Who would have thought that Carillion PLC was going to take a big tumble (pause), a 75% depreciation of its share price in a matter of days! For those who were invested in the shares (whether directly or indirectly), this was devastating.
With every great mistake, there is a great lesson to be learnt!
Let’s find out why investors are so scared of Carillion PLC.
Always observe the “Short Position”
Before we do any research, head over to the UK short interest tracker website. You see Carillion is the most shorted stock. The website shows short position going back to 2013. For Carillion, the short-sellers have begun establishing their positions from early 2015.
But, not all short companies mean falling share price. Take WM Morrison, for example. It is the third most shorted stock with 16% of shares on loan (greater than Tesco and Sainsbury), but the share price has recovered 70% from their lows.
Sometimes, short sellers do get it wrong!
Now, the question you want to know is: “Will Carillion implement the necessary restructuring to survive?”
And that requires some research.
Are Carillion acquisitions strategy paying off?
The “ONE” reason, most businesses give to justify any acquisition is “VALUE”, with “synergy/compatibility” coming in at a close second.
At the end of the day, the only guarantee from an acquisition is acquiring the company’s sales (unless it’s at “pre-sales” stage).
Carillion made three major acquisitions, but the results have been disappointing:
Carillion spent over £1.2bn on Mowlem, A McAlpine and Eaga.
All three have given the company a sales uplift from £2.28bn to £5.2bn of sales since 2005 while underlying profits have increased from £43m to £151.7m, a 252% growth.
These are positives, but investors are most interested in EPS growth. On that measure, underlying EPS growth grew by 55%, due to the increase in shares outstanding, while year-end borrowings rose from £90m to £689m. The increase is the equivalent of £1.40 per share!
(Important Observation): Since their last major acquisition in 2011, Carillion saw EPS fell from 37.2 pence in 2012 to 28.9 pence in 2016.
That is telling you the company relies on acquisitions to grow sales and profits, but not necessarily shareholders’ wealth.
Lesson: Spot the difference in debt from a major or several major acquisitions, as well as changes to underlying EPS.
Carillion’s debt levels are higher than expected
Businesses can make adjustments to display the least amounts of total borrowings on the “Balance Sheet” by collaborating with their suppliers and clients.
If you go to Carillion’s website and click on “Download Prelim Results Presentation”, it gives details on average net borrowing, as well as year-end net borrowing.
The difference between year-end and net borrowing is startling.
In 2016, average net borrowing was £250m more than their year-end number. So, this should prompt you to investigate the average total borrowings.
Instead of total debt coming in at £689m, Carillion’s average borrowings breach £1bn, a record! In fact, the balance sheet debt numbers had you believing in an improving financial position, but the opposite was happening!
(P.S. To work out the average total borrowings, I averaged out the cash figures from the interim and final results.)
How do we work out the average total borrowings, if companies don’t provide the data?
You can’t work it out accurately, but you can use common sense.
One way is to take the interest costs from the loans and divide against year-end borrowings.
In 2016, the year-end borrowings rate was 6.6% (Carillion’s average borrowing rate is 4.5%). Given that borrowing rates in the UK are at all-time lows, why does Carillion has a higher year-end borrowing rate? Would this cause a panic for Carillion’s shareholders?
Another strategy I used is to go through the company’s RNS releases, and find statements relating to “refinancing.” This prove fruitful because, in early 2017, the company refinance loans at a blend of the interest rate of sub-three per cent, including fees, signalling lower borrowing costs!
Rule: Lower the borrowing rates, higher total borrowings.
When the facts change, the lenders change their opinions
The bankers may reassess Carillion’s loans prompting fears of higher borrowing costs.
The 10th of July update also mentioned that net borrowings for interim 2017 will come in at £695m, which is £150m more than last year meaning more debt.
Lesson: Companies with long-term contracts and heavy capital spending has changeable debt position throughout the year. Focus on average total borrowings, rather than year-end total borrowings.
Also, read through RNS relating to “financing” to find borrowing rate.
Carillion Goodwill Cover
First, Carillion has a low depreciation and amortisation rate, thanks to the build-up of goodwill because it can only be impaired not amortised (I believe).
So, to work out if Carillion was depreciating assets appropriately, we must minus goodwill from depreciative assets. Instead of seeing 1-2% depreciation and amortisation rate, it is at 20-35%.
Most recently, you should see the red line dipping below the orange graph in the past four years meaning it is under depreciating assets and helping to uplift profits, but by how much?
