Doomed outsourcer Carillion (LSE:CLLN) bypassed administration on Monday and headed straight into liquidation after failing to secure the funding needed to pry it from the financial dire straits it has been unveiling since last summer. Carillion’s problems started last July when its shares fell by around 70pc on the back of a profit warning which saw the firm cut its hefty dividend, fire its boss, write down £845m, and undertake a large restructuring.
It turned out to be the first of three warnings in five months, which can largely be put down to rising debt and falling cash levels at the hands of three troubled public contracts. Aside from putting thousands of jobs at risk and transferring a number of public projects to the government, the company’s liquidation means that all of Carillion’s shareholders will suffer a 100pc loss.
I can only offer my sympathies to these investors. But with Carillion’s estimated debt coming in at between £900m and £2bn against a market cap of just £61m as of Friday, there are plenty of lessons to be learned the firm’s fall from grace.
Here, we will look at how investors can avoid getting caught up in a company like Carillion in the future. Not all falling knives are worth catching, after all.
Shares in Carillion were suspended from trading this morning after the company announced it had made an application to the High Court for compulsory liquidation. Accounting firm PWC will likely be appointed as administrators.
This came after talks between Carillion and key financial stakeholders – which includes the UK government – to reduce debt, strengthen its balance sheet, and get short-term financial support broke down over the weekend.
The news came just days after the business said it was continuing to engage in constructive discussions with stakeholders, and rejected claims that its business plan had been rejected.
The Wolverhampton-based company has 43,000 staff worldwide and is one of the government’s biggest contractors. It was working on projects like the £1.4bn HS2 high-speed rail line and £400m Battersea Power station redevelopment.
Although the government will now provide funding to maintain the public services run by Carillion, many of the thousands of small firms that carry out work on Carilion’s behalf risk not getting paid.
Why did it happen?
Carillion’s problems started last July, when shares tanked after the business warned markets that it was losing cash on key contracts and debt was rising.
Investors fled as the business suspended 2017 dividends to save £80m of cash to help cover its £580m pension black hole, wrote down £845m and launched a review of its operations which saw boss Richard Howson get the boot.
Problems were chiefly created by cost overruns on three UK public sector construction projects; a £350m hospital in Sandwell, the £335m Royal Liverpool Hospital, and the £745m Aberdeen bypass.
Despite issuing two more profit warnings, being subjected to an FCA probe, and warning that it was likely to breach its debt covenants, the firm has been awarded £1.3bn of contracts since July, according to research company Tussell.
This included one contract to design and build a 50-mile section of the HS2 railway from the government. This move raised many eyebrows at the time and is now coming under significant pressure from the national press.
Like Serco before it, many of Carillion’s problems have been put down to the mismanagement of contracts, with the business spreading itself too widely across many sectors.
It has also been accused of taking on projects with wafer-thin margins, made even thinner by a tough bidding environment which makes it more sensitive to cost over-runs.
Poor corporate governance, excessive senior staff bonuses, weak confidence among lenders, unsustainable growth through buying companies have also been named as contributors to the firm’s downfall.
With the announcement of an FCA probe earlier this month sending shares south again after a brief rise at the tail-end of 2017, today, the pressure became too much.
Lenders including Barclays, HSBC, Lloyds and Santander, refused to provide Carillion with the rumoured additional £20m it had requested for short-term financing. This would have sat on top of the £1.5bn they were already owed.
Carillion now stands accused of embodying the careless approach private companies take to public project work. Many of its projects partners have today outlined the eye-watering additional costs they will now have to cover.
We at ValueTheMarkets.com are not too proud to admit when we missed the mark. After all, it is all part of speculative investing.
Back in October, when Carillion’s share price looked to have hit a bottom around 42p, we suggested that, despite an overwhelming case to be bearish on the stock, it could be worth a punt.
Our justification was that the company had continued to secure substantial contracts, including some from the government, with its order book standing at around £16bn.
Furthermore, the firm said it had received multiple bids for its healthcare business, opening the possibility of more post-restructure sales on the horizon, potentially provoking a bidding war.
