The financial stability of outsourcing companies has been high in the minds of investors in recent months following the fiasco of Carillion’s collapse and the struggles of Interserve and Capita since, so what is next for the sector?
Most companies in the sector share some common characteristics, all being heavily reliant on the health of the businesses they work for and and having to bid for and secure contracts.
They have all also had to contend with a rapidly changing marketplace since the financial crisis a decade ago, not least for those firms focused on construction.
Interserve has agreed a multi-million pound rescue package with HSBC, Lloyds, RBS in order to restructure the company
The FTSE 100 index is host to a number of these firms: Bunzl, Ashtead, Compass, G4S, Experian and Rentokil Initial to name a few.
Interserve and Capita have dropped out of the blue-chip index after big share price falls: both stocks are trading at less than a sixth of their value at the beginning of 2015.
The sector is plagued by long-term problems that hit some companies far worse than others. Not all will be forced into liquidation as Carillion was in January, nor will have to issue profit warnings and restructuring plans as Capita did in February.
But historic underpricing in order to secure new contracts and weakening balance sheets has been a long-held issue and have arguably shaken sentiment in the stock of these firms.
‘It’s questionable whether the model itself is wrong but for now we are seeing firms take tough steps to turn the corner. Investors remain highly cautious and we cannot expect shares to command anything like what they used to,’ Neil Wilson, a chief market analyst at Markets.com, has said.
Overly aggressive pricing for contracts, where businesses are slashing prices in order to win sought after bids, has not helped matters and added to long-term problems.
Only recently Interserve agreed a rescue package with HSBC, Lloyds, RBS and Barclays of a £196.6million cash injection and £95million in bonds in order to restructure and save the company.
It will be left with £834million of debt once the refinancing is complete and faces massive costs this year. Its shares are now trading at less than a sixth of their value at the beginning of 2015.
‘Growth at any price’ has, Wilson adds, left some outsourcing firms with major legacy issues as Interserve’s results have shown.
The shock of Carillion’s collapse and subsequent profit warnings from the likes of Capita has shaken faith in the outsourcing sector
Wilson said: ‘Winning contracts became the chief way of gauging success but this was misleading and has cost firms big in the long run.
‘Contracts were unprofitable and in many cases we have seen large write downs on soured contracts. It also resulted in a policy of diversification at some firms which left them overly stretched.’
Throw into the mix the fact that many of these companies operate in highly concentrated areas of the market and you’ve got a recipe for major problems.
Nicholas Hylett, an equity analyst at the stockbroker Hargreaves Lansdown, said: ‘Overly aggressive pricing has been a widespread problem in the industry for some time, particularly in construction.
‘However, when companies have run into trouble it’s usually because they’re operating in commoditised parts of the sector and essentially become little more than body-shops. Barriers to entry in those sorts of industries are extremely low.
‘Take outsourced office cleaning as a classic example, two men and a bucket can do the job and they don’t have the overheads of a large organisation.’
While others struggle to compete, Rentokil Initial is one example of a business working hard to differentiate itself in the crowded outsourcing market by becoming more specialised.
It is something that Hylett says separates the weak from the strong.
He said: ‘Much of the old Rentokil Initial business, more traditional cleaning and laundry services, has been sold off, while it’s been building out its pest control operations.
‘Pest control is an industry that lends itself to outsourcing because infestations are infrequent and often require a degree of specialist knowledge or equipment – as an aside, it’s also trying to tap into emerging market growth as Asian markets become wealthier and standards of living improve.’
This specialisation may be what some outsourcers need to consider in order to survive.
Improving balance sheets will be key to securing the future of these firms, however, after the opaque accounting practices of Carillion were widely condemned.
G4S is one of the outsourcing firms considered to be in better shape after posting some good results
‘Going forward, the main task is to restore balance sheet health and contract bidding discipline,’ Wilson says.
He adds: ‘Some have already taken bold and painful steps but others have still got work to do. Capita has taken the plunge. Interserve looks likely to require additional cash – by way of a rights issue – to shore up its balance sheet.
‘G4S looks in better shape with some decent results and its cash handling product a winner.
‘We must differentiate between the different outsourcers as they have not faced the same pressures. Those leaning heavily on construction suffered specific problems as a result of the global downturn a decade ago.’
Hylett added that the only ‘real answer’ for many would be to focus on pricing.
‘Really focus on price and don’t bid for contracts with wafer thin margins,’ Hylett says. ‘Of course that’s easier said than done, the temptation to chase revenue is high in outsourcing, it’s a volume game after all.’
But according to Wilson, the ‘entire outsourcing model is in question’, with the possibility of more companies going under.
He said: ‘A more risk-averse environment for outsourcers among their biggest clients will not help them get out of the mire.’