Using the average depreciation and amortisation rate of 28.25621122% from 2003 to 2016, the total depreciation and amortisation should come to £875m, but Carillion reported £815m, a £60m underreporting. A closer look at the most recent period (since 2012) sees the company saved £83m in depreciative expenses or £21m per year, which represents 12-15% of operating profits.
Before we accuse Carillion of manipulating profits, one must make one further due diligence, that is SPOTTING ANY IMPAIRMENTS! Sometimes, an impairment to assets is like depreciating your assets all in one year.
Go to note 3 (breakdown of group operating profit) on their annual reports and in the past six years there has been ZERO impairment charges found.
Goodwill covering levels of tangible and useful intangible assets
If you add up tangibles, intangibles, joint ventures and other investment assets, but MINUS the GOODWILL, then the asset values have been declining!!!
Looking at the chart, the company assets are £180m below the peak of £600m set in 2008, but revenue has increased, but this can get distorted.
Lesson: Goodwill makes up the number of the asset side and most importantly Carillion’s subsidiaries aren’t producing quality profits (see below for details).
Is Carillion Manipulating Revenue by using Receivables?
There is nothing suspicious with Carillion’s trade receivables. You can see the falling trade receivables, as clients are eager to pay the company as quick as possible. Evident by the falling “receivables, as % of sales”.
However, smart investors wouldn’t be satisfied with this assessment without studying the trend in “Other Receivables” because Carillion can shift receivables into other receivables making cash cycle look better.
So, what are these other receivables?
Well, they include the following:
–Amounts owed by construction contracts;
–Other receivables and prepayment (prepayment is money paid relating to future expenses, I include it because Carillion didn’t say how much prepayments they have paid.);
–Amounts owed by Joint Venture;
–Amounts owed under jointly controlled operations.
Here is the chart:
By separating trade receivables and other receivables, you spot the difference and I.D. the real change in credit sales levels of Carillion business. Normally, total receivables account for 20%-22% but have average 30% per year for the past five years.
But, why is this so important?
Because it helps to boost sales by £300m-£400m per year. Also, more concerningly it helps to boost profits!!! If you think I am making this allegation up, just compare cumulative net profit and cumulative net cash flow over that period. So,
Cumulative Net Profit: £688.9m.
Cumulative Net Cash Flow: £166.4m.
The difference of over £400m in the past five years is a big reason why people are shorting this stock.
The major culprit comes from their construction division, which saw receivables rose from £190m to £614m, whereas trade receivables saw a £33m increase. Which is why they are disposing of some of their “construction” businesses, especially those in the Middle East.
As the saying goes, when over report on sales, you will over report on losses to balance out the distortions!!
Lesson: Always check for hidden receivables distortions.
Calling into question, Carillion’s solvency
Some analysts are now forecasting a £500m Rights Issue, so Carillion can keep the lights on. And that prompted me to ask why?
Given that, the company would be saving £80m from suspending their dividends and getting cash inflows from selling off their Middle-East and Canadian operations. And don’t forget that most of the £845m impairments are non-cash related.
Before we recover, it was using receivables to boost sales, the company’s interest coverage and fixed charge coverage comes to 2.5 times and 3 times respectively. Now, the authenticity of these ratios is in doubt and misleading!
Why do analysts say Carillion needs £500m?
A look at the debt and pension deficit against Carillion’s market capitalisation is a good warning sign.
P.S. The above chart is the same graph, with the difference between year-end debt and average debt.
The bad thing from these graphs is debt and obligations are dominating the market value, instead of it remaining to be stable (i.e. staying at 50%-60%). Now, given the collapse of its market value to under £300m, that means obligations outweigh valuation by 500%!
When will the debt mature?
Another caution is in three years, total debt of over £1.1bn matures meaning any debt renewal can have stricter rules in place and higher borrowing costs.
Most of it due in 2020 (£844m).
Lessons: Solvency ratios are rendered useless if operating profits are manipulated. Watch out if you see zero sale growth but debt is piling up.
Carillion’s Acquisitions don’t pan out
Earlier, we compared three major acquisitions to changes to Carillion’s EPS.
Now, let us examine this in detail. Below is the summary of acquisitions made:
Three major acquisitions were made five years apart costing Carillion £1.2bn, though two-thirds of the costs were bored by investors. Going through Carillion’s financial statements over ten years, you will notice that the company didn’t state the “true costs” of these acquisitions.
Take Mowlem, for example.
In 2006, it costs £350.3m and the method of payments was broken down into £117.3m in cash and £224.5m raised from equity issue. But in their 2007’s annual report it stated acquisition of a subsidiary, net of cash for £122.3m (attribute cash costs (£8.5m) minus cash and cash equivalent acquired of (£3.5m)). The confusing part is: “Why hasn’t equity proceed showed up in the financing section?”
