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Finding Efficiency in Government

(Guest Commentary by Rick Konrad – January 28, 2010)

Dear Subscribers and Readers,

For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick discusses the impending structural deficits of the U.S. and why it may not be as debilitating as it sounds.  He also introduces to us Serco, a UK based business services company that helps governments save money in the delivery of essential public service (which is sorely needed today). This commentary is a must-read.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "How is This Recovery Different?" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


As a dyed in the wool capitalist, it is not at all unusual for me to rail against government and its inefficiencies. As I write this commentary, this nation awaits President Obama's State of the Union message. Perhaps the backdrop for this message was crystallized in yesterday's Congressional Business Office annual report which called the U.S. budget outlook "bleak." The country faces a long-term structural deficit driven mainly by the rising cost of health care, the aging of the population, and a chronic need for more overall revenue.

The report gives emphasis to the serious imbalance between spending and revenues.  Total revenues covered less than 60 percent of total spending in 2009. Given the 40-percent gap between what the government brings in and what it tosses out, it's no wonder we're seeing record high deficits.

The CBO said the government will run an aggregate deficit of about $6 trillion during the next decade, a level that many economists worry could lead to currency shock, inflation, crippling interest rates or other economic maladies.

For a view of the CBO Report, please check: http://tinyurl.com/yc2ptry

John Podesta, of the Center for American Progress, testified before the House of Representative's Committee on the Budget just a few days ago:

“Both over-correcting and under-correcting pose serious threats to our economy. Failing to adequately address long-term deficits, on the one hand, threatens to result in a number of negative consequences. High levels of government borrowing can reduce domestic investment, raise interest rates, and spur inflation; seriously hinder the ability to make important public investments; and potentially leave us unable to stimulate the economy in a time of future crisis. The threat of sustained deficits can also lead to strong reactions by economic actors—investors, consumers, trading partners—that increase the likelihood of additional financial turbulence and threaten the stability of the dollar.”

“Overcorrecting, on the other hand—closing the spigot on the American Recovery and Reinvestment Act, in particular, before the economy has fully recovered—would both jeopardize our economy and kill the prospect of job growth, while also making it harder, over the long run, to address the deficit outlook over the next decade. Pursuing drastic and immediate deficit reduction when the economy has only recently returned to growth and unemployment is still at 10 percent would be an enormous mistake; fiscal retrenchment right now could lead to a double-dip recession. Those who would use current deficits as an excuse to curtail or prevent policies designed to speed the recovery are doing the country and future budgets a disservice. Recovery spending today is both necessary and entirely appropriate, even in light of the long-term budget challenge. It accelerates the recovery. Taking these appropriate steps today, in order to bring the economy back to its full health, will put us in the strongest position from which to undertake deficit reduction over the longer term. Deficit spending in the near term will help produce a return to robust economic and employment growth, yielding significant dividends in terms of future deficit reduction.”

For full testimony of Mr. Podesta, please check: http://tinyurl.com/yg25e2p

Though at times these problems seem intractable, I am far more optimistic than that. Government, much like private enterprise can and must find innovative solutions to these issues. As a Canadian, I can point to some elements of reform that were embraced to bring Canada to fiscal sovereignty and responsibility.

In an excellent article, “Reversing the Trend,” Jocelyn Bourgon, the President of Public Governance International and a former secretary in the Canadian federal cabinet writes in Ethos magazine:

“In the early 1990s all levels of government in Canada were running a budget deficit of 9.1% of GDP. The deficit of the Government of Canada stood at 5.3 % of GDP and public debt was 65% of GDP and rising. Canada's currency was weak and it faced the prospect of being crippled by debt if investors lost further confidence. Just a few years later, Canada's budget deficit was cut to zero and, in eight years, public debt was cut by a third. So how was this turnaround achieved?”

“The Canadian government used Program Review as its primary vehicle to eliminate the deficit. Program Review posited that it was vital to evaluate the relative importance of government programs and services within the overall fiscal framework. The exercise was less about what to cut and more about what to preserve in order to give Canada the comparative advantages needed to prosper in the future.”

In short, this was zero based budgeting with a feedback testing mechanism to ensure that social goals were met in the most efficient manner possible.

The tests consisted of an interactive sequence of questioning, taking into account the role of government and the effectiveness and affordability of the overall proposal. It was an ongoing process that looped back on itself should the overall proposal not generate significant savings.

Program Review Test: Decision Tree

Courtesy of Ethos, October 2009

http://www.ethosjournal.com/expert-view/item/152-reversing-the-trend

Efficiency is a strange term for us to think about in the context of government spending. It may be considered in two senses:

a) performance – very good outcomes – of an activity;

b) maximum effects of an activity related to the allocated or consumed resources.

We find both senses in the private and public sector. In the above context, the public sector is considered efficient when it provides maximum of public goods and services, within the limit of the available resources.

In order to produce results, that is to be efficient, public administration should apply the rules of market competition in providing goods and services, which implies privatization through the reorganization of the public organizations according to the principles that operate in the private sector or through determining the public organizations to enter into competition with the private ones.

The public organizations should be responsible towards the consumers and the degree of the consumers' satisfaction should be measured by their appreciation of the goods, services, information, products and facilities offered by these organizations.

In the Canadian experience, Program Review relied on cabinet ministers and their deputy minister to be the architects of departmental reforms. They were charged with the responsibility to provide a workable proposal, taking into account the Canadian government's three-year fiscal plan. To ensure a focus on role realignment rather than cuts, departments were not given individual fiscal targets until later in the exercise.

