The recent collapse in the share price of Carillion took many investors by surprise, but should it have?
I don’t think so.
Yes, on the surface things looked fine. Carillion was a highly successful company, with a very long track record of steady revenue, earnings and dividend growth.
But underneath the covers, there were some major problems which were easy to spot if you knew where to look.
Luckily for me, I’d already suffered at the hands of similar companies with similar problems (Balfour Beatty and Serco spring to mind), so I knew what to look out for from bitter experience.
To save you the bother of having to get that experience the hard way, I’ve written up what I think are Carillion’s five major problems in this month’s Master Investor magazine:
Important lessons from the Carillion disaster
Ciao John,
If you only wrote this piece 2 months ago!!! I am one of the investors who “had it bad”, I did spot the high debt and the acquisition spree, but I didn’t evaluate the operative margins or the pension scheme issue… I guess it’s “licking wounds time” for me, but it’s also part of investing, I should have done a better diligence on them.
Anyways thanks for the article, hopefully it will help me in making less mistakes in the future.
Regarding pension schemes, I see that many companies are trying to negotiate with the workforce new schemes, is that right? I am following RMG of lately and they seem rather busy in doing this with the unions, although it also seems that an agreement is hard to find. The thing that I do not understand is exactly how they want to change the system for the employees, just giving them less pensions?!
Ciao ciao
Stal
Hi Stal, on the plus side I would say that losing money is the best way to become a better investor! Unfortunate but true.
As for Royal Mail Group (RMG), it does indeed have a massive pension scheme, so I’m not surprised management are trying hard to reduce future liabilities by taking out insurance and negotiating with workers.
The total pension liabilities are currently just under £6 billion compared to 5yr average post-tax profits of about £0.7 billion. So the ratio of pension to profits isn’t quite over my limit of 10x, but it’s close. Also, it looks like a good guess at future average profits might be closer to £0.5 billion, which makes the pension picture even worse. However, one positive is that the scheme has a massive surplus, so there are no obvious signs of this pension being a drain on cash anytime soon (famous last words?)
This is a problem for quite a lot of long-established companies, and the well-trodden path is to close the scheme to new members and to close it to further accruals of benefits. Then there are various insurance-related options, including handing the whole scheme off to an insurer to deal with.
If you look at the RMG latest annual report, note 9, there’s a lot more detail on the pension and what RMG have been doing.
The poor quality of many company directors, and their lack of ability and intelligence is astounding. It’s just not good enough.
How is it feasible that no one had the billow, energy or honesty to deal with the problems before burning out shareholders. Salaries just don’t tally
Hi Michael, I don’t know exactly what the reasons were at Carillion, but in general I would say fixing excessive pension and debt obligations usually entails taking some unpleasant medicine (dividend cuts and rights issues primarily) that neither management nor institutional shareholders want to take.
So they cross their fingers and hope that “business as usual” can continue for the foreseeable future, or at least for as long as they remain in their current roles as major shareholders and executives. With a bit of luck they can get out while the going is still good, and make a tidy buck or two.
Obviously this isn’t always the case, but too often it’s a very plausible description.
John – I noted your comment about not avoiding construction companies (or service companies) but guarding against these problems to make intelligent investments in them..
To be honest I’ve seen so many of this type of company look so good for so long and then collapse I just can’t ever imagine myself investing in any of them. Even when a company has a strong balance sheet, low debts and/or no pension issues,, their industries are like taps — they can turn off ever so quickly and contracts are all fluid and cancellable or down scalable by the client — you simply won’t get a contract signed these days unless there are several (client favoured) get out clauses in the event of economic change.
My son is a in charge of projects with quantity surveyors and project planners and he sees this all the time.
Other companies that have similar long term contracts have also suffered – look at Capita (one for the same reasons I always imagined would come unstuck – just simply looking at it’s debt growth, rising revenue and falling profits). You don’t have to be a rocket scientist to figure them out – you just have to tune your self in as your article illustrates so eloquently.
I am pretty confident that Babcock is next on the list after Serco, Capita, Interserve, Carillion, Balfour and many more.
I’m afraid, rightly or wrongly, I have a mental shut off point and my eyes glaze over when certain sectors and companies within them are “bigged up” by analysts and stock pundits.
This is one of the worst sectors, but there are others also that I just can’t now touch anymore.
LR
Hi LR, to be honest I kind of agree with you, but I hate to shut off certain sectors just because lots of companies within them have problems. I think I’ll keep an open mind for now and continue to invest in construction companies where the risk/reward ratio looks good. But if I get burned a few more times then perhaps a blanket ban is the way to go.
I have have shares of Serco. Hopefully, they will be able to improvise operations. What are your thoughts on Serco?
I haven’t looked at Serco in a long while; ever since I sold the company for a 50% loss in 2015.
