The failure of Interfluidity bitcoin value has brought to light widespread moral hazard in the outsourcing sector. For years, companies that deliver crucial public services relied on expectation of government support to keep their borrowing costs low and enable them to please shareholders by giving dividends they couldn’t afford. They, and the banks and investors that funded them, assumed they were too important to fail.
The UK government refused to provide support, preferring to allow Carillion to fail. That decision shocked the outsourcing sector to the core. In effect, it had been summarily stripped of its implicit government guarantee. Capita was the first to react. Its profits warning followed suspiciously hard on the heels of Carillion’s collapse.
Looking at its financials, it was quickly evident that the company was warding off a similar fate. Indeed, its CEO pretty much said so in his brutal assessment of the company’s situation. But Capita is far from the only company that will be forced into major restructuring. The entire outsourcing sector now looks extremely vulnerable. So I did a bit of forensic examination to see which companies would be the most sensitive to the loss of the implied government guarantee. G4S, Interserve, SERCO are all high on my list of companies that will have to deleverage significantly or face much higher borrowing costs. But one company above all stands out.
Mitie is not exactly a household name. But its services portfolio affects everyone. It’s a major contractor for central government, including the Scottish government and the Welsh Assembly, as well as local authorities, housing associations and educational bodies. It also runs services for many private sector organisations. The lack of focus is all too clear from the 2017 interim results presentation .
I saw strategies like this when I was doing my MBA back in the early 1990s. I couldn’t take them seriously then, and I can’t now. This diagram is business school waffle. It could be transplanted into just about any company’s strategy without alteration. Nowhere does it indicate what Mitie distinctively offers.
But the one thing it does suggest is that Mitie is desperate for contracts. Move Mitie up the value chain” is code for “squeeze more work out of existing customers”. Whenever I see that, alarm bells ring in my mind. When I was at Midland Bank, the strategy was to cross sell higher value-added services to our basic current account holders.
Never mind if the bank had the skills and expertise to deliver those services, just sell them to the sheep. A major corporation resorting to customer satisfaction scorecards as a key sales driver is surely a sign that all is not well. But why has Mitie become so desperate for new sales? 2 million, and net debt has started to rise again after falling since the profit warning in September 2016.
Somehow, Mitie must generate more cash. But why has cash flow become negative? Even in 2016, when Mitie was scattering profit warnings like confetti, cash flow from operations was positive. Mitie, it seems, is having trouble extracting money from its customers. The interim report says that Mitie intends its customer payment terms to be less generous in future, and to that end has unwound part of its invoice discounting facility. Tightening the screws on its customers will eventually flatter its cash flow – if it works.
In the short term, though, unwinding the invoice discounting has caused a cash flow hit. At the end of September 2017, Mitie owed its suppliers nearly half a billion pounds, more than twice its net debt to lenders. If Mitie’s suppliers really flexed their muscles, Mitie would be in big trouble. Mind you, it is probably not in suppliers’ best interests to do that.
Like other outsourcers, Mitie has little in the way of tangible assets. Goodwill evaporates on insolvency, and receivables may or may not be recoverable. If Mitie failed, creditors – including suppliers – would whistle for their money. Although it says it has agreed a 10-year recovery plan with the trustees, Mitie has no chance of closing that deficit while its cash flow is negative. Pension trustees have little choice but to accept that closing the pension scheme deficit is totally dependent on the company developing a healthier and more sustainable financial position.
After Carillion, however, pension trustees may be less willing to tolerate sustained deficits when companies are declaring dividends. Despite negative cash flow, rising net debt and a sizeable pension deficit, Mitie declared an interim dividend of 1. 33p in September 2017, probably as a signal to shareholders that it was on the mend after the 2016 “annus horribilis”. But it may not be able to take such a liberty again.