Brexit risks, market for government services, Carillion collapse, future direction

Serco Group plc – Annual report – 31 December 2017

Industry: support services

Chief Executive’s Review (extract 1)

Risks associated with Serco’s trading environment

Last year, we reported on the risks around our trading environment, and focused on the possible impact of Brexit, instability in the Middle East, and lack of clarity in the US following the election of President Trump.

None of these risks has markedly reduced in the last twelve months: in terms of Brexit, our business directly serving European bodies which accounts for around 5% of Serco’s revenue is unlikely to be greatly affected, as it is served by EU-resident companies. We believe Brexit may have an impact on labour cost and availability in the UK if EU citizens cannot come to UK to work in essential frontline service roles. The greatest impact for us is that UK Central Government is largely focused upon the overwhelming need to manage Brexit, which has been described by the Head of the Civil Service as the greatest peacetime challenge ever faced by the Civil Service, and it is clear that their priority is going to be focused in this direction for several years to come. However, in the medium term the repatriation of swathes of regulatory functions may lead to important opportunities, and many of our largest customers – most notably the Ministry of Defence, the Ministry of Justice and the Home Office – still have pressing needs to reduce costs and increase efficiency.

In the US, it is clear that the Affordable Care Act or ‘Obamacare’, and associated contracts such as ours providing eligibility processing services to those seeking health insurance, will continue in some form, although the promised expansion in Defence spending is yet to be seen. Disappointingly, there are few signs of resolution in the dispute between Qatar and other states in the Middle East.

However, since last year’s report, in addition to the risks set out above, the UK public sector outsourcing market has in recent months been thrown into turmoil as the result of the collapse of Carillion, and the crystallisation on some contracts of very significant risks which government had transferred to suppliers. This has reignited the debate about the wisdom of government outsourcing to private companies the delivery of public services, and we suspect that this will become a theme in the next General Election. There is a very real risk that this will make the UK Government more than normally cautious in dealing with its suppliers. On the other hand, it may make them more inclined to deal with suppliers who have established a track record for strong delivery, prudent accounting and who have a robust balance sheet. The possible consequences of these events are examined in more detail under ‘Industry Backdrop and Concluding Thoughts’, below.

Chief Executive’s Review (extract 2)

Industry backdrop and concluding thoughts

“No plan ever survives first contact with the enemy” was a phrase first coined by the military strategist Helmuth von Moltke in the 19th century. So far, Serco’s three-stage plan (Stabilise – Transform – Grow), which we conceived in late 2014, has survived contact with the flow of events surprisingly well. After a period of decline, our profits have started to grow again; we have re-established our reputation for operational delivery; we have kept our promises to our customers; our portfolio of onerous contracts is running off in line with the expectations we set in 2014; we have had a strong year of order intake in 2017; and we are taking steps to improve margins to take us to more normal levels, even if weak demand will probably mean it will take us longer to get there. We are not yet able to resume dividend payments, but our pension schemes are fully funded and our balance sheet is robust.

Into this generally positive scene of Serco’s own progress has intruded a traumatic event in the form of the collapse of one of the UK’s largest suppliers of public services, Carillion. Quite apart from the usual miseries associated with the bankruptcy of a major company, it has put at risk the supply of a number of sensitive public service contracts and caused the UK Government distraction and expense. Not unnaturally, this has reignited the already-glowing embers of the debate about the desirability of allowing private companies to deliver public services. This cuts to the heart of what we do; the UK is Serco’s home market, and accounts for around half of our revenue, and understanding recent developments is high on the agenda of many investors.

It must be stressed that the UK Government successfully buys some £200bn of goods and services from private companies and charities each year. There are over one million people employed by the private sector delivering services to Government, and the vast majority of this work is delivered to a high standard. Huge benefits have been delivered by private companies and charities providing public services which are both efficient and innovative. Nevertheless, the collapse of Carillion stands as a reminder that since 2010 a significant number of businesses supplying Government services in the UK have suffered very large losses, Serco included, and that all is not right in the market for Government services in the UK.

