Outsourcer and construction group Carillion collapsed last week, but trouble was brewing for some time. What were the warnings signs?
It was obvious to many investors for quite some time that Carillion was in a mess but some professional investors seemed to miss the warning signs. Even a fund managed by the esteemed Janus Henderson still owned shares in the business right until the end, but it was private investors who owned a major chunk of the shares. They were obviously betting on a turnaround that ultimately did not happen.
Shares in Carillion started falling January in 2015. They were the most-shorted share in the market for quite some time, with about a quarter of its stock out on loan to investors who expected its valuation to fall sharply. While short-sellers are often incorrect and forced to capitulate, it is important to keep an eye on where current negative sentiment lies. If numerous hedge funds are circling a business like vultures – and they were doing so for some time in the case of Carillion – investing in that business could be regarded as pretty heroic. Doing some basic research on the internet will reveal whether such a red flag exists.
One other major warning sign for Carillion was its complexity, with Carillion operating in a number of different industries and geographies
Carillion’s main problem was its profit – or rather a lack of it. The company’s markets were so competitive that managers were bidding for business at such low margins there was no in-built emergency cushion should anything go wrong. This is irresponsible of management, as over the length of a contract there can be rises in labour or commodity costs that crush any chance of making a profit. This underbidding issue is not only confined to the outsourcing and construction sector either. Oil services companies have also experienced similar issues, where a highly competitive market has resulted in a race to the bottom for companies seeking new business at any cost. As an investor, it is better to look to invest in an industry that has high barriers to entry and little competition than one where it is easy for competitors to eat each other’s lunch.
However, the actual terms of these contracts are confidential, so investors do not get to see them. That’s why looking at what’s happening to a company’s cash is vital. Of course, it is too simplistic to say that a fall in a company’s free cash flow is always a bad thing. A business may be making large investments that will provide a significant return in the future – and all of this needs to be taken into account. Also, if a company is putting the brakes on any investment in its business merely to flatter its cash flows this could store up problems further down the line. There is always a judgment call for an investor to make – so using hindsight to argue that investments were obviously a good or bad thing is dangerous. But it is important to try and learn investment lessons in cases such as this.
Cash is the ultimate test of real value. Profit figures can be adjusted or boosted by accounting tricks, but cash is real. Looking at a company’s balance sheet and cashflow statement is therefore more important than a business’s profits and loss account. Looking at how much cash goes into a business and how much comes out gives a much better indication over what’s actually going on. Debts at Carillion were rising sharply, as was its pension deficit which would obviously need filling. High debt is another significant warning sign and it’s best to avoid investing in companies saddled with excessive borrowing unless it is clear how they plan to pay this back. Dividends to shareholders are paid at management’s discretion – but this is not the case with the repayment of debt. Management cannot pick and choose the level of repayments to debtors – and this rigid structure can land a company with real problems should a business cycle turn against it or, in Carillion’s case, should a contract go wrong. Many private investors were likely attracted by Carillion’s chunky dividend over the last year or so, but the debt carried on its balance sheet was a clear indication that the payment was not sustainable. Management did not have the strength to cut its dividend soon enough, only suspending the payment when it scale of its problems became obvious.
One other major warning sign for Carillion was its complexity, with Carillion operating in a number of different industries and geographies, including its high profile move into the notoriously difficult Middle East. As things started to go wrong on a couple of fronts, the business had too many moving parts for its management to juggle. Berkshire Hathaway chief executive Warren Buffett famously will not invest in any business he does not understand. To a certain extent this is good advice but he admits this has led to a series of missed opportunities. However in the case of Carillion it is clear that the complexity of its business after a long series of acquisitions was a major problem.
Many of the private investors who bought into the business after the profit warning in July last year were hoping for a turnaround in the business. Investors love a bargain – but some things are cheap for a reason and it is likely that these investors did not do their proper research. If you are going to bet on a turnaround, you must look under the bonnet of the business in question. It’s also vital to remember that cash is always king.
The above article was first published by Charles Stanley on 22nd January 2018