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Killik's six Carillion red flag warnings for investors

Killik head of education Tim Bennett highlights the warning signals investors should have taken heed of before Carillion's collapse.

The collapse of Carillion at the start of the year left the government and many investors with plenty of egg on their faces.

The construction firm's problems had been well documented in the months leading up to its fall from grace.

While Killik's head of education Tim Bennett acknowledges 'rear-view mirror investing is always easy', he said there were a number of signals that Carillion had become a risky share to own a long time before it failed.

 

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The collapse of Carillion at the start of the year left the government and many investors with plenty of egg on their faces.

The construction firm's problems had been well documented in the months leading up to its fall from grace.

While Killik's head of education Tim Bennett acknowledges 'rear-view mirror investing is always easy', he said there were a number of signals that Carillion had become a risky share to own a long time before it failed.

 

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On the one hand, Carillion was a firm with sales well over £4 billion and assets of around £1 billion in 2016, Bennett notes.

'[However] it also carried huge debts of around £1 billion and a pension deficit of a further £0.6 billion, all of which would prove too much as it struggled throughout 2016 and 2017 to bring key contacts under control and collect sufficient cash to keep its creditors at bay,' Bennett added.

Now that some of the dust has settled, Bennett takes a look at six warning signs that investors should heed when weighing up the riskiness of other investments.  

 

 

 

 

 

 

 

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Red flag 1 – multiple acquisitions

'It is unfair to label all acquisitive firms as basketcases – Carillion was treading a well-worn corporate path as it bought up a string of businesses over the last decade,' Bennett says. 

'[However], long before a failed attempt to merge with Balfour Beatty in 2016 set alarm bells ringing, investors should have questioned how effectively Carillion was able to manage the integration of huge new businesses that spanned multiple specialist areas of construction and facilities management. ' 

Carillion's deals over the last decade include: Mowlem (2006), Alfred McAlpine (2008), Eaga (2011), John Laing Facilities Management (2014) Balfour Beatty (failed merger attempt - 2016)

While the motives for the deals are easy to understand, especially when they could be financed in the era of cheap debt, they should also set alarm bells ringing Bennett says. 

'Investors need to remember that big deals also take up a lot of senior management time and the integration or predator and prey usually proves to be a lot harder than the initial deal,' he explains. 

'Following these acquisitions, Carillion ended up with a vast, sprawling empire that would have operationally challenged even the best management teams.' 

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Red flag 2 – high dividends

The fact Carillion was offering a dividend yield well above the market average, was another warning signal for Killik. 

'Tempting though it is to take a 7.7% yield (the level on offer when the share price peaked in 2017), there are no free lunches in investing and this represented double the level available on the FTSE All-Share index,' Bennett says. 

'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, diversified firm.' 

Bennett also pointed out that Carillion had substantial commitments relating to interest payments and the pension fund to meet from its operating cashflow.

'One challenging contract was enough to threaten the dividend and whilst its more recent Middle Eastern ventures were profitable, they left Carillion struggling to collect around £400 million'.   

 

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Red flag 3 – vulnerable margins

A third red flag was the big deal the company made of the impressive operating profit margins it 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%.

'In the early days of outsourcing, private sector firms could print money as government agencies arguably failed to price contracts correctly,' Bennett points out. 

'In recent years, however, the pendulum has swung back – some might say too far operationally such that margins on public sector work can be frighteningly thin and leave little room for operational error.

'[At Carillion] an operating profit of just £146 million on sales of over £4 billion in 2016 left very wiggle room when it came to contract delivery, especially in the Middle East where higher margin work was not translating into cash flow. Further, profitability was being flattered by some one-off gains, a fact that some investors were seemingly slow to pick up.' 

 

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Red flag 4 – working capital stress

Killik also highlights that 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,' Bennett says. 

'[This] is something that directors need to manage carefully and that investors often struggle to monitor and evaluate – so much so that this issue is being addressed in a brand new international accounting standard (IFRS 15).' 

However, Bennett believes that if anyone had looked closely enough, they would have seen signs of stress within the supply chain, indicating some of its key contracts were running out of control. 

'Suppliers were waiting 120 days or more for payment and yet Carillion was being paid much faster than that by one of its main customers, the UK government,' Bennett says. 

'Like others in its peer group, Carillion relied on a supplier Early Payment Facility to help manage payments. Some investors may have missed the significance of the bank loan (in effect) that this created in place of conventional payables in the balance sheet. Receivables were rising faster than sales – never a good sign
Annual cash flow was surprisingly low and volatile.' 

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Red flag 5 – persistent short selling interest

Another obvious red flag was the presence of lots of short sellers on a stock, which is a strong hint the business could be in trouble.  

Bennett says: 'Around 25% of Carillion’s stock was subject to short selling interest at the start of 2016 (it would later peak at 32%) leaving other long investors to hang on in the belief that the many shorts had got it wrong. We now know that they had not.' 

 

 

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Red flag 6 – sliding stock market 'technicals'

Bennett describes this as his final 'smell test'.

He says: '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.' 

Poor financial strength (for example, as flagged by Piotroski 'Z' scores), negative relative strength indicator readings ('RSI'), downward consensus earnings revisions (as one-off profits were excluded), were some of the examples Bennett cited. 

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The takeaway

Bennett accepts it is easy enough to be wise after a corporate failure such as this.

But nonetheless, he says investors should recognise that: 'Red flags usually point to trouble, especially in combination. No stock is “too big to fail”. Size, prestige and profile are no guarantee of success.

It is also an example of a situation where 'buying on the dips' was a triumph of hope over logic.

Bennet also warns of about an overreliance on diversification. 

'The argument goes that it can take away a lot of the single stock risk in a portfolio and reduce the impact of a Carillion.

'[However] when there are multiple red flags on a holding, it can pay to question whether your money might be better actively deployed elsewhere rather than leaving it passively locked into a losing position.' 

 

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