How can an investor spot when a company is in real trouble? Tim Bennett explains six warning signs that were flashing well ahead of Carillion’s demise.
Carillion’s collapse – six investing lessons
Company headlines have been dominated recently by the failure of Carillion, a huge UK firm with tentacles that spread across many parts of the public sector. With hindsight, it is always easy to point to problems that, in the event, turned out to be fatal. Nonetheless, there were quite a few red flags at Carillion well before it finally succumbed to liquidation. Here, I take a quick look at six that investors should apply when analysing the riskiness of other investments.
What happened at Carillion?
The full answer to this question may not emerge for some time, as the liquidation process has only just begun under PriceWaterhouseCoopers and Carillion was a 43,000 employee firm that operated across many different sectors and geographies.
However, what is clear is that the problems that eventually lead to its downfall were evident for months, and in some cases years, before the end finally came. On the one hand, this was a firm with sales well over £4bn and assets of around £1bn in 2016. However, it also carried huge debts and struggled throughout 2016 and 2017 to bring key contacts under control in terms of cash collection. The result was a string of profit warnings and a share price battering. In early 2017 the firm was put into liquidation.
So what were the biggest red flags?
Red flag 1 – multiple acquisitions
Clearly it is unfair to label all acquisitive firms as basket-cases – Carillion was treading a well-worn path as it bought up a string of businesses over the last decade. However, long before a failed attempt to merge with Balfour Beatty in 2016 set some alarm bells ringing in the City, cynics pondered how effectively Carillion was able to manage the integration of huge new businesses that spanned multiple specialist areas of construction and facilities management. A list of the largest deals from the last decade follows here;
As I have highlighted in other videos (see list below) when a firm goes for aggressive expansion in an era of cheap debt you always have to analyse carefully how much value is being added. That’s because buying businesses can be a good route to flattering both earnings in the short-term and also director’s remuneration via a boost in the share price.
Following these deals, Carillion ended up with a vast, sprawling empire that would have challenged the best management teams to co-ordinate. It was a jack-of-all-trades approach that failed when it became apparent that the firm was master of none. Much-hyped synergies were slow to materialise as the firm spread across a massive range of different specialisms, from building and managing house for the Ministry of Defence, to developing football stadia and the iconic Battersea Power Station site.
Red flag 2 – high dividends
When a firm offers a dividend yield that is well above the market average, investors should question why. Tempting though it is to take a 7.7% yield (the level on offer when the share price peaked in 2017), the truth is there are no free lunches in investing. More specifically, although the firm claimed its dividends were covered, Carillion’s cash flows over the last five years were derived from some complex long-term contracts and were surprisingly volatile for such a large, diverse firm as a result.
Red flag 3 – vulnerable margins
Much was made of the impressive operating profit margins that Carillion could command versus its peer group. In 2016 for example it reported a margin of around 3.3% when some similar firms supplying to the UK government and public sector were struggling to get much above 1-2%. However, an operating profit of just £146m on sales of over £4bn in 2016 left very little margin for error when it came to contract delivery especially in light of the firm’s foray into the Middle East where the promise of higher margin work was not translating into cash flow. Further, profitability was being flattered by one-off gains, something that not all investors fully factored in.
Red flag 4 – working capital stress
Long-term contracts of the type entered by Carillion, are difficult to manage and even harder to evaluate. Judgements have to be made about when certain milestones have been reached and when and whether to recognise profit. The result can be a sizeable disparity between profits being booked and cash being received. So much so that this issue is being addressed in a forthcoming new international accounting standard (IFRS 15) albeit this will arrive too late to help Carillion’s investors. For anyone looking for them, there were signs of stress within the supply chain that suggested some of its key contracts were running out of control;
Red flag 5 – short selling interest
Short sellers can be unpopular, especially amongst boards of directors. That’s because they aim to make money from falling share prices using a range of techniques from borrowing stock they don’t own to taking derivative positions (when they are available/permitted). However, their unpopularity aside, the presence of lots of short sellers in the market hints heavily that a stock may be in trouble. Given that around 25% of Carillion’s stock is estimated to have been subject to short selling interest at the start of 2016, you had to believe either that a lot of bright, risk-taking investors had got it wrong (which is possible) or that they correctly sensed an opportunity to make money from a company operating on the edge.
Red flag 6 – sliding stock market “technicals”
Investors with an eye for technical stock market indicators could see that parts of the stock market were nervous about Carillion months before it collapsed. The next slide summarises some of the bigger signals that were showing a negative reading for much of the last two years. By themselves, none of these is automatically fatal but they do paint a grim picture in combination.
Hindsight is always a wonderful thing – it is easy to be wise after an event such as this. Nonetheless, investors should recognise that no stock is “too big to fail” and that size, prestige and profile are no guarantee of success. Diversification can take away a lot of the single stock risk in a portfolio but equally when there are multiple red flags active on a single, large stock, it can pay to go a bit further and question whether your money might be better deployed elsewhere.
Other Killik Explains videos
I cover some of the red flags mentioned above in more detail in other videos. Here is a list – just head for killik.com/learn and click the relevant tab to find them.