How has this situation arisen? In one sense, this is the market at work, with a tendency for the balance of advantage to move between buyers and sellers in accordance with supply and demand. In the ’90’s and ’00’s, Government was keen to enlist the support of private sector companies to improve the efficiency and productivity of public services, and many new opportunities came to market; the Government was feeling its way and trying to develop new contracting structures such as Private Finance Initiatives which had never been tested before, and was sometimes outrun by more sophisticated and canny suppliers, who were double-digit revenue growth a year with strong margins, cash flows and returns on capital. As is the way of markets, this strong growth attracted new competitors, many from abroad or from other sectors. As is also the way of markets, the flow of milk and honey did not last indefinitely.

Around 2010, the balance of power in the market began to turn. Government introduced austerity and sought to reduce expenditure, the supply of new work slowed, just as new competitors entered the market. At the same time, Government started to hire poachers and made them its gamekeepers, and in recent years has improved its commercial and contracting capabilities beyond all recognition. Feeling compelled to deliver the growth they had promised, suppliers competed fiercely for a reducing pool of new business; prices fell, and a newly-savvy Government discovered it had anxious suppliers prepared to accept risks and contract terms which in normal conditions they would not have agreed to. Sophisticated buying techniques were imported from the private sector; contracts for sensitive public services such as caring for asylum seekers were awarded to the lowest bidder by online auction. As margins fell, suppliers shrank their capital employed and increased their debt; some made assumptions in their accounting which had the effect of pulling forward reported profits; some used opaque financing facilities and extended the payment terms to their suppliers to make their reported cash flow more nearly match the stretched profits. At the same time, falling interest rates and increasing longevity sent pension deficits soaring. So in a matter of a few years, a sector which previously had delivered healthy returns and supported well-capitalised balance sheets became under-capitalised, over-leveraged, and operationally and financially fragile. Given the amount of contractual risk suppliers were carrying, that fragility was going to show itself sooner or later.

Serco was the first major UK public services supplier to reveal the consequences of carrying those risks. In 2014, we had to take £447m of onerous contract provisions to reflect the cost of contractual commitments we had made, and in total some £1.3bn of provisions and write-downs were required. Fortunately, our banks and shareholders backed our decision to stand by our commitments to our customers, and we raised some £700m of equity and a further £250m from disposals to make our balance sheet robust. Since then, few suppliers in the sector have escaped unscathed, but Carillion is the first major bankruptcy.

Does this matter? Over 12,000 companies go into insolvency in a year in the UK, so why should Carillion be of such concern? The reason is that the nature of public services contracts are that they often involve the delivery of services of national importance that need to operate 24 hours a day. Hospitals cannot operate without cleaners and caterers; courts cannot operate without prisoner transport; defence bases cannot operate without air traffic control. The security of supply of these contracts is a matter of national importance and a proper concern of Government.

How did we get into this position? The answer is: nobody is blameless. Company managers and directors should have remembered the adage that “no deal is better than a bad deal”; and that over-optimistic accounting judgements, or flattering reported cash flow, will always be found out in the end; and that pension deficits were not a temporary aberration but a liability that needed to be addressed. And for its part, Government has used its position as a monopoly buyer to push companies, large and small, into accepting contractual terms and risks that they could not conceivably manage or hedge. Sooner or later, some of those risks were bound to crystallise, and when they did, suppliers delivering vital public services would be mortally wounded and even become functionally or formally insolvent, which would not be in the interests of either taxpayers or service users.

Where will the market go next? Clearly, both Government and suppliers should take time to consider carefully the implications of recent events. Suppliers will likely become much more wary; there will be fewer new entrants; existing players may shift the balance of their attention towards other markets, if they can. The UK Government runs the risk of being offered less choice and innovation, less competition and higher risk premiums. And efforts to encourage small and medium sized suppliers into the market are likely to be set back, as they see what has happened to some of the large and strong companies who supply Government.

In the short term, the situation may offer opportunities to companies such as Serco which have already re-financed their balance sheets and focused on developing the strength and depth of their management. But this is no time for schadenfreude. Serco’s interest lies in seeing the market restored to health as soon as possible, where suppliers have the confidence to invest in bringing innovation and efficiency to help Government rise to the challenges of providing what it so badly needs, which is more public services, of higher quality, at lower cost. And Government needs to feel confident that it has a choice of strong suppliers, who it can trust to deliver and stand by their promises, and who have balance sheets robust enough to sustain them through the lumps and bumps inherent in the delivery of large and complex contracts.

