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Six lessons investors can draw from Carillion’s collapse

16th Jan 18 10:01 am

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“While the recriminations are only just beginning, investors can immediately draw six lessons from the Carillion debacle which they will be able to apply to stocks from all geographies and sectors,” says Russ Mould, AJ Bell Investment Director.

1. Beware complexity – keep it simple

“It is hard to find what operational synergy or overlap in expertise can be found between providing school meals, maintaining prisons, building hospitals or arranging project finance, yet Carillion did them all and it did so in several geographies, not just one. The very best long-term investments develop a competitive edge – via a technological lead, a brand or market share, for example – and then deepen their core competence. Carillion was juggling complex, long-term contracts across a range of disciplines and geographies, a feat which ultimately proved beyond it, especially once a small number of big projects went wrong.”

2. Be wary of companies whose history is littered with acquisitions

“Merger and acquisition (M&A) activity brings complexity too, as deals must be integrated staff kept motivated and customer service maintained. M&A tends to work best when small, bolt-on deals are used to supplement existing momentum (as is the case at Halma and Bunzl) not create it. Carillion acquired Mowlem in 2006, Alfred McAlpine in 2008, Eaga in 2011 and John Laing’s facilities management business in 2014 before a failed lunge for Balfour Beatty in 2014. These deals expanded the company’s range of services and geographical reach – to bring complexity into the company and take some cash out of it.

3. Debt can be deadly if profit margins are thin.

“Debt in its own right is not inherently bad as it can be a cheap and ready source of funding. However, the company’s business model must be suitable – and that means demand must be fairly predictable and margins consistent (and preferably fairly high) so that the interest can be paid without difficulty and interest cover is good. Utilities and tobacco stocks can take on a lot of debt pretty comfortably. Tech stocks tend to avoid it, as they need to keep investing in research so their fixed costs are high, and construction firms tend to avoid debt, too, to ensure they have a nice cash buffer in case a big project goes wrong and they are hit by cost over-runs. Carillion did not take this precaution and it was further hobbled by a huge pension deficit with disastrous consequences. In 2016, it generated a stated operating profit of £146 million on sales of £4.4 billion for a margin of just 3.3 per cent – and that operating profit had to fund £60 million of interest and pension payments, tax and £79.8 million in dividends so there was little margin for error.”

4. Always look at how management is incentivised to behave.

“As Charlie Munger, vice-chairman of Berkshire Hathaway once said, “Show me the incentive and I will show you the outcome” and questions can be asked about how bonuses and options were triggered for senior executive directors at Carillion.

“In 2016, former chief executive Richard Howson received a £245,000 bonus and £346,000 in long-term performance incentives which helped to take his total package to £1.5 million.

“In principle, the structure of the bonus mechanism seems sensible enough, as it was 30% based on earnings per share, 20 per cent on cash conversion, 25 per cent on operational performance indicators and 25% on internal leadership and staff engagement ratings. Yet the 2016 bonus contained telling clues for investors – the zero score for earnings per share, cash, and ratings from customers – while the use of a specific earnings per share figure (36.1p) was simply wrong, as this can lead to temptation and corner-cutting, even in this case the threshold was not reached.

Ex-Carillion CEO Richard Howson’s bonus triggers and performance, 2016

Measure Target Stretch Maximum % Awarded
EPS (30%) 36.1p 39.7p 35.3p 0%
Cash conversion (20%) 100% 106% 117% 0%
Operational indicators (25%)       15.625%
Leadership and people (25%)       21.5%
TOTAL       37.125%

Source: Company accounts

“The LEAP (Leadership Equity Award Plan) was similarly flawed. A three-year time horizon (2014 to 2016) was too short and all LEAP plans should only vest three to five years after the executives leaves the firm, to combat short-termism and ensure proper strategic and succession planning. In addition, 50 per cent of salary was based on earnings per share, 50 per cent on cash conversion and another 50 per cent of salary could be accrued on the basis of other performance targets, based on cost-efficiencies, staff engagement and (less sensibly) order intake and the book-to-bill ratio.”

5. Why cash flow is more important than profit

“Too many investors look at the profit and loss account and nothing else, forgetting the old market maxim that “Profit is a matter of opinion, cash is a fact.” Profits may drive short-term sentiment but it is cash that pays the bills such as salaries, interest and tax, so investors must always look at the balance sheet first, the cash flow statement second and the profit and loss account third. The first will explain how safe (or otherwise) the firm is. The second can show if there are any problems, accounting issues or issues of earnings quality to address. And the third will provide a short-term snapshot of trading.

“One quick test is to compare and contrast growth in sales, stated profit and cash flow. While they may grow at different rates, owing to operational gearing and investment, they should generally all show the same direction of travel. If they do not, investors may need to delve deeper into the company’s accounting, to ensure it is not aggressively recognising revenue or relying on asset sales and capital gains to “make the numbers”, as the failure of cash flow growth to tally to profit and sales growth can be a ‘red flag’.

£ millions 2011 2012 2013 2014 2015 2016
Sales 4,153.1 3,666.2 3,332.6 3,493.9 3,950.7 4,394.9
Operating profit 104.9 164.1 124.4 175.0 183.4 145.6
Tax (3.8) 2.9 4.6 (4.3) (7.5) (4.2)
Depreciation & amortisation 62.3 62.2 44.3 44.8 45.4 45.0
Net working capital (71.2) (164.9) (165.5) 9.0 (7.4) 4.6
Capital expenditure (9.8) (14.6) (21.8) (25.8) (30.4) (27.3)
Operating Free Cash Flow 82.4 49.7 (14.0) 198.7 183.5 163.7
Change in sales   -11.7% -9.1% 4.8% 13.1% 11.2%
Change in operating profit   56.4% -24.2% 40.7% 4.8% -20.6%
Change in operating free cash flow   -39.7% -128.2% 1519.3% -7.6% -10.8%

Source: Carillion 2016 accounts

6. Dividend yields that look too good to be true usually are

“At last year’s share price high of 238p Carillion was offering a dividend yield of 7.7 per cent, assuming even an unchanged annual pay-out of 18.45p. That no doubt drew a lot of income-seekers to their doom, as the dividend was cut to zero as the profit warnings rained in and the shares collapsed.

“This reinforces the importance of looking at the net debt position (including any pension and lease liabilities) and cash flow as well as earnings cover when assessing whether a dividend is safe.

“Investors should also consider how much risk they are taking if a company is offering such a yield. Such optically fat pay-outs can be the market’s polite way of saying it does not believe the earnings forecast or the dividend forecast (or both).”

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