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Outsourcers: the good, the bad and the ugly

The last 12 months have been an Annus horribilis for the outsourcing sector, but is there more pain to come?
January 25, 2018

Even before the collapse of Carillion, many investors were bearish on the outlook for outsourcing companies. A common refrain is that competition over non-specialised public sector works leads to suppliers competing on margin and – all too often – committing themselves to contracts they are later unable to fulfil profitably. When budgets overrun or the cost of labour increases, the situation worsens. It is a familiar pattern in the industry, leading many companies to include provisions in their accounts for onerous contracts they are obliged to complete, even at a loss.

Yet a race to the bottom on costs is but one problem facing the outsourcers. While many (ourselves included) did not see Carillion’s spectacular demise, or even the downturn heralded by last July’s dreadful trading update, there were warning signs. Receivables climbed higher and higher as a percentage of sales, while off-balance-sheet debt also grew, in turn attracting the attention of short-sellers, who bet against Carillion stock in the run-up to its collapse. 

Bets against the sector can be found elsewhere: there are short positions of at least 8.6 and 6.4 per cent respectively in the shares of Interserve (IRV) and Mitie (MTO), according to disclosures to the Financial Conduct Authority. The UK government has said the situation at neither of those companies, nor any of its other suppliers, are comparable with Carillion. But it’s still worth asking the question: are the same red flags flying elsewhere? An analysis of the accounts of the major UK-listed outsourcers during the past decade certainly throws up some common, worrying, trends.  

High receivables v revenue

The time lag between outsourcers booking revenue they expect to receive for contracts, and the actual time revenue is collected, presents one such risk. Of course, with the long-term nature of many contracts, this is something of an occupational hazard. Of the big six outsourcers, Interserve and Capita (CPI) had the highest level of receivables as a proportion of revenue at December 2016, at a ratio of 21 per cent. In fact, during the three years to 2016, receivables almost doubled at Interserve (see chart 1), primarily due to the acquisition of Initial Facilities in March 2014. While there may not be an optimal ratio between revenue recognition and receivables, these figures are above the longer-term averages, and leave outsourcers more exposed when liquidity problems do arise.

However, the recent introduction of IFRS 15 – which dictates how companies should recognise revenues from long-term contracts – should go some way to ameliorating this. Capita decided to implement the change early, which could mean lower revenues and profits are recognised during the first years of a contract, if there are more upfront costs involved.

Rising one-off items

However, it’s not just the unpredictability of cash coming in that has caused issues for outsourcers. Higher-than-expected costs associated with completing – or exiting – contracts, winding-down businesses and restructuring operations have hammered profitability in recent times.

Take Interserve, where exceptional or unusual items have been creeping up for four years. Investors may have forgiven this in 2014, when one-off costs associated with its purchase of Initial might have been expected, although exceptional items have risen sharply in comparison to headline profits (see chart 2). But the real problems began in 2016, when the outsourcer first booked a £70m provision against its six energy-from-waste (EfW) contracts in Glasgow. At issue was the cost of the design, procurement and installation of its Glasgow gasification plant, along with the administration of a subcontractor, which ballooned into a £160m impairment at 2016 full-year results last February. By October, another £35m had been added to the charge, and given Interserve’s failure to draw a line under the rising costs associated with the EfW business, we think more pain could come.

Operating margins 
 G4SSerco
20105.90%5.60%
20116.10%6%
20124.90%5.30%
20134.50%4.50%
20144.50%-17.80%
20154.80%2.30%
20165.30%2.30%
Source: S&P Capital 

Even more worrying has been the impact on leverage. Net debt was expected to hit £513m at the end of 2017, up from £274m in a year, and while £180m in additional short-term funding facilities were secured in December – after it had warned of the “realistic prospect” it would breach its covenants – these expire in March.    

Similarly, Capita’s profits began to take a hit from exceptional items in 2013, when concerns were raised around operating margins and its ability to complete work profitably (note the sharp rise in receivables as a proportion of revenue in the preceding two years). The issue for Capita has been its acquisitive growth strategy; whenever organic growth has slumped, management opted for bolt-on deals. However, this slew of deals has meant the group’s divisional structure has been subject to several changes, resulting in significant costs associated with business closures, asset writedowns and restructuring. For instance, the white-collar outsourcer was forced to take a £110m impairment on goodwill and other assets in 2011, after closing non-core and low-growth businesses. As a result, one-off charges have been rising as a proportion of headline profits.

That strategy sowed the seeds for its dramatic fall from grace in 2016, amid delays to the implementation of new IT systems for Transport for London, and a slowdown in the IT and workplace services divisions. As the group’s structure bulged, operating costs increased and focus diverged, the outsourcer was left more vulnerable to a slowdown in organic growth. It was forced to take a whopping £410m in non-underlying charges in 2016 after writing off £40m in accrued income and impairing £50m of contract assets.    

Facilities management specialist Mitie has been plagued by persistent large exceptional costs, too. Disposals, restructuring and impairment of goodwill exacted a heavy toll on last year’s earnings, when the bill for so-called “other items” came in at £154m, a figure in part due to accounting errors revealed following the sale of its housing division. Prior periods had to be adjusted by £34.5m, including £20.9m in FY2016. As a result of these mistakes and the costs of sorting them out, Mitie recorded a pre-tax operating loss of £42.9m in the period, from a profit of £107.6m the year before.