The Lessons of Carillion
Blog February 19th 2018
In the month since Carillion went into liquidation (January 15th), many wise heads have been shaken and many knowledgeable fingers wagged.
Astonishing numbers of commentators had realised years ago that Carillion, a construction company and service provider, was fatally challenged, and only kept going through creative accounting and a string of acquisitions.
In recent months, the shares of quite a few companies have slumped, including Provident Financial, Capita, Dignity, Saga, Restaurant Group and St. Ives. By hook or by crook, TB Wise Multi-Asset Income has managed not to own any of these companies. But we did hold Carillion, until the profit warning last July.
We then sold the shares for two reasons. (1) The first was that Carillion cancelled dividend payments, which are an absolute pre-requisite for inclusion in the fund. The other was that what the company had been telling us, and what was revealed on that day, simply didn’t add up. The FCA believes that the company’s problems were much worse than they had been telling investors, and is investigating to what extent its officers knew how bad things were and should have notified the market sooner. A separate enquiry is being conducted into the company’s auditors, to see whether they should have refused to sign the accounts off, as not being a true reflection of the financial state of affairs within Carillion. However, whatever the results of these enquiries, nothing will return our investors their money. We need to understand what it is that we missed, and how we might be able to avoid falling into similar traps in the future.
And does the behaviour of the government, and of other companies in the sector, offer us any clues as to how the industry might evolve in future?
The investment case for Carillion.
When we bought Carillion the shares had already fallen a long way. We liked the company’s multi-billion pound order book, which provided visibility of revenue for several years ahead. We liked the company’s involvement in services, which are a good complement to a construction company, as services (property maintenance, waste recycling, street cleaning, provision of school meals, etc), are much less cyclical than construction, offer higher margins, and require less capital investment.
The company had its share of problems. They had closed their loss-making subsidiary in the Caribbean. They were struggling in Canada too, where they believed that contracts were being given only to local firms. Like other firms trading in the Middle East since the collapse in the oil price, they had found payments from the region took longer and longer to appear, with an increasing number of retentions at the end of contracts.
Carillion had a large pension deficit, which, despite large remedial payments, had increased in the year before the company failed. However, this increase in pension deficits was common to all companies with final-salary pensions, and was caused by a drop in the discount rate, which in turn was the result of a fall in the yield on government bonds. Bond yields are used by scheme actuaries to determine how big a pension fund needs to be in order to meet its obligations to pay pensions to present and retired members of staff. At 2.55%, the level of the discount rate in the company’s final months, its pension scheme assets were expected to grow by just 2.55% per annum, meaning that the fund needed to be much larger than a few years earlier, when the discount rate was higher. We expected that the discount rate would rise with government bonds, and that the problem would go away by itself. This is exactly what has happened to the pension schemes of other companies in our investment universe, but it didn’t happen soon enough to make any difference to Carillion.
Carillion’s biggest problem was its debt, which came partly from acquisitions it had made in previous years, including the contractors Mowlem and Alfred McAlpine, Eaga, and the facilities business of John Laing, together with the cash-flow drag of the Middle East clients, who couldn’t be sued because they were either governments or related parties. Also, and this was something we should have been aware of, many of Carillion’s customers were holding back payments because projects were delivered below specification.
We prefer to invest in companies with no debt, or with very low levels of debt. However, we will consider investing in companies with higher levels of debt, so long as certain conditions are met. How did the indebtedness arise? Did the company borrow for worthy reasons, such as a transformational acquisition? How well has the company borrowed – is the debt short-term and expensive, or is it long-term and cheap? Is there a covenant, and if so is the company anywhere near breaching it? How well are the interest payments covered by profits, and in the event of a downturn, would they still be adequately covered? Crucially, what is the management’s attitude to the debt? Are they genuinely committed to reducing it, and is there a clear and credible plan to reduce it to insignificant levels within a meaningful timescale of no more than two or three years? Finally, how well is the debt covered by assets, and are at least some of these assets ones that could be sold if needed, to reduce it quickly?
In the case of Carillion, we didn’t ask these questions ruthlessly enough. The management told us in a phone call in May 2017 that they were steadily selling assets, and would reduce debt progressively by around £25-50m a year. However, much of the asset value on the balance sheet was in contracts which the company had been awarded. In last July’s profit warning £825m of these contracts were quite simply written off, with a further £200m three months later.
Carillion was a relatively new holding for TB Wise Multi-Asset Income. We normally meet the management of companies either before investing in them, or soon after. Carillion’s management was among the most elusive we have ever come across, and after months of trying to pin them down, we eventually had to make do with a phone call, in which they assured us that despite the issues they were facing in Canada and the Middle East, things were moving in the right direction. Reluctance to engage with investors is a big negative for us. A good company wants to have the best possible relationships with investors and potential investors, and is happy to share as much information as the rules allow. In large companies, where the executives are too busy to meet all but the largest investors themselves, there is an investment relations team.
The lesson of Carillion for us is that a company as indebted as Carillion was, is best avoided. If we do invest, we must be certain that the debt is covered under all circumstances, and that the assets on the balance sheet are virtually bomb-proof. We need to have met the management and discussed the debt with them in detail, and exactly how it is going to be reduced. And the company’s reluctance to engage with us should have been a red flag.
The Government’s relationship with Carillion in its last few months
During the period up to July 2017, when we owned the shares, Carillion continued to win government contracts, and astonishingly, on July 17th, when it was clear that the company was fighting for its life, it was awarded two design mandates on the central sections of HS2 between Aylesbury and Banbury. Now, it would be reasonable for investors to assume that before selecting companies for the HS2 contract, the government would have subjected them to intense scrutiny, for the simple reason that those companies would need to remain solvent for several years in order to complete the work. Either the Department of Transport failed to do its due diligence, or else it knew how bad things were, but awarded the contracts anyway. There is even a possibility that government was trying to offer Carillion a lifeline, hoping that the work would help to pull the company through. If this explanation turns out to be correct, it reflects an astonishingly reckless attitude on the government’s part, because if the plan backfired, as it quickly did, the other joint venture partners in the consortia would be left to sort out the mess left by Carillion’s insolvency. Neither explanation reflects any credit on the government.
