Sometimes when I’m scouring the markets in search of a good place to put my money, I’ll get a sense of déjà vu, a kind of “hang on, I’ve been here before” moment. That’s exactly what I get when I look at the shares of Carillion PLC, the leading support services company.
Why should I get that déjà vu feeling? It’s because Carillion looks uncannily like Interserve did when I bought it back in early 2011. To date, my investment in Interserve has returned 114.5%, so finding another investment like that is obviously high on my list of priorities.
Carillion – An overview
The company operates in the Support Services sector, which means it provides maintenance and facilities management for a wide variety of buildings, as well as financing, designing and building both property and infrastructure (including Public Private Partnership projects).
It’s valued at just over £1 billion, is listed on the FTSE 250 and generates about 75% of revenues from the UK (with the remainder coming from Canada, the Middle East and North Africa).
Past performance
Starting with the past, here’s a chart showing how Carillion has done in recent years on a per-share basis.
There are two conflicting stories in this chart. The first is the relative stagnation in revenues, while the second is the near doubling of earnings and dividends.
If a company can double its earnings and dividends, then, of course, that’s good, but there are limits to what can be done if revenues are not growing. After all, margins can only be expanded so far.
Why have revenues failed to grow for the best part of a decade? The financial crisis certainly doesn’t help. The UK construction industry is apparently still shrinking, and as Carillion gets around 75% of revenues from the UK, that’s the main reason. However, management has a plan to grow internationally, and personally, I’m always more comfortable when a company has an international footprint.
The plan is to grow the Canadian and Middle East businesses to around £1 billion in revenues by 2015. That would leave the company with a more diverse revenue split, with around 60% coming from the UK and 40% from overseas.
From where things are today, that will require a near doubling of revenues from overseas, so whether or not this goal is actually achieved is uncertain, but accepting uncertainty about the future is a key part of being a successful equity investor.
By combining the growth rate in sales, earnings and dividends, we can estimate the overall per-share growth rate at 7.7% over the last decade, and that growth has been slightly more consistent than the growth of earnings and dividends in the overall UK market.
In other words, Carillion has had faster, more consistent growth than the market, which in my books, makes it a good investment candidate.
The present situation
I have three main requirements when it comes to the present:
- The company is not in the middle of some major crisis which may have significant long-term impacts.
- Debt levels aren’t high enough to put the company’s future at risk
- The share price is low relative to the company’s proven earnings and dividend-paying ability.
On the crisis front, there doesn’t seem to be one. There is the UK issue, where revenues are shrinking due to the shrinking UK construction sector, but this is a known issue and has been actively managed since 2010; although, as I said before, whether shrinking UK revenues can be fully mitigated is another matter.
Debt levels are quite high at around £800 million, but the company carries large amounts of cash on the balance sheet (close to £650 million), offsetting the debts to some degree. Interest cover is a reasonable 11.
And then there’s the pension. With current defined benefit obligations of £2,343 million, the company has massive pension liabilities. The current funding gap is £270 million, and deficit recovery payments are around £30 million a year. That’s from a company where profits are under £200 million a year.
For me, these pension obligations are likely to be too much as I have strict rules that limit borrowings and pension liabilities. That’s a shame because otherwise, Carillion was looking good.
Still, not everybody has the same rules as I do, so perhaps you can live with the company’s pension as it is. It certainly isn’t a sure thing that the pension will cause problems or dividend cuts in the future, so let’s turn our attention from the company to its shares.
Value for money?
The current share price is 262p as I type. At that price, the PE is 7.5, the PE10 (price to 10-year average earnings ratio, which helps to smooth out the yearly ups and downs in earnings) is 9.8, and the dividend yield is 6.6%.
All of those compare very favourably with the market average as measured by the FTSE 100. That index, at yesterday’s close of 6,165, can only manage a PE of 12.4, a PE10 of 13.4 and a dividend yield of 3.7%.
For me, the most striking difference is the dividend yield. When I bought Interserve at 246p, its dividend yield was 7.3%. At the time, I couldn’t see any rational reason why a company with reasonable prospects should have a 7.3% yield. However, over the years, I have come to realise that the market is sometimes far from rational.
I put most of Interserve’s gains down to the dividend. At 246p, the yield was 7.3%, and as it became clear that the dividend was still growing, investors bid up the shares until they reached around 500p, giving a current yield of 4.1%. Investors chasing the yield down have driven capital gains of 100% in just 2 years.
What will the future bring for Carillion?
