On Monday 15th
January UK construction services company Carillion filed for compulsory liquidation after rescue talks with the government and lenders broke down at the weekend. Apparently Carillion has been carrying £1.5bn of debt. including a £587m pension deficit, and a £300m cash hole. At the time of liquidation the Company only had £29m of cash on turnover of around £5bn. As recently as last Friday, 12th
January, Carillion issued a statement:-
“that it met with representatives of its creditor groups to present its business plan on 10th January…it is too early to predict the outcome of these discussions but Carillion expects that (an) agreement is likely to involve the raising of new capital and the conversion of existing financial indebtedness to equity which would result in significant dilution to existing shareholders.
The board remains focused on seeking to deliver an outcome that will ensure that the group emerges considerably strengthened and able to continue delivering excellent service to its many public and private customers.”
So in just three days the Board went from “being focused on seeking to deliver an outcome that will ensure that the group emerges considerably strengthened”
to making the following statement:-
“Further to the announcement made on 12 January 2018, Carillion continued to engage with its key financial and other stakeholders, including Her Majesty’s Government, over the course of the weekend regarding options to reduce debt and strengthen the group’s balance sheet. As part of this engagement, Carillion also asked those stakeholders for limited short term financial support, to enable it to continue to trade whilst longer term engagement continued.
Despite considerable efforts, those discussions have not been successful, and the board of Carillion has therefore concluded that it had no choice but to take steps to enter into compulsory liquidation with immediate effect.”
I had planned to blog about a different subject this week but some of my regular readers asked me if I would cover this and on reflection I agreed as it is no doubt one of the biggest crises facing British industry since the banking debacle of 2007-8. It has ramifications not only for shareholders and customers as indicated in the RNS announcements[i]
but also for employees and pensioners, suppliers and partners, and for the Government as a whole.
Much of the coverage so far has been predictably thin in reasoned analysis, quite emotional and irrational, and quite often wrong. The looney left has jumped on the case as an opportunity to further their argument that capitalism is responsible for much of what is wrong in British society and must go. Jeremy Corbyn seems to be arguing that all the public services currently operated by private corporations should be nationalised thus bankrupting the government and possibly the country.
In fact, it is not so much a failure of capitalism but a failure of the mixed economy that has been the way so much of this country has been run for so many years. The so-called Public Private Partnerships and Private Finance Initiatives that were very much the models followed by Carillion and its competitors were introduced by John Major’s Conservative government but hugely expanded by Tony Blair’s and Gordon Brown’s Labour governments. David Cameron’s Coalition government continued to follow them and the socialist Scottish Nationalists use them widely in Scotland. The former Labour minister Alan Milburn said “Private Finance Initiatives or bust”. What he meant was that the government could not afford to build all the hospitals, schools and roads it wanted to so it shoved them off its own already bloated balance sheet onto private corporations who could raise the necessary money. They could also build them far more quickly than was done under public control. In return these same private corporations were awarded long-term contracts not only to build the infrastructure but to run some of the services associated with it.
So how did Carillion get in this mess? And first of all, what is (or was) Carillion?
Carillion was created when the long running construction company Tarmac (founded 1903) was demerged into a construction company and a services company in 1999. The latter, christened Carillion, then went on a rapid acquisition trail picking up Mowlem (founded 1822) and Alfred McAlpine (formed 1940 as a demerger from the parent company Sir Robert McAlpine, founded 1869) among several others. It developed what it came to describe as an integrated support services business, employing around 43,000 people, including 20,000 in the UK. It also operated in Canada and the Middle East. From its roots in construction it widened its coverage to include transport and power networks. It was involved in initial project finance, through design and construction to ongoing maintenance and facilities management.
In its public statements it took pride in working in “partnership with the public sector to deliver important services which offer value for money and make a positive difference to the lives of people in the communities where it worked…..At the heart of everything we do are our people and our Values. They drive our commitment to delivering safe, sustainable and effective solutions for our customers”
It had four business segments:-
· “Support services - Facilities management, facilities services, energy services, rail services, road maintenance and utility services.
· Public Private Partnership (PPP) projects – Our investing activities in PPP projects range from defence, heath, education, transport, security, energy services and other Government accommodation. (sic).
· Middle East construction services – Our building and civil engineering activities in the Middle East.[ii]
· Construction services (excluding the Middle East) – Our market leading consultancy, building, civil engineering and developments activities in the UK[iii]”
How did Carillion get in this mess?
