Everyone’s a winner

Drinks with an outsourcing analyst last month we were laughing about how, for her sector, it was 2008. It’s not fun to be an analyst when your sector becomes uninvestable. “No one trusts the management, the numbers, the forecasts, the accounting.” I laughed, it brought back some old memories.
There are interesting parallels. Like banks 10 years earlier, companies like Carillion, Serco and Capita were supposed to be boring, systemically important, and deriving a stable source of revenues from the Government. Capita share price grew from 10p a share in the mid-1990s to almost 800p 3 decades later (an 80-bagger). These were supposed to be good companies in a sector that had been attractive for shareholders. This is particularly frightening for a “buy and hold” investor, because the story never seemed to change, right up until the profit warnings started.
More of the same is different. Fortunately we have a pithy summary of what went wrong from Serco’s Annual Report 2017:

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. [But]…. the flow of milk and honey did not last indefinitely.

Before 2008, banks too had a couple of decades of benign conditions. No transformational strategies, no cautious hints in outlook statements from management. Just double digit earnings growth and apparently sustainably high returns in the mid 20% RoE range. The future seems to resemble the past. But at some point in time the future has to be different…that’s what makes it the future.
Under the surface outsourcing companies were facing problems which would eventually rise and become visible. As Serco points for the outsourcing sector the change went unreported:

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.

Despite this deterioration, Capita increased margin guidance in their 2015 report talking about “the significant structural growth opportunities in our markets”, just before things went wrong. Similarly bullish outlook statements were being made by Northern Rock, backed up double digit EPS growth and market share gains in the first half of 2007, months before it collapsed. But below the surface, all was not well, as Serco now tells us:

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.

Given the accounting games companies play with reported profits it’s difficult even for professional analysts to spot the danger. But perhaps that’s the red flag in itself. In early 2007, Northern Rock reported statutory EPS growth +30% for the previous year. Barclays Capital reported a +55% jump in profits for the same time period, putting Royal Bank’s Global Banking and Markets division at “only” +25% in the shade. If these gains were real, where were the profit warnings from companies or retail customers complaining that their financing costs had risen hugely?
All the banks reported great results. In a competitive sector, everyone seemed to be winning. We now know, the gains were coming from pulling forward reported revenues, opaque and unsustainable financial activities. The more cynical might also notice that management rewards come from these artificially inflated reported profits.
Thinking back even further, this game has been going on for decades. Telecoms around the turn of the century recorded gains which seemed to be coming out of thin air, until they weren’t and Global Crossing, WorldCom etc collapsed. Enron used Mark-to-Market accounting as a performance enhancing drug: revenues grew from $10bn to $100bn in 4 years.
So rather than delve too deeply into the accounting shenanigans, revenue recognition versus growth in receivables, comparing profits to operating cashflow, net debt manipulation etc; there might be much easier “caveat emptor”. Beware when a company (or all companies in a sector) claim to be growing revenue much faster than the economy, and there are no signs of stress, no one is disappointing. A simple rule of thumb is to be wary of sectors where everyone’s a winner.
So now, who’d like to buy a London house at the asking price? Anyone?

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