Serco chastened by costly lesson in outsourcing risk

By Neil Maidment

LONDON (Reuters) - From broken Australian Navy boats, to hotel bills for UK asylum seekers, the costs have piled up for Serco, a pioneer of an outsourcing boom that promised lucrative returns but has proved a far riskier business than many thought.

The persistent payouts, combined with scandals over government contracts in Britain, have battered profits and exposed flaws in the way Serco won and operated business, resulting in the most disastrous spell in its 85 years.

Serco's 1.5 billion pounds of write downs and subsequent share price dive that wiped a third off its value on Monday may serve as a cautionary tale to investors once wowed by the promise of a golden age of outsourcing.

"I think that at great expense to the shareholders we have learnt some big lessons," Serco Chief Executive Rupert Soames told analysts this week.

Since joining in May, Soames, grandson of British wartime Prime Minister Winston Churchill, has blamed Serco's problems on two things: an acquisition-led move into private sector back office work like accounting, and a desire to win as much government work as possible, regardless of risk or poor returns.

He asked consultants McKinsey to build a strategy for a group sprawled across 30 countries with over 100,000 staff and, after slow progress on its own review, hired forty EY accountants in September to comb its finances and 700 contracts.

EY said Serco needed a provision of 450 million pounds to cover expected losses on the life of a handful of contracts. The colossal sum was announced on Monday as part of the 1.5 billion pound writedown, along with a fourth profit warning of 2014, a suspended dividend and a 550 million pound cash call.

The market's response was Serco's steepest ever one-day share fall, as investors digested news that profits would slump at least until 2016 due to the problems, as well as falling margins and less work.

INTENSIVE CARE

In one problem contract, a 175 million pound, five-year deal to provide asylum seeker accommodation in Britain, Serco loses money on each person it processes, after its bid team, largely disbanded since, failed to take into account rising housing costs, increasing asylum numbers and the pace of deportations.

In Australia, a contract to maintain Royal Navy patrol boats hit the rocks nine months ago when, after higher than expected usage and poor maintenance by Serco, hulls began to crack.

A new engineering team needed be hired and their assessment showed the boats need "intensive care" until the contract ends in 2022, costing Serco 150 million pounds.

Big problems had started for Serco in 2013 when, alongside rival G4S, it was found to have falsely billed the British government for tagging criminals, some of whom were never given the tag that would allow them to be tracked outside of jail, some were in prison and others were dead.

Both companies were banned temporarily from bidding for new government work, received multi-million pound fines and remain the focus of an investigation by Britain's Serious Fraud Office.

The scandal fuelled public suspicion about successive British governments' enthusiasm for outsourcing, already intense after G4S failed to provide enough security guards for the London 2012 Olympics.

In 2013, Serco waived profits on a UK prisoner escort contract after staff were found to have recorded prisoners as having been delivered ready for court when they were not.

It has since taken a loss on the work after realising it needed a raft of extras, from 100 more staff, to IT improvements and a consultancy team to help meet its targets.

Despite such costly lessons, Soames sees Serco's future almost exclusively in outsourced public services in areas such as justice, healthcare and defence, as governments continue to turn to the private sector as a way of achieving budget savings.

Soames says such markets are set to grow at 5-7 percent, but analysts think reputational damage and restructuring upheaval means it will be years before Serco can push its margins from 2-3 percent to the 5-6 percent enjoyed by some peers.

The fact that Soames' reviews will not complete until March also means further bad news cannot be ruled out.

Part of Serco's recovery will be learning to say 'no' to contracts. Soames said deals would no longer be signed unless they could be shown to be profitable.

"To me the critical thing is ... how much risk are we taking for the return that we're getting?," he said.

"That is not to say that we will never make mistakes, but we have been badly bitten, and we will be thrice shy."

(Editing by Robin Pomeroy)

By Neil Maidment

LONDON (Reuters) - From broken Australian Navy boats, to hotel bills for UK asylum seekers, the costs have piled up for Serco, a pioneer of an outsourcing boom that promised lucrative returns but has proved a far riskier business than many thought.

The persistent payouts, combined with scandals over government contracts in Britain, have battered profits and exposed flaws in the way Serco won and operated business, resulting in the most disastrous spell in its 85 years.

Serco's 1.5 billion pounds of write downs and subsequent share price dive that wiped a third off its value on Monday may serve as a cautionary tale to investors once wowed by the promise of a golden age of outsourcing.

"I think that at great expense to the shareholders we have learnt some big lessons," Serco Chief Executive Rupert Soames told analysts this week.

Since joining in May, Soames, grandson of British wartime Prime Minister Winston Churchill, has blamed Serco's problems on two things: an acquisition-led move into private sector back office work like accounting, and a desire to win as much government work as possible, regardless of risk or poor returns.

He asked consultants McKinsey to build a strategy for a group sprawled across 30 countries with over 100,000 staff and, after slow progress on its own review, hired forty EY accountants in September to comb its finances and 700 contracts.

EY said Serco needed a provision of 450 million pounds to cover expected losses on the life of a handful of contracts. The colossal sum was announced on Monday as part of the 1.5 billion pound writedown, along with a fourth profit warning of 2014, a suspended dividend and a 550 million pound cash call.

The market's response was Serco's steepest ever one-day share fall, as investors digested news that profits would slump at least until 2016 due to the problems, as well as falling margins and less work.

INTENSIVE CARE

In one problem contract, a 175 million pound, five-year deal to provide asylum seeker accommodation in Britain, Serco loses money on each person it processes, after its bid team, largely disbanded since, failed to take into account rising housing costs, increasing asylum numbers and the pace of deportations.

In Australia, a contract to maintain Royal Navy patrol boats hit the rocks nine months ago when, after higher than expected usage and poor maintenance by Serco, hulls began to crack.

A new engineering team needed be hired and their assessment showed the boats need "intensive care" until the contract ends in 2022, costing Serco 150 million pounds.

Big problems had started for Serco in 2013 when, alongside rival G4S, it was found to have falsely billed the British government for tagging criminals, some of whom were never given the tag that would allow them to be tracked outside of jail, some were in prison and others were dead.

Both companies were banned temporarily from bidding for new government work, received multi-million pound fines and remain the focus of an investigation by Britain's Serious Fraud Office.

The scandal fuelled public suspicion about successive British governments' enthusiasm for outsourcing, already intense after G4S failed to provide enough security guards for the London 2012 Olympics.

In 2013, Serco waived profits on a UK prisoner escort contract after staff were found to have recorded prisoners as having been delivered ready for court when they were not.

It has since taken a loss on the work after realising it needed a raft of extras, from 100 more staff, to IT improvements and a consultancy team to help meet its targets.

Despite such costly lessons, Soames sees Serco's future almost exclusively in outsourced public services in areas such as justice, healthcare and defence, as governments continue to turn to the private sector as a way of achieving budget savings.

Soames says such markets are set to grow at 5-7 percent, but analysts think reputational damage and restructuring upheaval means it will be years before Serco can push its margins from 2-3 percent to the 5-6 percent enjoyed by some peers.

The fact that Soames' reviews will not complete until March also means further bad news cannot be ruled out.

Part of Serco's recovery will be learning to say 'no' to contracts. Soames said deals would no longer be signed unless they could be shown to be profitable.

"To me the critical thing is ... how much risk are we taking for the return that we're getting?," he said.

"That is not to say that we will never make mistakes, but we have been badly bitten, and we will be thrice shy."

(Editing by Robin Pomeroy)