly reassuring, as many feared that Serco would struggle after the wind-down of Test and Trace. Elsewhere, Sureserve (SUR), which handles energy services for council housing, reported a 50 per cent jump in orders.

There is little sign yet, therefore, that government cuts are affecting demand. And analysts argue that outsourcing is less correlated with economic growth than other sectors. Indeed, outsourcing is often seen as a way of saving money and transferring risk onto a third party. 

Inflation looms, however. In a sector plagued by spiralling costs and underperforming contracts, how can companies be sure they won’t get entangled in loss-making work again?

For one, there are protection mechanisms in place. Mitie said this year that between 80 and 90 per cent of its contracts contain clauses which enable it to pass on inflation to customers. Meanwhile – according to Liberum figures – 52 per cent of Serco’s contracts have indexation provision, and a third are either cost-plus (with a fixed mark-up) or short term. 

This looks to be working so far. Mitie has been able to pass on more cost rises than it had previously expected, and Serco predicted that “current inflation levels will not have a material impact on the group's profitability”. Timing could prove a problem, however, as cost increases and contract updates are not guaranteed to coincide. More pressing still is the issue of wages. 

“The peak risk for the industry is if [retail and consumer price index figures] start to fade but wage inflation stays high,’ said Kean Marden, head of business services equity research at Jefferies. In this scenario, groups could be lumbered with costs they are unable to pass on via indexation.

Marden was optimistic about the future of the sector, however, saying that several “disruptive peers” that used to price their services very aggressively had dropped out of the market. “Procurement managers used to allot work to the lowest cost bidder. But Covid has made them reassess – sanitation, security and air quality became more important. The quality and reliability of the service is more important in the decision matrix.”

It’s unlikely we’ve seen the last outsourcing disaster. Revenue recognition, debt, loss-making contracts, and government penny pinching will always torment contractors. But certain companies are emerging from the rubble of the past decade in significantly better shape and with a good pipeline of work. For investors willing to keep an eagle on company accounts, they may be worth a look.