Carillion was the UK’s second largest construction company. One might have expected its demise to have a positive effect on the share prices of its peers, by making the tendering environment less competitive. However, the share prices of other construction and outsourcing companies fell. For some, like Galliford Try, there was a direct Carillion-related reason for the weaknesses of their shares. Without Carillion, Galliford Try and Balfour Beatty will have to complete the loss-making Aberdeen West ring road project on their own. However, these relatively short-term contracts aside, the environment may improve for the construction companies. During the crisis of 2007-9, companies were happy to take on large multi-year government contracts at fixed prices, in order to keep their staff employed and the money coming in. Many of these contracts went wrong. In the years after 2009, a labour shortage developed in the construction industry. In order to deliver their projects, companies had to pay skilled workers far more than they’d budgeted, but couldn’t pass the extra costs on. However, the surviving companies are telling us that they are no longer interested in bidding for these large multi-year fixed-price contracts, where the margins on offer simply don’t reflect the level of risk involved. They are looking for cost-plus contracts, where the profit margin is fixed, rather than the all-in price.
Your view on the failure of Carillion may depend as much on your politics as anything else. It is easy to portray the directors of Carillion as fat-cat bosses, paying themselves obscene salaries while the pension-deficit and their company’s debt ballooned. Equally, it is possible to look at the number of outsourcing companies which have got into serious difficulties over the last few years – Carillion, Capita, Serco, Mitie, G4S and Interserve, for example, and wonder whether the root of the problem lies in the tendering process, which awards contracts to the lowest bidder, often at a level below where it is possible to break even, and where the real winners are the companies that aren’t awarded the contract.
The Government and the private sector
Looking back over the last twenty years or so, it is possible to see two different tendencies in government behaviour. When there is a favoured political objective at stake, government is inclined to be remarkably generous. The Private Finance Initiative (PFI) was perhaps the most high-profile of these sacred cows. Under the PFI, the government would invite tenders for the building of a school or hospital. The winning bidder would build the school using its own funds, and then manage it, making an annual charge to the government over a long, typically 25-year term. The rewards for participants in the scheme were attractive, but as we now know, the result in many cases was an expensive sub-standard, inflexible asset. Other examples of government largesse include the privatisation of the railways, which were sold for a fraction of their asset value, the subsidies for domestic solar panels, and the guaranteed price for electricity which has been offered to the Chinese owners of the Hinckley Point nuclear plant.
By contrast, government’s treatment of private sector companies in its day-to-day negotiations appears excessively tight-fisted, as the succession of problems at outsourcing companies has shown.
The existence of a government which is extremely generous in some circumstances, and extremely mean in others, may explain why the media narrative around the demise of Carillion is so confused. On the one hand, we have the fat-cat private sector, and on the other, these same fat-cat companies struggling to stay solvent.
I have seen no serious discussion on how the failure of Carillion might affect the future of the construction and outsourcing sectors. What we observe ourselves is a determination on behalf of the companies we talk to, not to engage in long-term contracts where they take all the risk. If they all remain determined to walk away from these contracts, government may find itself having to offer more viable ones. This may end up being a positive for all concerned. Increasingly contracts are offered through ‘platforms’, which exist in various sectors such as health and education. Several companies are accepted onto a platform, usually lasting three or five years, and then work is parcelled out between them. The jobs are usually smaller, shorter-terms, and the margins are acceptable. The companies are happy with this structure, and it may be the way forward on the larger contracts, as appears to be the case with HS2.
A Labour Government
Labour would like to renationalise the PFI, though it has said it would review all PFI contracts, regulate them more tightly, and renationalise the worst-performing ones. At the same time, it is committed to renationalising the railways, together with the power and water sectors. To renationalise the whole of the outsourced construction and infrastructure sectors at the same time, might be a bit of an ask.
A Labour government might not win an overall majority, and might experience opposition to some of its plans, not least from within its own party. It’s easy to forget that less than a year ago, the media were applauding Mrs May for her audacity in calling an election, which she couldn’t fail to win, against a hopelessly weak and unpopular Mr. Corbyn. Jeremy Corbyn’s strong showing in the election has allowed his faction to gain control of the party, and they are busily replacing moderates wherever they can. However, the centrist Blairite faction remains a core part of the Labour party. Labour is a deeply divided party. In government that will become more obvious than it is at present, when it is the divisions within the Conservative party that make all the headlines.
Our tentative conclusion from the above is that a Labour government is likely to continue using contractors for public works. Whatever its views on how to negotiate with private companies, it is likely to encounter a sector which is quietly determined not to sign up to any more of the type of fixed-price contracts which have cost it so dearly over the last decade. A Labour government might even adopt the newer platform structure, which appears to work well for all concerned.
As ever, I am happy to receive your comments as we continue to evolve our thinking in these areas, and will do my best to answer any questions you may have
Please note – this blog contains the personal opinions of Tony Yarrow as at February 20th, 2018, and is not intended as financial or investment advice.
- On the day of the announcement, the shares collapsed from around £1.90 to 45p. We didn’t sell them immediately, but waited in anticipation of a better opportunity. Fortunately, there was a rumour soon afterwards that the company was going to be the subject of a take-over. The shares spiked up to 65p, allowing us to sell in the low 60s, which meant that we ‘only’ lost 70% of the money invested.