In short many of its markets have slowed down and the thin margins it makes on most of its contracts do not compensate. Its results for 2016 were more or less OK though no doubt papering over the cracks. But in the first half of 2017 it posted more than a £1.4bn loss. Its Chief Executive was replaced by one of the NEDs on an interim basis and this news sent the share price into a tail spin from 230 pence a year ago to just over 14 pence at Friday’s close.
Many of its contracts are long term and were taken at very low margins during the recession when it was a matter of winning work at all costs. But there are accounting issues too, (remember Enron, anyone?) Carillion operated project accounting, which tends to recognise losses late in the project, effectively when the project starts to run out of money. It was surprising to some that it went straight into liquidation without an attempt at administration first. The reasons are simple. Firstly, it had a pension deficit of £587m and no one wants that. Secondly, it had virtually no assets to sell. A house building company might be sitting on a land bank which it could start to liquidate if it was short of cash. Carillion was just a service company whose assets clock on every day.
Reading Carillion’s accounts is not easy. It refers to underlying profits whatever they are, but they’re not huge. In 2016 it recorded revenue of £5.2bn, up by 14%. However its “underlying profit from operations” was just £235.9m up by only 1%, and a margin of only 4.5% vs 5.3% in 2015. Its underlying profit before taxation was just £178m. Its underlying earnings per share were just 35.3p but the directors proposed a full-year dividend of 18.45p, i.e. 52% of total earnings. This looks somewhat reckless, and not just with hindsight. First, the pension deficit was over three times profit before tax, and secondly, in any case, you can only pay dividends from cash.
As part of a review of contracts at this time by a new Finance Director and KPMG an unexpected contract provision of £845m at 30th June 2017 was made of which £375m related to the UK (mainly 3 PPP projects) and £470m to overseas markets, mainly the Middle East and Canada. On these contracts Carillion forecast future net cash outflows of £100m-£150m (primarily in 2017 and 2018). In other words they were losing substantial revenue on specific contracts.
These modest results with no increase in earnings in real terms were nevertheless described by management as “Our performance in 2016 reflected the benefits of our consistent and successful strategy”
. By July they were reporting on their first half with total revenue flat at £2.5bn; underlying pre-tax profit down 40% due to the phasing of PPP equity disposals; and the trading of contracts with H1 provisions at zero margin. The loss before taxation was £ (1,153)m and the net debt £571m.
The CEO’s head rolled but as is the way of things these days he would stay around to help the interim CEO and would continue to draw his full salary until October 2018. The interim CEO Keith Cochrane then conducted a Strategic Review of the business and by September was ready to report more bad news. An additional £200m provision was made for the Support Services. He said:-
“The Strategic Review that we launched in July has enabled us to get a firm handle on the group’s problems and we have implemented a clear plan to address them. Our objective is to be a lower risk, lower cost, higher quality business generating sustainable cash backed earnings. In the immediate short term, our focus is to complete the disposal programme, accelerate our action to take cost out of the business and get our balance sheet back to where it can support Carillion going forward.
No one is in any doubt of the challenge that lies ahead. We have made an encouraging start and the ambition is there to build on that progress. Supported by an operating model that manages risk much more effectively and led by a fresh management team with a mandate to drive cultural change, I am confident that a strong business can emerge.”
In January 2018 Carillion announced that the Financial Conduct Authority was investigating the timeliness and content of the company’s announcements from December 2016 regarding its financial statements.
Companies quoted on the London Stock Exchange are expected to maintain a very high standard of accuracy in their public announcements. The code of practice governing them is both lengthy and weighty. I have been both a Chief Executive and a Chairman of quoted companies and we used to spend a great deal of time on getting the tone as well as the content of a statement right. Reading these statements by Carillion one can’t help thinking there is a great deal of wishful thinking in them.
There has been much talk this week on the Government’s record of continuing to award contracts to Carillion even after they have made several profit warnings. I am not sure if all the politicians and the media commentators understand what a ‘profit warning’ is. A publicly quoted company is not allowed by law to make a public forecast of its revenues and profits. Instead it can give ‘guidance’ to the market and independent analysts employed by stock brokers may make their own forecasts of what results are likely to be. It is on these that investors rely and make their decisions about whether to buy, hold or sell the shares. If, however, events occur which mean that the results expected by the market are unlikely to be realised then the management is obliged to issue a ‘profit warning’. This will not be specific but will indicate what has happened and give the analysts the opportunity to revise their forecasts.
