Carillion collapse lays bare UK government contracting problems

On the face of it, the business of specialising in government contracts should be a safe, even plodding corporate strategy.

Akin to a utility, firms that deliver services to states that seek efficiency gains have a stable customer with no liquidity issues.

Events in the UK in recent weeks have laid bare the hollow foundations of large brand name operators.

The collapse of Carillion last month, which has its roots in construction but was in effect a conglomerate of contracting, has opened up a series of fundamental issues.

“If one good thing comes from the mess of Carillion, it should be that this kind of disaster never happens again,” wrote Josh Hardie, deputy director general of the Confederation of British Industry last week.

A short trading frenzy that is targeting another services firm, Capita, shows how any weaknesses in the basic business can become a self-fulfilling disaster. Not so many years ago the security services rivals Serco and G4S fell into similarly traumatic restructuring slumps.

The blame game after Carillion's collapse is set to intensify this week as former senior management figures appear before Parliament's House of Commons committees that are inquiring into the collapse. The Sunday Telegraph newspaper reported that Zafar Khan, the ousted finance director, who uncovered an £800 million (Dh4.15 billion) blackhole in the business last year, believes the firm was sunk by a delayed £200m payment from Qatar.

The former Dubai-based executive reportedly plans to tell MPs that ex-boss Richard Howson, who headed the company from 2012 until July 2017 was retained by the firm to recover this money from a Doha project but failed to secure its return.

The Carillion debacle has broadly turned a spotlight on the British government’s dealings with its suppliers, leading to calls for a better deal for the private operators that deliver large swathes of public sector work.

“Government must recognise and support the thriving supply chains of small and large businesses that are already the norm and are working together to deliver value," said Mr Hardie. "It must also act as a true champion of enterprise, extending best practice to benefit society. And all parties must be honest about success and failure.”

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Read more:

UK's Capita shares plunges as new CEO halts dividend, plans rights issue

Carillion's collapse shows corporations are not always vested in the public good

Former executive ‘unearthed major problems at Carillion’

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Issues surrounding the sprawling nature of the contracting businesses themselves have also been in focus. When the key to growth was to chase every opportunity that emerges, the legacy was often poor execution and inefficient corporate frameworks. According to The Times columnist Alistair Osborne there is a curse of "toos" to avoid: "Too complex, too widely spread across multiple markets and services and with too much emphasis on acquisitions to drive growth."

Despite widespread reporting of botched contracts, Capita was a stock market favourite just a few years ago. Its shares peaked at £13.96 in 2015 before slumping below £2 last week. A Morgan Stanley trading note said the competitive challenges in the business justifies the discount to other firms.

Many analysts have predicted a second overhaul of the British government’s Private Financing Initiative, which was a groundbreaking approach to working with outside firms to develop government assets. This in turn could lead to a squeeze on the amount of work available.

Rory Mackenzie, an analyst at UBS, posed the key question to the Capita boss Jonathan Lewis on the analyst call announcing the firm-wide restructuring, saying: “Do you think the issue is, effectively, a declining gross margin in the industries you’re exposed to or is it more an issue of the internal efficiency and the conversation of that into profits?”

The latest quarterly survey of profit warnings by consultancy EY issued last month laid the blame on poor management of failing contracts in the support services sector.

“In the last few years, companies caught on the wrong side of these pressures and poorly originated contracts have struggled to turn the situation around. It can only take a few contracts to turn bad for businesses to find themselves in trouble, especially if they also have high levels of leverage and high levels of operational gearing,” it observed. “The fact that we have regularly seen the FTSE Support Services sector top the profit warning charts each year and a quarter of Business Support Services companies warning every 12 months underlines these structural difficulties.”

There have been turnaround stories in the sector, not least Serco and G4S. Rupert Soames, the chief executive of Serco, wrote the playbook that Capita is now following: stop the dividend; engage in disposals to reduce debt; and launch an underwritten rights issues.

The fate of thousands of firms that are dependent on sub-contracting to the big players remains in the balance. Although in Carillion case, the British government has had to provide a loans and support framework that sustains work on official contracts, many will have been caught out by its failure to step in to rescue the firm. “Many of Carillion’s suppliers will have automatically assumed that a group the size of Carillion would be rescued. Therefore, many will not have prepared for its collapse and will struggle to get alternative contracts in place,” said Lee Causer of the insolvency specialists Moore Stephens.

“The failure of Carillion will inevitably lead to disruption across the supply chain, and financial turmoil for sub-contractors who relied on business from Carillion.”

Is there light at the end of the tunnel? The shares in G4S are back trading in the range last seen five years ago having bottomed out at half that figure. One key to that is less reliance on official contracting. The latest results showed that it relied on government contracts for just 5 per cent of its £7.5bn annual revenue.