“Program Review was an open process. The Minister of Finance undertook a broad dialogue with private sector experts, Parliament and the Canadian public about planning assumptions and potential fiscal measures. This contributed to the building of public understanding and support for an ambitious reform program. Planning assumptions for growth and interest rates were more cautious than the private sector average.”

“Program Review also contributed to innovations in the role of departments. In some cases, particularly in the economic sector, the Canadian government shifted its role from ownership and operations to policy development and regulatory responsibilities. In the social sector, roles were realigned among levels of government to reduce overlap and duplication, and to provide integrated services to citizens. Some government services were re-engineered and delivery functions were modernized. Barriers were eliminated among organizations in the federal government and delivery structures were changed to provide one-stop access to government services. New information technologies were harnessed. Alternative delivery models were developed.”

Innovation is a peculiar word to use when discussing government yet innovation will be needed in effectively dealing with the fiscal mess in which the US finds itself. Government must be innovative when it has more often than not has been risk-averse, radical when it has been cautious, and empowering when it has been controlled. Rhetoric and good intentions have never transformed organizations, let alone governmental systems infested and infected with bureaucracy and vested interests. What is needed is a complete overhaul, not unlike what took place in Canada.

For a complete paper on the Canadian Program Review process, please check:  http://tinyurl.com/yb66agf

As usual, I continue to search for investment ideas that are relevant in the context of this theme. I present an idea that has been brought to me by a dear friend, consultant, and former colleague, Cleopatra Zagrean. Cleo, who was educated in Eastern Europe has earned her Chartered Financial Analyst designation while she was working for me as an analyst. She has supplemented her education with a recently minted Wharton MBA.

Cleo has introduced me to Serco, a UK based business services company. As the firm describes itself, “We improve services by managing people, processes, technology and assets more effectively. We advise policy makers, design innovative solutions, integrate systems and - most of all - deliver to the public.”

The notion of a public/ private partnership is part of the inherent culture of this firm. The company has demonstrated its expertise in partnering with government from running world-class nuclear facilities, to providing air-traffic control in some airports. It has supported defense departments, protected borders, and run prisons. Public service represents over 90% of its revenues.

Herewith, Cleo's capsule comments on Serco:

Serco Group plc – Doing Well by Doing Good

Please check: http://www.serco.com/default.asp

Serco helps governments save money in the delivery of essential public services. A U.K.-based company that is in essence a collection of around 600 service delivery contracts, Serco has navigated the crisis on a rising tide – FY 2008 revenues of £3.1bn represented an increase of 11.1% over FY 2007, and adjusted EPS of 22.20p ( i.e. excluding goodwill amortization) rose 19.6% on the prior year. Growth continued in FY 2009, with 1H revenue rising 30.8% (10.8% excluding currency and an acquisition), and adjusted EPS rising 35%. Management estimates that 2H performance will be strong also, enabling double digit revenue growth and margin improvement for the full year. Furthermore, management expressed confidence that by FY 2012 the company will reach £5bn in revenue from current operations - an estimated 8% average growth rate over the 3-year period starting in FY 2009 - and additional margin increases. Acquisitions could add to both growth rate and margins, as last year's acquisition of IS International has. 70% of revenues are derived from the U.K. and 30% internationally.

How is this performance possible in the midst of severe challenges to business models in almost all sectors and geographies? Serco capitalizes on governments' need to cut expenses in providing essential services and on its experience and reputation achieved over more than 40 years. More than 70,000 employees deliver services in four segments (performance data is based on 1H 2009 results):

Civil Government (41.5% of revenue, 31.8% of operating profit, 49.1% growth in 1H 2009): integrated facilities management, IT and business process outsourcing (BPO) support and consulting services for home affairs, healthcare, local government, education and children's services.

Defense (25.6 of revenue, 30.9% of operating profit, 33.2% growth in 1H 2009): training, engineering and operational support, maintenance of strategic defense assets, cost analysis, human resources, systems engineering, safety assurance and risk management services, operational support services to the armed forces of the UK, US, Canada, Germany and Australia.

Transport (17.8% of revenue, 13.9% of operating profit, 13.2% growth in 1H 2009): heavy and light rail systems, development of integrated traffic management systems, and leading supplier of air traffic control services transport services to the UK, Australia, the Middle East and US

Science (15.2% of revenue, 23.4% of operating profit, 10.5% growth in 1H 2009): Management of science-based organizations, e.g. a joint venture with Lockheed Martin and Jacobs Engineering to manage and operate the UK's Atomic Weapons Establishment (AWE). 

Customer relationships, reputation, and competence are key strategic advantages for Serco. Other competitors are less focused on the delivery of public services and less diversified in their service offering. Diversification provides both stability in revenue and the ability to gain efficiencies and to share best practices. Governments' needs to cuts costs provide a long-term opportunity for the company, and Serco is only now beginning to expand abroad, in both developed markets such as the U.S. - through last year's acquisition of SI International– and emerging markets such as India.

This has truly been a growth company, not an easy virtue to find in the UK market with 5 year revenue growth of 18.7% and earnings growth of 21.1%. Dividends have grown along this period as well tracking at 16.4%.

Here is a link to the historical cash flows of Serco: http://tinyurl.com/ya9uqvm

Here is a link to the some important valuation metrics and ratio analysis for Serco: http://tinyurl.com/y86gssa

A discounted cash flow valuation based on management's long-term guidance yields a fair value estimate of £6.7, 33% above the current price of £5.05.

We think companies like Serco will continue to thrive in an environment where government will becoming more willing to accept innovation and public private partnerships as a solution to current problems.

Disclaimer: I, my family and clients do not currently own a position in Serco.

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