So the fact of a profit warning would not be a reason not to award a contract. Far from it. It might indeed be reason why a contract should
be awarded if the terms are right so that the contractor can recover its position. Or in another situation a highly profitable, well-run company might still face a situation where a profit warning is required but still be highly profitable.
Other politicians, notably Sir Vince Cable, have criticised the government because they point out that hedge funds have made money shorting Carillion’s stock. ‘If they could see it coming surely the rest of you could’, is the cry. This is disingenuous. I read Money Week
, an excellent publication on all aspects of money- making it, keeping it, spending it. On a monthly basis they publish the top ten most shorted stocks. Sainsbury’s has been in the list for years because major supermarkets are being squeezed. It does not mean that Sainsbury’s is about to go bust. Hedge funds get it wrong too, more than they get it right.
But it is a scandal. There will be many losers from this debacle. Firstly, the genuine shareholders who have been wiped out. I have not heard one word of sympathy for them in the media. One left wing popinjay talked about privatising profit and nationalising risk. But the main risk was taken by the shareholders and they have lost everything. The company had a market capitalisation of about £1bn a year ago; today it is zero. To be clear Carillion’s problems were that it was not profitable enough, not that it was too profitable.
The taxpayer will have to pay for renegotiated contracts and temporary arrangements pending the negotiations. Not all employees will keep their jobs. Small companies in the supply chain will be at risk. Existing pensioners will be protected by the Pension Protection Fund (PPF) but under the scheme future pensioners take a haircut of 10%.
And who should pay? Who is responsible? Well, clearly the board over several years. I can’t quite understand how they were still signing this off as a going concern, or for that matter, were the auditors. Why they were using their valuable cash to pay dividends when the business was clearly not as strong as they claimed, I cannot understand. And how can the managers look at themselves in the mirror for the giant bonuses they were taking out of the business with threadbare, and sometimes non-existent, margins? And while I have sympathy for independent shareholders, two-thirds of the institutional shareholders were rating Carillion a ‘buy’ as recently as 2015, according to the Financial Times
. Perhaps they were seduced by its attractive but pernicious habit of paying out half its earnings in dividends when a cursory look at its balance sheet and its cash position showed that was not tenable.
As early as 2013, Carillion moved to a system of reverse factoring. Factoring is a perfectly normal process whereby a company seeks to improve its own cash flow at the expense of some of its margin by paying a fee to a factoring company which then takes over its debtor file, pays the account upfront minus its fee and then collects the receivables in its own time. Reverse factoring is where the company receives payments from its banking partners for its own debts and then the bank discharges those. In July 2017 the new interim CEO admitted that these debts amounted to £412m, about a third of Carillion’s total debts and that they would seek to reduce its reliance on such reverse factoring. More wishful thinking.
And what about the Government? As I have explained the idea of awarding government contracts to private firms to get investments off balance sheet and also to take advantage of the superior performance of privately run firms has been supported by all political parties over more than two decades, so it is hypocritical to make it a party political issue. One front bench Labour spokesman was particularly perverse when he called for an inquiry because Philip Green, Chairman[iv]
, had been an adviser to David Cameron. He forgot to mention that Baroness Sally Morgan, the Senior Non-Executive Director of Carillion was Tony Blair’s right hand woman while another former Labour minister was also on the board.
But party politics apart, if the Government is going to award contracts to private firms it needs to improve its procurement function. I have long thought that a new breed of corporation emerged to exploit this trend led by companies such as Capita, or Crapita in its frequent appearances in Private Eye
. Their only true skill seems to be their ability to win government contracts. They manage the relationship closely and develop an attitude of 'we’ll take care of that for you', even when they have no particular skill in that department. Looking at Carillion’s business model, that is exactly what it was. It has diversified into areas miles away from its origins because it can win the relevant contract. In business one of the best pieces of advice you will ever get, is ‘Stick to the knitting’.
PS One of the reasons I wasn’t going to write about this is that I am not a journalist and prefer to work with hard and fast facts. I have done my best researching this blog which I finished writing on Friday 19th
in the afternoon. On that evening’s news was a story saying the real debts were over £5bn versus £1.5bn announced to the High Court by Carillion representatives. Similarly the real pension deficit is now reported as £2.5bn versus £587m revealed to the High Court. It will probably take years to get all the facts but I hope my general conclusions remain valid.