The collapse of Carillion in January this year marked a low point for outsourcers. Already much maligned by investors for aggressive accounting methods, repeat profit warnings and consistent write-downs, the collapse of a company with a market value of close to a billion pounds could have served as an inflexion point for the sector.
Little more than 10 months later, however, things haven't really changed. And over the last few weeks in particular, some high-profile outsourcers have run into trouble. Shares in Interserve (IRV) dropped to their lowest level since 1984 as rising debt fuelled existing rumours of a potential capital raise. Then Capita (CPI) was criticised by the British Medical Association for failing to send cancer screening letters to more than 47,000 women. It's also been speculated that Babcock (BAB) – once held a cut above its peers due to the specialised and non-discretionary nature of its work – has damaged its relationship with the Ministry of Defence following the sudden closure of the Appledore shipyard. At the half-year results in mid-November, Babcock also announced a £120m restructuring of its oil and gas business.
Is the sector doomed? Or will the companies’ efforts to salvage themselves ultimately come good?
PR problems
A major challenge for outsourcing companies is the sector’s image problem. In fact, sentiment is so poor that a news report quoting just a single, anonymous source is enough to send company shares tanking. But some investors appear to be using this to their advantage. Earlier this year, Babcock's shares fell following the release of a "malicious" report from Boatman Capital Research, an unknown research firm which the company described as "untraceable". The investment community reacted to the report with incredulity, with one analyst telling Investors Chronicle to take the report "with a bucket of salt". Even so, its publication was enough to prompt a 4 per cent share price drop.
It's been speculated that the report was published by a short seller who stood to benefit from a falling share price. It's fair to say the outsourcers have long been a favourite target of short sellers and, while shorting levels have fallen back recently, five funds are still shorting Interserve’s shares, covering 6.4 per cent of the shares in issue. On that note, 5.5 per cent of Babcock’s shares are being shorted, while Capita and Mitie (MTO) both face shorting levels of a little under 4 per cent each.
In late November, The Financial Times reported outsourcers supplying the UK government such as Capita and Serco (SRP) had drawn up contingency plans to ensure public services wouldn't suffer interruptions should the companies go bust.
The government's fault
When Carillion collapsed, some Labour Party MPs were quick to blame the government’s approach to outsourcing. And while it would be easy to dismiss this as the inevitable response of any opposition party, that would ignore the role the public sector has had in fostering market dysfunction.
The UK government is a major outsourcing customer, true, but not uniquely so. The latest available data from the The Organisation for Economic Co-operation and Development (OECD) shows the UK spending 13.4 per cent of GDP on government procurement in 2016, less than the 19.5 per cent spent in the Netherlands, 17.7 per cent in Finland or 15.5 per cent in Germany.
What’s more, public sensitivity as to which services are outsourced differs from country to country. Professor Gary Sturgess, a former director at Serco and now chair of public service delivery for The Australia and New Zealand School of Government at the University of New South Wales, noted that while UK citizens would likely baulk at the idea of private companies providing emergency services such as firefighting, this is the norm in Denmark. Similarly, the US would struggle with the concept of privately run lighthouses and seamarks, while this is more common in the UK.
Success or failure in outsourcing relies on the two parties’ ability to balance risk and reward appropriately. Critically, a select committee report into the outsourcing market concluded the UK government "often transferred risks to contractors that they cannot possibly manage", further complicated by a failure to understand the services or projects it chose to outsource. The report also found the government’s process for awarding contracts was at times opaque, adding it wasn't always clear whether the government followed its own guidelines for awarding contracts or not.
Name your price
The result is a highly price-sensitive market. A survey of 250 contractors by the Confederation of British Industry (CBI) found only 2 per cent of respondents thought service quality was the determining factor in winning contracts, while 60 per cent thought a low initial bid price was most important. This poses a significant problem. It leaves groups bidding for non-specialised work such as facilities management on wafer-thin margins, exposing them to unexpected costs such as a rise in the minimum wage or an increase in pension auto-enrolment contributions. To combat this, major outsourcers have little choice but to sell off non-core divisions or contracts in favour of more specialised work where they can command a higher rate. Unfortunately, as the businesses restructure, many are forced to book losses on disposals which, in some cases, damages profits. Whether these improvements will actually deliver in the long term is far from guaranteed as well.
But the public sector’s appetite for outsourcing doesn't appear to be shrinking. In fact, research from outsourcing specialist Arvato Bertelsmann found that, after a slow start, public sector outsourcing rose 39 per cent year no year in the first half of 2018, before recording its highest level since 2016 in the third quarter of the year. And while Chancellor Philip Hammond announced in his recent budget speech that the government would abolish the use of both PFI and PF2 private finance initiatives (PFI) for future government projects, spending levels show the public sector isn't ending its love affair with outsourcing.
Turning it around
With the government focused on Brexit for the foreseeable future, a near-term overhaul of outsourcing policy looks unlikely. Instead, investors must rely on companies to bid for work responsibly and execute contracts faithfully. If they can do this, outsourcers may be able to weather the current storm and move into recovery.
Business support services reasons for profit warnings (2018)
| Delays or discontinued contracts/negotiations | 42% |
| Increasing costs and overheads | 32% |
| Sales short of forecasts | 26% |
| Restructuring costs | 21% |
| Operational issues | 21% |
| Increasing investment | 21% |
| Price pressures | 11% |
| Higher financing costs | 5% |
| Changing sales mix | 5% |
| Bad debts | 5% |
| Accounting issues | 5% |
Source: EY
Superficially, at least, it looks like this could be happening. Research on the business support services sub-sector – of which the outsourcers are a part – compiled by consultancy EY showed the number of profit warnings had dropped precipitously in recent years, from 39 in 2015 to 33 last year and 18 so far this year. However, Kirsten Tompkins, a markets analyst for EY, said historic warnings will have led to widespread downgrades, making profit warnings less likely for now.