That’s because Carillion has “netted out” the original cost from the equity proceeds.
The same happened to other acquisitions!!! But, remember investors paid two-thirds of the costs, but are they getting valued for money?
Before we answer this question, here is the last four years of financial data before they got acquired:
From the table, you would have spotted the following: –
- Mowlem’s sales have been declining for four years (if not longer?) and profits have turned to losses!
- Both Alfred McAlpine and Mowlem reported big write-downs, before getting acquired by Carillion.
- Eaga saw decent profit growth, but cash profits remain at similar levels. For both Alfred McAlpine and Mowlem, their net cash flow was deteriorating.
- Total borrowings from Alfred McAlpine and Mowlem increased dramatically, raising fears of sustainability.
- You can’t help but think the only reason for buying these businesses are to boost their sales because it acquires £3.5bn of sales for £1.2bn or 0.34 times’ sales. Before you say it’s cheap, Carillion has sales of £5bn with the market valuing the business at £900m or 0.18 times’ sales (before the great share price crash!). Now, it’s more like 0.05 times’ sales.
Now, let’s see if these acquisitions represent value for money. Apparently, not.
If we take total the cumulative operating profits for each subsidiary since they got purchased, you get this:
A McAlpine: -£6.9m;
But, looking at the cumulative net profits for each subsidiary shows this:
A McAlpine: £63.1m;
*includes £190m profit from disposal.
What does it all mean?
It means 70% of Carillion group sales produce cumulative operating loss of £210m and cumulative net loss of £20m (despite profits from asset disposal).
Also, it gave credence to Carillion manipulating sales to boost profits, which is why they have to announce a provisional of £845m impairments (mostly GOODWILL write down).
Lessons: Always go through past acquisitions and say does it represent value for money.
HS2, a saving grace?
The most recent contract wins from HS2 construction looks big with two contracts worth £1.4bn, but it was a joint effort with Kier Group and Eiffage. Therefore, Carillion share is worth an estimated £450m, according to analysts. Given that it normally wins £4bn-£5bn of new orders each year, this makes up 10% of new orders.
Here is a historical look at Carillion’s order books and new orders dating back to 2007:
Carillion’s order book has been declining, despite revenue rising. And this prompt the order book/sales ratio to fall at their lowest levels. 2017 H1 order book is estimated to be £16bn, same as last year.
Lesson: Don’t be fooled by big orders, instead ask this: “Has Carillion been making quality earnings from their orders?”
Carillion’s Quality of Earnings is poor
For the last eleven years, Carillion manages to earn cumulative normalised after-tax earnings of £1.8bn, but free cash flow to shareholders saw cash outflow of £175.2m.
When you look at the depreciation expenses to sales you would assume a “capex-light” business, despite it being in construction.
Before they stopped paying dividends for 2017, the cumulative dividends paid out since 2005 total £681.4m.
Lesson: Be wary when a company not generating positive free cash over a long period of time.
Summarising the three BIG factors why fund managers were shorting Carillion
Here are my three reasons why fund managers took a dim view of Carillion:
Warning Signal number one: Growth of trade receivables is faster than sales meanings profits are of low quality and likely been distorted. Check net cash flow for obvious evidence.
Warning Signal number two: Major acquisitions (mostly paid for by investors) were loss-making after purchase.
Warning Signal number three: Rising debt levels and pension deficits, compared with market valuation. Another signal of poor earnings when a business requires external financings to create earnings.
What Now for Carillion PLC?
First, revenue for 2018, not 2017 will see a big fall because of exiting their Middle-East and Canadian operations.
Their Middle-East operations report sales of £668m in 2016, while their Canadian operations have sales of £600m. So, by 2018, Carillion will report revenue of £4bn.
Second, the suspension of dividends will last for three to four years because of the uncertainties surrounding this restructuring. Also, the company has their biggest debt mature (over £800m) in 2020. They want to restructure this debt at the lowest borrowing rate as possible. Any extra borrowing costs would add £30m to £40m in extra expenses.
Third, expect a huge accounting loss for 2017 in the region of £700m to £1bn, but focus on the company’s net cash flow.
Fourth, shareholders will want management to focus on the profitability of taking on projects, instead of booking revenue. This would be difficult to achieve given the level of competition.
Fifth, the company can’t engage in “crap” acquisitions, which has cost shareholders over £700m of their investment.
Sixth, there is a probability the company will come under investigation from accounting manipulations. Despite, greater transparency, Carillion has aggressively booked sales early.