Alas, mistakes are merely steps up the ladder, or so the saying goes, and this did not turn out to be the case.
With short-sellers eyeing up Carillion for months before its share price collapsed, signs that the firm was on the rocks were clearly there if you knew where to look.
Aside from once again showing how useful it is to keep an eye on the FCA’s daily register of short sellers, there are plenty of lessons to be learned form the outsourcer’s downfall.
Firstly, when searching for investment opportunities, all investors must look out for growing debt levels at firms. While debt can often be a useful source of funding, in Carillion’s case it reached an unsustainable level.
By Friday, Carillion’s last day of trading, the firm’s share price had fallen 90pc since July and its market cap had shrunk from £2bn in 2016 to a minuscule £61m.
This meant Carillion’s debt, which the business puts at £900m but is estimated to be as high as £2bn by some sources, alongside its £600m pension liabilities, far outweighed its equity value.
Debt can be especially dangerous when profit margins are weak, and here Carillion failed to take enough precautions to ensure it could pay back creditors.
As Russ Mould, investment director at AJ Bell, puts it: ‘In 2016, Carillion generated a stated operating profit of £146m on sales of £4.4bn for a margin of just 3.3 per cent – and that operating profit had to fund £60m of interest and pension payments, tax and £79.8m in dividends so there was little margin for error.’
The dividend honey trap
Despite underlying problems Carillion long attracted income investors with its high dividend yield. In the months before it was cut it reached more than 7pc, but the business kept the party going long after it should have finished.
Some have accused the business of making large purchases – such as Mowlem for £350.3m, Alfred McAlpine for £554.4m and Eaga for £298.4m – to mask slowing growth in other parts of its business.
They argue Carillion was also selling off other parts of the business to create extra cash. This would allow dividends to be paid for longer in order to give the impression that everything was rosy.
This meant investors were mostly unaware of the true scale of Carillion’s problems, which short sellers had already latched onto, until last July. This partially explains the whopping 70pc share price drop over the days that followed.
Looking back, it seems clear that Carillion’s profits and share price were struggling for some time. Weak free cash flow and low margins were putting the company’s dividend at risk, and the firm was using acquisitions to drive its prospects.
What can be taken from this is firstly that it is important to be wary of companies, which are carrying out large numbers of acquisitions. They must also be skeptical of high-yielding stocks; this can often be the sign of a poorly-run company.
If they are not properly covered, large dividends can often hamper business growth by reducing the amount that is invested back into the company. They are also highly volatile due to their dependence on financial performance.
Aside from their lack of future guarantee, a large dividend can often indicate that a stock is out of favour, because share prices and yields are often inversely related.
In its 2016 annual report, Carillion boasted of increasing its dividend every year since it was founded in 1999. This stood for little when payouts were cut to zero in one fail swoop last July.
Things can always get worse
With that in mind, investors also need to remember that just because a company’s share price has had a large fall, it can still fall further. It often said that profit warnings come in threes, and this is so in the case of Carillion.
Carillion’s restructure and profit warning did not change the fact the firm was taking on increasingly risky projects in a construction environment where margins were already being squeezed ever tighter.
Add to that the ongoing risk of late payments and project delays continuing to lurk in the background at a time where the business had little cash to cover any potential problems.
As such, Carillion issued two further profit warnings – a total three in five months – and shares fell even further. Those who bought after the first dip on the assumption that shares would bounce back, found themselves sitting on losses.
Cutting your losses
This brings me on to the most important lesson of all here, which is recognising when to cut your losses by getting rid of the losers.
At its last call to 21p in November last year, following the news that it was likely to breach its covenants, Carillion’s debt level still far outweighed its market cap. This remained the case until it was suspended from trading today.
If you had removed Carillion from your portfolio then, you would lost some of your original investment. However, you would be also in an infinitely better position than those who still owned shares when the company went into liquidation.
There are so many stocks out offering decent, covered dividends and great potential, which are yet to be noticed by the market.
There is simply no reason to remain invested in a firm where debt significantly outweighs market cap, with little evidence of a turnaround evident.