Where Financial Carnage Comes as Part of the Contract

(Bloomberg Opinion) -- Serco Group Plc CEO Rupert Soames frequently boasts that the U.K. contracting firm was an early adopter of financial carnage – to stress that the business is now the better for it.

. Pulling through a crisis five years ago has given Soames the credibility to embark on M&A, and he has had his eye on defense contractor Babcock International Group Plc.

. Contrast this with construction group Kier Group Plc, which on Monday reminded investors just what financial carnage looks as it unveiled a plan to shrink and cut debt.

. Government contracting is a potentially attractive business – but when it goes wrong, it can be a disaster. Memories of Carillion Plc’s bankruptcy may still be fresh in investors’ minds. At least Serco shows that these businesses can, eventually, pull through.

. With the shares at a two-year high, Serco is in the luxurious position of being able to fund deals by selling stock. It has come a long way since 2014’s emergency rights offering. A takeover of Babcock – which has a market value of about 2.5 billion pounds ($3.2 billion) against Serco’s 1.7 billion pounds – would be ambitious and involve issuing stock to Babcock shareholders.

. The move looks opportunistic: The target’s shares have halved in the last two years, its management is out of favor, and a recent investor day prompted a lukewarm response.

. The combination would seem to offer more to Serco than to Babcock – unless there were a significant premium to compensate, and the relative size of the businesses would make such a thing hard to engineer.

. Serco hasn’t been fully rehabilitated; its dividend remains suspended. Babcock, which does pay a dividend, has niche businesses in aerospace and defense with better-than-average margins. Much as its shareholders may admire Soames, a deal would surely dilute the quality of the Babcock business. It’s not hard to see why the target rejected talks following an approach earlier this year.

. Kier, 10%-owned by beleaguered investor Neil Woodford, is finally doing the same things as Serco did during its crisis – selling assets, changing management and raising equity – albeit in the wrong order. December's 250 million-pound rescue rights offering has already been exhausted and the company is only now just embarking on a radical self-help program . Its market value today is just 178 million pounds.

. It’s now clear there is much that Kier could have done by way of restructuring before asking shareholders to stump up last year. New CEO Andrew Davies is jettisoning businesses, such is its residential property construction arm, that drain working capital and have few synergies with the core contracting operation, which is focused on infrastructure and highways. The dividend is going altogether, as are 1,200 jobs, largely from corporate center.

. Kier points to the absence of near-term debt maturities, which should give it some breathing space. But the company appears to be a forced seller and will need to attract competing bids to inject some tension into the sale process.

. This is an uncomfortable position to be in given the uncertainty around Brexit. The financial strains are now dictating strategy after an aggressive program of expansion by acquisition left the company short of cash.

. It is possible Kier will pull through, its share price will pick up and that one day Davies, like Soames, will be able to look back and joke about financial carnage. For investors right now, that moment seems an incredibly long way off. As for Serco, its acquisition currency may not yet be tempting enough, and its target’s woes not painful enough, to make a deal with Babcock a reality.

. To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net

. This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

. Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

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Where Financial Carnage Comes as Part of the Contract