Sadly, I have no crystal ball. Can it overcome the ball and chain which is its pension obligations? I do not know.
If Carillion can follow Interserve and maintain and indeed grow its dividend, then at some point, it seems likely that investor sentiment will change, just as it did for Interserve. At that point, the shares could increase massively from their current levels in a relatively short period of time.
Only time will tell.
Disclaimer: I still own shares in Interserve.
If its any comfort Carillion was on my radar too but I didn’t pull the trigger on it because of the debt. Pity because otherwise it looks good here technically. Any thoughts on Balfour Beatty as an alternative in the space?
Hi Andrew, Balfour… I own it already and have done since 2011.
I don’t have anything interesting to add because Balfour is pretty much what it is. Hopefully dividends will be sustained and perhaps grow until something interesting comes along (£100 billion infrastructure spending from the government?) to pick the company and its stock up.
Just on the debt again, I remember reading on your site that earnings before taxes should be over one fifth of the total liabilities. It doesn’t look like either Carillion or Baflour Beatty are in that position?
Hi Andrew, generally if I’m comparing earnings to liabilities I’ll mention smoothing earnings because they’re so volatile that a one year figure is meaningless (e.g. if the company makes a loss this year). So generally I’ll mention taking the latest three year average of earnings to smooth things out.
However, in my own research (and in the subscription part of this site) I use a slightly more convoluted method which looks at earnings smoothed over a decade and adjusted for earnings stability and growth. It a bit complex to cover in a blog post and virtually nobody would use it anyway as the data is hard to pull together, and it’s kind of proprietary anyway.
So yes, you may sometimes see slight differences between the analysis used in these blog posts – simpler, stripped down – compared to the paid newsletter which contains a more detailed analysis using some bespoke metrics.
But your general point still stands in that debts are somewhat high in both companies. E.g. Carillion is at 90% of the debts I would allow, which certainly isn’t helped by the relatively high pension liabilities.
John is right to average earnings in a company like BB or Carillion. These companies are involved in big projects and over 50% of net earnings are accrued not realised.
A simple example is for building a boat (neither of these companies are involved in this field as far as I know). If company A has a contract of £100m to build a big container ship at an internal return rate (IRR) of 10% it means that when the boat is delivered company A should make £10m profits. If the company A books all the profits in year 2 there is no profit in year 1 but accountants became smart about 90 years ago: as the boat is 50% built at the end of the year 1, they will book £5m as profits for company A for year 1.
However this may not work well and the boat may be delivered late and penalities may be paid. The actual profit on this project may result to be only 6% but with 5% already booked in year 1 there is only 1% to book for year 2.
There is research available which show that where the accrued earnings component of the total earnings is high there is poor earnings persistence and a market inefficiency results from the failure of investors to fully appreciate the implications of cash flows and accruals for future earnings performance.
For me the negative cash flow from operations as I found in the 2012 annual accounts is a worry. It is very easy to book profits, more important is to get money in the till.
Very interesting since I have been looking at Carillion lately — given that pension liabilities can be such a decision-changer, isn’t there an argument for taking this factor into account in the ranking? Perhaps integrated into the debt ratio column — it is a kind of debt effectively?
Hi Ranald. It would be nice, but unfortunately pension liability data is hard to come by in electronic form, or at least I haven’t found a source so far. That means it’s a manual job I’m afraid.
However, pension liabilities are a less severe problem than debts or borrowings, and the situations where pension liabilities cause a company to completely fail are much rarer than situations where borrowings cause a company to fail. As I’ve said in another reply to Monevator, there is a chance I would invest in Carillion and flout my own rules as the pension limit has yet to be tested (unlike the debt ratio limit which proved to be useful in avoiding FirstGroup).
Good write-up as usual, thanks, and the dividend cover looks pretty reasonable.
With regards to the pension, one thing to consider is what will happen if interest rates (and hence the long-term discount rate) rises?
It could well be that a lot of these pension deficits start to fall pretty rapidly in that scenario, revealing a lot of underlying value.
These things tend to ying and yang. It’s not like these companies have spent their pensions over the past few years to get into this situation — it was pretty much out of their control.
Food for thought? 🙂
Hi Monevator. I’m pretty relaxed about pensions and the vast majority of companies get past my pension screen… but not Carillion. The problem is that they are legally obliged to fund any persistent gaps and that can be a big drain on cash.
As I said I have no idea whether or not it will actually be a problem, or whether changes in asset valuations make the situation better or worse over time, but I see it as a clear risk to cash flow and would rather buy something else.
