£1.5bn writedown sees Serco go cap in hand to the market

ONE OF THE UK’s biggest government outsourcers faces further restructuring following huge writedowns.

Serco, which was banned from UK government contracts last year for offender mis-tagging, has taken a £1.5bn impairment charge relating to contract provisions and goodwill/intangible assets writedowns.

Its ongoing contract and balance sheet reviews, which have involved assistance by EY, have currently outlined £1.5bn in adjustments although “the range of possible outcomes is still wide”, Serco said in a statement to the stock exchange.

Banking covenants will also require negotiation, the outsourcer said. Its principal financial covenant requires that its leverage should not exceed 3.5x EBITDA. Net debt at 31 December 2014 is likely to be in the region of £650m-£700m, due to lower cash flows and forex movements – this will see net debt exceed 3x EBITDA, while further non-exceptional onerous contract provisions or other income statement charges would further reduce the calculation.

“Whilst it is a bitter pill, it is better for all concerned that we swallow it now and establish a really solid foundation on which to build Serco’s future,” said group CEO Rupert Soames.

Non-core businesses, including its UK environmental and leisure businesses, will be disposed.

Equity call

Aside from changing the covenant testing date or amendments to the terms, Serco is also looking to raise equity. It is aiming to raise £550m in Q1 2015, and has been fully underwritten on a standby basis by Bank of America Merrill Lynch and JP Morgan Cazenove.

The rights issue will also fund Serco’s attempt to focus on a core strategy of ‘business-to-government’, or B2G. Its strategy review had found that Serco had made “two strategic mis-steps”. Firstly, it diversified and made acquisitions in an attempt to counteract slowing growth rates in core markets, which diluted the business.

Secondly, it concentrated too much on winning new business, losing focus on effective management of existing work – particularly where UK contracts now transfer much more risk onto the supplier. The group is now making “large losses” on a number of contracts.

Serco’s infrastructure has also failed to keep pace with its growing scale, breadth and complexity, with the result that its systems, processes and management information “fall short” of what is required.

“As a consequence the business has lacked operational visibility as evidenced by the issues that arose last year on certain UK government contracts; has made some poor judgement on how much risk to accept within contracts; and has found it hard to control costs,” Serco said.

These system and process shortfalls have been dealt with, Serco added, including a strengthening of risk assessment, internal audit and its board – with new FD Angus Cockburn in situ for the past two weeks. Two divisions have been created in the UK: for central government; and UK & Europe local and regional government, where one existed before. Operational management responsibility has also been brought closer to the board.

“We therefore believe we have learned the hard lessons of the past couple of years such that we are now appropriately equipped to do what has always been our core competence,” Serco stated.

Contract travails

Serco’s travails follow hot on the heels of similar issues at Balfour Beatty – where contract controls have also been put into question and impairments have been made.

With Serco’s share price plummeting 96.8p in this morning’s trading (to 220.3p), Cass Business School professor Andre Spicer said it had paid a “potentially astronimcal cost” for failing to carry out is contractual obligations…”trust was undermined”.

“Restoring the outsourcer’s reputation is going to take time. One of the major ways they can do so is by developing a better understanding of the soft risks associated with their activities. This means having a better understanding of people and culture, not just costs and whether KPIs are achieved,” said Spicer.

“In addition, Serco should ensure employees and service users are able to speak up or challenge bad behaviour before it gets out of hand. This means listening, taking action on what you have heard and then reporting back.”