Carillion and the warning signs that weren’t heeded

Those in the UK will have no doubt have heard about the liquidation of Carillion, a construction and services sector.  Carillion was one of the largest contractors employed by the UK government to work on a variety of projects including working on contracts for schools, hospitals and the military  as well as being involved in the High Speed Railway project.

At the start of 2018 however, the company has collapsed after being crushed by spiralling debts of over £1bn, and unable to meet its obligations due to falling revenues. After being refused extra credit by its lenders and the government, the firm is now going into liquidation with one of Ernst & Young or Pricewaterhouse Coopers set to be appointed as administrators.

This is an embarrassing humiliation for the government, especially considering that the taxpayer has awarded the contractor over £2n after it posted 3 separate profit warnings over the course of 2017. This disaster will also serve to embolden the left-wing side, who will cite this example to justify the claim that outsourcing public sector projects to private sector companies through a Private Finance Initiative is of no benefit to the taxpayer, especially considering that PFI costs more in interest than it would for the government to simply borrow funds and run the project itself. Furthermore, further fuel is likely to be thrown in the fire when more people hear that the Chief Executive of Carillion enjoyed over £1.5m in pay and benefits a year before the firm went bust, all while workers will face redundancies and various smaller subcontractors will likely go under due to not receiving payment from Carillion. The £600m in pension liabilities to employees of Carillion will not be paid either; although the Pension Protection Fund will provide a pension, this is likely to be smaller than what the workers were otherwise set to receive from their employer through no fault of their own.

Investors who bought shares will have lost over 90% of their shareholding, with the market cap of Carillion collapsing from a high of £2bn in 2016 to £61m at the time of its collapse. Strikingly, two thirds of investment analysts recommended buying Carillion to their clients back in 2015, and reading from the 2015 annual report, things seemed very rosy from a brief glance at the first few pages. Postings of underlying profit up 8%, revenue up 13%, and an above inflation increase of the full year dividend of 3% are very encouraging statistics for a prospective investor, who would be further encouraged by the chairman who posted a positive outlook for the company. A similar glance at the 2016 report shows a generally reasonable year; with revenues up 11%, a dividend increase of 1%, which is well covered by earnings (which dipped 6% due mainly to the sale of investments in certain public private partnerships). At the surface there isn’t any real evident cause for alarm. Yet the phrase “the devil is in the detail” is an idiom that works perfectly here… Let’s look a little more closely.

In 2011, the UK government introduced a scheme known as the Early Payment Facility, which was a facility enabling businesses and contractors to transfer monies owed to them to banks, in exchange for a fee. This facility was used by clients of Carillion. The value of debt accrued using the EPF was at £263m in 2011, but ballooned up to £561.2m in 2015 and £760m in 2016. This was very easy to miss out, as these numbers weren’t included in the main debt numbers in the balance sheet items, but were hidden in footnotes more than 100 pages down in both the 2015 and 2016 annual reports.

Another issue was that it was taking customers longer to pay Carillion. Scrutinising the cash flow statement in the 2016 annual results shows a clear warning sign that should have been paid more attention to. The “Trade and other receivables” row, which is in other words monies owed but not yet paid to Carillion, increased by £260m, this is a huge jump from the £48m reduction in the previous year! Furthermore, the Financial Times reported on Tuesday the 16th of January 2018 that unpaid money from clients reached 31.6% of non-construction revenues by 2016 (up from 14.4% in 2009).

All of this could have been spotted by investors after taking a long time to read the financial statements in full. However, investors also could have exited earlier after receiving the first profit warning in July. Losses would still have been very painful, but investors would have been 30% better off than if they held on and hoped for a recovery. Profit warnings mean the “story” you bought the shares on have changed, and I would generally be inclined to exit as soon as I find out about this. Sometimes these are one-offs, other times they could be a first sign of trouble brewing ahead.

Disasters such as Carillion are why it’s crucial that you react quickly to adverse news. If you had a portfolio of 10 shares with equal sums invested in each, if one of them was Carillion and it dropped 60% and you acted quickly, you would only lose 6% as a proportion of your entire portfolio. An unfortunate but not a disastrous outcome, showing the importance of sufficient diversification!

Many retail investors have placed their savings in share dealing accounts with various brokerage accounts. Carillion was in the top 20 shareholdings among these investors, hoping for a turnaround. With the impending liquidation it comes to show that very often share prices plummet for good reason and retail investors ought to be far more cautious going forward, and of course keep abreast of market news.






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