However, I am aware that skipping situations on relatively unfounded probabilities of future events can be an opportunity cost (i.e. avoid Carillion and then the shares double), so there’s still a chance I would invest in Carillion as an experiment (with my typical 3% position size) to see what happens. If things turn out well then it might be worth expanding the pension limit until one of my holdings does have a problem with pension payments that impacts dividends or something else that’s important.
Then at least I’ll have an example of what constitutes too much pension liabilities. There are various studies into pension funds, such as the LCP European Pensions Briefing below:
http://www.lcpbe.com/media/3961/LCP%20European%20Pension%20Briefing%202011.pdf
Which shows that the vast majority of companies have pension obligations less than 50% of their market cap, so having that as a cut off (which I don’t – mine is slightly different and looks at cyclically adjusted earnings rather than market cap, but it generally works out at something slightly more than market cap) seems reasonable, i.e. you would only miss out on a very few companies.
I’m not sure it’s out of their control either. It was their decision after all to have a defined benefits plan. If it was defined contribution then there is no liability whatsoever. Defined benefit pensions were always a bad idea in my opinion.
John
As a pension transfer specialist I didn’t like you comments about the defined benefit pension. I did not have time to check but probably the DB scheme is closed to new entrants and it may be even closed for future accruals and all members may be in deferral now having a new defined contribution pension in place.
The fact that the company offered a DB scheme could have been important for this company, we just do not know. Employees that are loials are very important as they cary all the know-how and the wisdom of how to deal with a construction project, and in these days very few projects are similar.
Looking at the figures presented there, the deficit of the scheme calculated in % is less than average for a FTSE 350 company. £30m annual pension contribution is not high if the profits are £200m. Obviously God knows what is going to happen with the profits. The PER is so low as the consensus of investors is that it can’t be maintained.
Hi Eugen, let’s agree to differ on DB pensions then. I still think it’s a drag on Carillion and hurts shareholders. If that £30 million was paid to shareholders instead of the pension fund it would add almost 50% to the existing dividend taking the yield to around 9% at the current prices.
That’s fine, but as the £30m is there we should not complain about it. We make investment decisions knowing about it.
Nearly every FTSE 350 has a scheme in deficit which is subject to a 10 years recovery plan. Obviously at every 3 years actuarial valuation if the deficit is higher that planned initialy the recovery plan is reviewed and contributions will increase.
However as defined benefit pensions become a thing of the past, there is a new guaranteed pension proposed and some companies are already interested in them. The name is defined ambition (DA) pension scheme. There is obviously a diferrence between DB and DA schemes, DA only offers a guaranteed return on auto-enrolment pension contributions until retirement – let’s say 6% per annum. It obviously helps employees who retire immediately after stock markets have a big drop. From there on a retiring employee could buy an annuity, which is a guaranteed income.
WM Morrison is first to offer this scheme. It has some strings attached, as employees need to stay with the company for 10 years until they qualify for this guaranteed benefit. These schemes are important for big companies, it helps them retain their employees and hire the best skilled employees. For you it may look like a cost that drains the company, but the employees are the main driver for profits in every company.
To ease your mind, there are new pension rules that just came through. A company could request the trustees of the scheme to stop making pension contributions under a recovery plan for up to three years. Obviously there should be reasons for that. I have just seen a request approved for Trinity Mirror Plc, a small cap stock.
I will start looking at Carillion myself, it doesn’t fit my investing profile but I have the feeling things may improve. I will not invest now but keep an eye on the stock. Cash flow is a worry at this moment, the cash flow from operations it was negative last year (probably this is a sign) so the company needed to borrow more.
I think the pensions issue is a red herring. They are not the only company by far having to make up for a pension deficit, although over the last year company pension deficits have fallen as the stock market has made gains. Carillion’s total debt is on target to decrease significantly (see Carillion’s October 2013 statement) and they are looking outside the UK for growth (although they are still winning a steady stream of new contracts in the UK too), and the performance is leaving Balfour Beatty trailing behind. I bought into Carillion at 260 and I’ve since enjoyed a steady stream of rising dividend income. I see Carillion as a solid long term stock.
Hi Anon, I’m inclined to agree.
However, I have seen examples of other companies where the pension liabilities were smaller, but because the pension assets were underperforming it led to significant cash having to be fed into the pension plan. So while Carillion looks okay at the moment it is still a risk, but yes, I would probably say that the risk is very small.
But as I’m always fond of saying, there are plenty of other fish in the sea and so missing out on Carillion is not the end of the world.