Business Services sector comment – Outsourcing: Carillion’s collapse raises pertinent questions

It is not for the first time the spotlight has unwelcomely been shone on the outsourcing sector. In fact, in the last couple of years it has been difficult to keep leading players such as Interserve, Capita and Serco out of the headlines as the companies have been tarnished by profit warnings, redundancies, accounting scandals and malpractice. Nothing, however, compares to the news last week that Carillion plc, the UK’s 2nd largest contractor, has entered liquidation. The consequences, of which are far reaching and unprecedented, raise a number of pertinent questions:

Tendering – a need for change?

The preference for the government to principally award contracts based on price with less weighting attributed to service quality and sustainability, has led to key players adopting aggressive bid strategies intended to undercut competition. Outsourcers then look to raise margins through chargeable change requests which fall outside of the initial project scope. A further challenge is that the bid teams incentivised to win contracts are often too distant from the actual execution divisions.

M&A – coherent strategy?

Carillion expanded rapidly through debt-funded acquisitions in new geographies and service lines, in turn helping to mask the true underlying performance of the business. Its debt levels rose rapidly and a bid for rival Balfour Beatty in 2014 was an audacious attempt to further disguise its financial health. Whilst M&A helped build the business through its initial mergers, it also contributed to its downfall as it was unable to raise cash through proposed Middle Eastern disposals. The failure highlights the complexities in delivering synergies from a geographically disperse operation with no common cost base.

Brexit – skills shortages and apprentices?

Carillion attributed a slowdown in orders and poor performance to Brexit and the change of government. Whilst the claim may have been used as somewhat of a scapegoat (Carillion won £2bn worth of contracts post vote), data does indicate that skills shortages in the sector have been exacerbated following the referendum. It also now brings into question the security of the 2,000 apprentices in the process of completing a government funded contract Carillion had been paid £6.5m to deliver.

Sub-contractors / suppliers – financial health and sustainability?

Hedge funds that were shorting the stock would argue that the writing was on the wall when Carillion extended its payment terms to sub-contractors to 120 days. This was in contradiction to the construction supply chain payment charter which was intended to reduce payment terms to a supply chain to 30 days. Whilst this did not come into effect until January this year, Carillion was a signatory. Sub-contractors were however able to take advantage of the early payment facility, a form of reverse factoring to gain immediate payment of invoices.

The real tragedy rests in the outstanding balance Carillion owes its partners, sub-contractors and suppliers. A situation made worse by the fact Carillion only self-delivered 10-15% of its services. The large sums of money will bring into question the sustainability of a number of sub-contractors who considered Carillion a key client and at best will receive pennies on the pound of monies owed. The collapse will also impact joint venture partners who are contractually obliged to fulfil commitments.

The more positive news however is that the market backdrop remains strong and the fundamental demand for services has not changed. Suppliers and sub-contractors able to pivot to other tier 1 outsources who are well placed to secure significant contracts in the future will, in the longer term, prosper.

CSR – acting ethically?

The news that Carillion paid £72m in dividends to shareholders as recently as June 2017 despite ailing performance and a growing pension deficit brings into question its corporate governance. The pensions of employees now inherited by the Pension Protection Fund, will need to impose a levy on other members. It also beggars belief that until recently the departed management team were entitled to salary payments until late 2018, despite overseeing its demise. A further point of controversy is the reporting of the use of reverse factoring, the detail of which appeared in a note towards the back of the annual report under the line “other creditors” and as such subtly keeping it out of the key Net Debt to EBITDA metric. This helped present the illusion of a financially stable business.

There is no doubt that the impact of Carillion’s failure is colossal and will take years to unwind. The key question though of whether lessons have been learned remains to be seen.