Back then, Serco was just like the Carillion of today: 1) dependent upon large complex contracts; 2) weak profitability; 3) saddled with lots of debt; 4) a massive pension scheme and 5) a history of recent large acquisitions.
The company suspended its dividend in 2015, so it’s currently excluded from my stock screen, which only shows companies with at least 10 years of unbroken dividend payments.
So Serco is definitely a no-go stock for me because of of all the factors listed above.
For me to like Serco, it would have to 1) massively reduce its debt and pension obligations, 2) improve profitability, 3) start paying a dividend and 4) show consistently good results over a number of years.
As for whether or not the company can improve, I have no idea, but I certainly won’t be investing until it has.
Nice insight into the contracted life of a support services business. Agreed that long-term contracts can be loss-making if wages and material inputs (due to the weak GBP) rises faster than forecast.
I actually did some work on Carillion and would like to add a few more things to the conversation:
-Trade receivables, as % of sales fell from 6.5% in 2004 to 4.4% by 2016. But, Total Receivables, as % of sales rose from 18.5% to 31.9% in the same period. That would have contributed to their profits!
Another measure is to use operating cash conversion. So, in the past five years, it made cumulative net profit of £688.9m, but net cash flow of £166.4m!
-Their £1.3bn acquisitions contributed a net loss of £20m, instead of the impressive profits.
-Support services and long-term contractors can manipulate their accounts to show better borrowing figures. But, Carillion did say their average borrowing is over £1bn in 2016, compared to year-end borrowings of £688m.
Given that a Rights issue is inevitable, how much do you think Carillion need to deleverage their balance sheet and sustain operations?
My guess is £400m but could be more.
Hi Walter
I like your blog post on Carillion; interesting that we both chose to write about the same company at the same time! I guess it is a bit of a high profile car crash.
In terms of how much cash I would want to raise if I were CEO, here’s my fag-packet estimate:
I would want to see the debt ratio (of borrowings to 5yr average earnings) brought down from 5 to 3. The borrowings are currently £700m (rounded up) and average earnings are £140m, so reducing borrowings by £280m to £420m would be a start.
However, that’s small fry. I think the real problem is the pension. Currently, total pension liabilities come to £3400m (rounded up). while average earnings are £140m. I prefer pension liabilities to be less than 10x earnings, so I’d like to see that liability come down to below £1400m. Obviously the company isn’t going to raise £2000m in a rights issue, so that level of reduction is not going to happen. A more “realistic” measure would be to clear the deficit, which is currently over £800m (or almost £700m if you deduct deferred tax). Either way, it’s a massive deficit. Carillion isn’t going to ask the market for £700m or £800m on top of the £420m required to reduce its debts, so the deficit isn’t going to get cleared. I think a more realistic route would be for some sort of deal with an insurance company to take on the risks and rewards, but of course that’s not going to be cheap either.
So in summary, you think about £400m needs to be raised and in your blog post you mention other analysts who say £500m. I say that neither of those amounts is likely to do much good. I’d like to see the company raise more than £1 billion, but of course that’s never going to happen.
Hopefully Carillion can survive but from where I’m sitting it chances do not look good.
Easy article to write after the fact. There were certainly signs with heavy shorting for some 2 years but nobody was quite expecting this.
Of course things always look clearer in hindsight, but the warning signs that I wrote about were there for years. If Carillion had been at today’s price at any point during the last five years I would have avoided it, precisely because it combined a cyclical business model with high debts, a massive pension scheme and a history of large acquisitions.
John — I’m going to have a stab at what your next article might be entitled :-
“Important lessons from the collapse of Provident Financial’s share price”
LR
Good idea. Perhaps we can snatch victory from the jaws of somebody else’s defeat?
John, Perhaps with the AA or WPP, rather than PFG.
Hard to say at the moment, looking into the first two with an open mind.
LR
Hi John,
How rigorously would you apply the rule about only investing in a company if its debt/earnings ratio is below 4 for a cyclical sector stock and below 5 for a defensive stock? The ratio for REITs is almost always likely to above 5, however this debt is backed by property which should (I hope) have a more stable valuation than acquisitions which may succeed or fail. Would you apply a different rule to a REIT?
Hi FD
I don’t invest in REITs, so I don’t have a good answer for you I’m afraid. I don’t have anything against REITs, it’s just that I prefer to stick with trading companies rather than investment companies.
If I did invest in REITs then you’re right, I’d probably have to come up with a different rule for them as their situation is somewhat unique. But I have no idea what that rule would be.
Hi John,
I have a discretionary arrangement with stockbroker who recommended Carillion & stuck with it after I’d aired my doubts – so took a big hit. Is there any way to get some sort of compensation?
Thanks,
Tom
Hi Tom. Possibly. Here’s the FCA page on complaints and compensation:
https://www.fca.org.uk/consumers/how-complain