By , of Spain, the UK, and Mexico and an editor at Wolf Street. Originally published at
Two large British outsourcers are at risk of following in the doomed footsteps of Carillion, the infrastructure and services giant that in free-fall fashion in January. Between them the two firms, Capita and Interserve, employ roughly 150,000 workers worldwide and are responsible for delivering a dizzying array of vital public services in the UK.
Both are in deep financial trouble. Fears are growing that Carillion was not a one-off episode but rather the swan song of a dying business model. Until two months ago Carillion was the UK’s second largest construction firm. Now, what remains of its corporate corpse is being picked apart by employees of PricewaterhouseCoopers (PwC), which was hired to liquidate the company.
There’s unlikely to be much to liquidate. Big outsourcers like Carillion generally have relatively few tangible assets and borrow against intangibles — such as contracts or the value attached to an acquired brand name — which may have little value if a business fails, Adam Leaver, a professor at Sheffield University Management School, told the .
For years Carillion was able to mask the true state of its financial health by delaying payments to subcontractors. The maximum payment term was increased from 30 days to 65 and then from 65 to 120 days, and suppliers would incur a charge from the banks if they requested to be paid earlier.
By the time it collapsed, approximately a third of the company’s £1.5 billion debt to banking partners was “reverse factoring” — a popular financing arrangement whereby banks pay a company’s invoices to suppliers as a form of temporary lending. Part of the attraction of reverse factoring is that companies are not required to disclose the money owed in their financial reports, and can thus conceal the full extent of their debt liabilities.
In its later stages, Carillion needed to win new contracts just to be able to pay subcontractors “who they treated as a short-term creditor, making it something like a legal Ponzi scheme”, says Prof Leaver. “Once you’re borrowing from one place to pay your debts from another, that’s pretty much the definition of Ponzi-like financing.”
Carillion’s demise has already shaken the foundations of a high-growth, thinning-margin, poor cash-flow, high-debt business model used across Britain’s outsourcing industry. Attention is now shifting warily to Capita and Interserve.
Capita’s shares crashed in February, after it had The shares, now at £1.52, are down 56% from the end of January and 88% from July 2015 (€13.20). Market cap plunged to just over £1 billion. The new CEO, Jon Lewis, , announced plans to tap the capital market for £700 million, and suspended a dividend that had paid out over £200 million to shareholders last year.
At the height of the rout, the government released a statement insisting that Capita was “not another Carillion.” But whatever the government might say, there is still between the two companies, including their huge dependence on government projects and their penchant for running up absurdly high levels of debt.
On the positive side, unlike Carlillion, Capita has over £1 billion of cash on its balance sheet. And Capita doesn’t have high-risk high-cost construction projects bleeding it dry. But nonetheless it is still hemorrhaging funds at a startling rate. Its reported revenues keep shrinking and it has been losing important business contracts, partly as a result of the political uncertainty over Brexit.
Whether Capita gets through the immediate storm it faces will depend largely on its ability to raise £700 million from shareholders, for which it claims it already has full “standby underwriting.” But this undertaking has gotten immensely more difficult after the crash of its shares.
Capita’s rival, Interserve, is in even graver condition. At last count, its total debt was over £500 million, and its current market cap has plunged to £112 million. In January the government became so worried about the company that it assigned a team of officials to monitor its financial situation.
Interserve has been plagued for years by in its waste management division. But recently the problems have spread to its core UK businesses, almost all of which are under-performing, as the company itself alerted in a profit warning in October 2017:
In U.K. support services, [losses were] driven by the continued employment cost pressures in the business, the cost of contract mobilizations, margin deterioration driven by a cost base which has not been flexible enough and contract performance in the justice business. Our U.K. construction business has seen further deterioration in operating profit as challenging market conditions and cost pressures as well as operational delivery issues have continued to impact performance.
Interserve warned that it probably would breach its banking covenants. The company’s lenders want to cut their losses but the firm is not completely out of options just yet. The Telegraph earlier this month that since in recent months private equity firm Emerald Investment Partners has been quietly buying up Interserve’s debt from the likes of Lloyds and Barclays “for as little as 50 pence on the pound” and “may now own as much as a third of [the]loans.” The vultures are circling.
This may be a play for the best pieces of the cadaver in a debt restructuring that could include wiping out or sharply diluting current shareholders. Even if it is a play for an eventual recovery of the business, the core problem — the poor performance of its underlying businesses — is unlikely to change, even with new financing.
If either Capita or Interserve do succumb in the coming months, the UK could begin to have a genuine crisis on its hands. Not only will investor confidence in an already fragile sector be shattered at a time that fears of Brexit are already taking their toll on market sentiment, but the government will pick up the pieces, once again, at substantial cost to taxpayers. Meanwhile, many of the fortunes amassed and extracted during the outsourcing boom continue to sit comfortably in private bank accounts dotted across many of the world’s tax havens. By .
Carillion collapsed even as KPMG signed off on its financial statements; now KPMG denies any responsibility. Read…