We believe that recent events present an opportunity for both Government and its suppliers to work together to construct a new approach to the provision of public services which will avoid the problems of the past. There is broad consensus that public service provision should be a mixed economy of the state, not-for-profit organisations, and the private sector; and also that the provision of public services should not be completely exposed to the harshest rough-and-tumble, boom-and-bust cycle of a totally free market where the relative powers of either buyer or seller may become unbalanced. Few people believe that the delivery of public services should always be a monopoly of employees of the state. The question is a practical one of how to make the procurement of public services, whether delivered by the state itself, by not-for-profits, or private companies, work better.

Serco will be contributing energetically to this discussion, and we will be proposing four principles which we suggest should govern relations between Government and its suppliers, be they public bodies, not-for-profit organisations or private sector companies.

  • We should strengthen transparency in public contracting. This means that for large contracts for public services, which are not commoditised, which do not impinge on National Security, and which do not include significant amounts of intellectual property, the presumption should be in favour of open-book accounting, in which the Cabinet Office and National Audit Office can see the suppliers’ accounts of major contracts, whether they be performed by public or private operators. There should also be far greater transparency of operational performance: except in exceptional circumstances, suppliers, be they private or Government-owned, should be required to publish every six months their performance against key operational indicators, so they are held accountable for the delivery of their promises to the taxpayers who are paying for them and the users who they are serving. And we believe that there should be a formal, rigorous and transparent decision-making process by which Government decides what mechanism it should use, be it in-house or by a third party, to deliver a given project or policy. We call this the “Transparency Principle”.
  • Both suppliers and the Government should have the right, on payment of an agreed break fee, to exit a contract at pre-determined intervals. We call this the “Orderly Exit Principle”. The purpose of this is to give both Government and supplier the ability to exit contracts which are not working out as intended. For instance, if the supplier is making greater than expected profits, or Government policy changes, or performance is unsatisfactory but still within the bounds of the contract, the Government should be able, on payment of a break fee, to re-compete or take back in-house the contract; and likewise if the supplier was making unexpected losses, or changes in regulation had made it impossible to deliver the contract as intended, the supplier can exit the contract on payment of a fee which would compensate the Government for the cost of retendering. This would, for both Government and supplier, significantly reduce the risk of being stuck together in unhappy marriages.
  • Suppliers of sensitive contracts should be obliged to lodge with Government a “living will”, being a set of arrangements to facilitate the transfer of a contract back to Government or to another supplier if required. This would significantly reduce the operational risk to Government of supplier failure. This is the “Security of Supply Principle”.
  • Government and suppliers should agree to abide by a mutually-agreed code of conduct, which would set out expected standards of behaviour from Government and its contractors. This would involve the Government agreeing not to impose punitive or unfair terms and conditions or transfer unmanageable state risk; and suppliers would agree to maintain certain metrics of financial stability; pay their subcontractors in a timely fashion; and adequately fund their pensions. We think it would be important to have a process of independent arbitration built into the code of conduct to ensure that there is some avenue of redress and calling to account those who do not abide by the code. We call this the “Fairness Principle”.

It is vital to the well-being of any country that public services are delivered to high standards and offer value for money, and for the most part, in the UK, private and third-sector providers have done a good job of doing this. The UK has hundreds of new hospitals and schools, built and maintained to high standards; thousands of contracts have delivered innovation, improved services and lowered costs, along with far higher degrees of visibility of operational performance than is commonly available from public sector delivery. And as the UK advances towards Brexit, it is clear that there will be the need for a whole lot more Government as we “take back control”. With this in mind, we believe that there is an urgent need to re-think the relationship between the UK Government and its suppliers. We believe an approach based on the Four Principles above would serve to restore trust and common sense in the market; remove the risk of excessive profits or losses; and encourage a more vibrant and competitive market for Government services, one in which Serco would be an enthusiastic participant.

 

 

 

 

 

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