The UK鈥檚 second-biggest contractor has posted some pretty alarming figures recently, from its 拢695m debt to its 拢845m writedown. But how did it get into this state, how can it get out again, and what does it mean for the wider industry?
When Carillion released its half-year trading update at 7am on Monday 10 July, the City was already braced for bad news. Its joint venture partners on a 拢745m Scottish road-building project, Balfour Beatty and Galliford Try, had already made big write-downs related to the scheme, and there were reports of delays and problems on other contracts. According to Canaccord Genuity Wealth Management it was the most 鈥渟horted鈥� stock in the UK prior to the announcement, meaning investors were already betting against Carillion in order to make money if the share price fell in value.
But the sheer scale of the problems finally admitted to by the 拢5bn-turnover contracting giant took investors, competitors and the wider industry completely by surprise. Following a review by accountancy firm KPMG, Carillion admitted contract revenues would be 拢845m lower than expected, that net debt had soared by another 拢110m to 拢695m, and that it was exiting the PFI market and parting company with its chief executive, UK buildings boss and three divisional finance directors. Sam Cullen, equity analyst at Jefferies International, says: 鈥淧eople suspected a write-down was coming. But everyone was shocked just at the scale of it.鈥�
While interim chief executive Keith Cochrane pointed to the firm鈥檚 continued success in winning work and 鈥済reat capabilities鈥�, analysts were united in concluding that Carillion needed an urgent injection of equity of 拢400m-600m. However, given the subsequent 70% collapse in the share price, there is no obvious route to get it. Suddenly, from the presumption it was simply going to join the long list of contractors to be beleaguered by a few underperforming contracts, the UK鈥檚 second biggest construction firm could be facing a threat to its very existence. The impact on the supply chain of it actually going under, given its sheer scale, makes it a problem for the whole industry. Steve Beechey, group strategy director at rival contractor Wates, says: 鈥淪uddenly Carillion is on everyone鈥檚 agenda. It鈥檚 the talk of board meetings across the industry. It鈥檚 big news.鈥�
So, how did it get into this situation, can it get out of it, and what does it mean for the rest of the industry?
Big news
In some ways Carillion鈥檚 shock announcement just makes it the latest of a very long list of UK contractors to report financial woes on the way out of a recession longer and deeper than anyone had expected. Already this year Galliford Try and Skanska have revealed problems, following the likes of Balfour Beatty, Kier, Sir Robert McAlpine, Vinci and ISG.
But with a writedown of 拢845m, Carillion has been saving the biggest till last. The firm said it stemmed from its 拢2bn-turnover construction business, and primarily related to difficulties getting paid what it expected. About 40% of the figure 鈥� 拢375m 鈥� related to the UK, and the rest 鈥� 拢470m 鈥� to the Middle East and Canada. Jefferies鈥� Cullen says: 鈥淚t鈥檚 classic problems we鈥檝e seen with contractors, such as carrying out work without agreeing cost or value. But with Carillion it鈥檚 on top of a balance sheet already layered with debt.
However, the predicted 拢900m average net debt for the second half of the year is not its only balance sheet difficulty, as it also has a pension fund deficit of 拢587m, and a 拢400m-plus debt facility set up to pay its supply chain early. This leaves 鈥� according to Cenkos analyst Kevin Cammack 鈥� shareholders鈥� funds of just 拢300m. Cammack says this 鈥渋s simply unsustainable as a structure and a risk profile鈥� for a 拢5bn-turnover business, meaning it needs new equity to prop up the balance sheet 鈥� and fast.
Cammack thinks the firm has until the end of the year to come up with a plan, while Cullen says it needs to act even more quickly 鈥� by the time of half-year results in September. Carillion has promised to report on a strategic review it has commissioned from accountant EY by that time, for which interim chief executive Cochrane said: 鈥渘othing is off the table.鈥� Stephen Rawlinson, analyst at Applied Value, says: 鈥淭he share price is now arguably a sideshow, at present, as the average net debt, supplier early payments and the 拢600m pension deficit will govern survival.鈥�
Aggressive expansion
While quick action is needed, analysts and peers say the firm鈥檚 problems have had a long gestation. After being formed from the construction arm of Tarmac in 1999, Carillion set about moving quickly into the higher value support services arena. However, the 2006 purchase of struggling contractor Mowlem for 拢313m, which necessitated a 拢90m writedown due to unforeseen problem contracts, set the tone for aggressive acquisition-led expansion, which saw it spend 拢572m on a hostile takeover of Alfred McAlpine just two years later. While this saw it take more than 拢200m in net debt onto its balance sheet, selective sales of some of its operating businesses and buoyant contracting revenues retrieved the position, right until its 2011 purchase of energy services business Eaga for 拢298m.
Eaga, rebranded Carillion Energy Services, was quickly hit hard by government changes in renewables subsidies and within six months of purchase Carillion was spending 拢40m 鈥渞estructuring鈥� the business fit for a less ambitious future. Cammack describes the value for money for shareholders of both the Mowlem and Eaga purchases as 鈥渕iserable鈥�, but most important was what they did to the firm鈥檚 balance sheet.
Suddenly Carillion is on everyone鈥檚 agenda. It鈥檚 the talk of board meetings across the industry. It鈥檚 big news
Steve Beechey, Wates
By 2012 Carillion again had more than 拢200m of debt on the books, but with a deepening recession forcing the firm to shrink its construction business, there was no organic way to bring cash back in. One rival listed contractor chief executive says: 鈥淭he rot started with the Eaga deal. Everyone had bad jobs, but this took 拢300m off the balance sheet.鈥�
Against this backdrop, Carillion sought expansion in the Middle East, where it had already worked successfully for years alongside local partners in Oman and the United Arab Emirates. This time the target was the booming Qatari economy, where in 2011 it picked up a prized project 鈥� Msheireb Properties鈥� 拢395m Downtown Doha regeneration scheme, which Msheireb describes as 鈥渢he world鈥檚 first sustainable downtown regeneration project, designed to regenerate and preserve the historical heart of Doha鈥� seemingly vindicating the strategy.
After last month鈥檚 writedown announcement, of which 拢325m related to the Middle East, the venture looks like a high-stakes gamble that went spectacularly wrong. Cullen says: 鈥淕oing into Qatar in 2011 was a risk. Getting paid in the Middle East is often difficult.鈥� The Downtown Doha scheme is pointed to by several analysts as being the cause of Carillion鈥檚 Middle Eastern problems, with Rawlinson saying he understands that 鈥渢he Msheireb project accounts for a large portion of the outstanding cash owed to the company.鈥� Carillion has said only that much of the Middle Eastern losses stem from one contract, and Msheireb Properties said it 鈥渄oes not comment on speculation鈥�.
Squeezing the pips
In the UK, Carillion has for years been reporting healthy contracting margins, but here too the chickens have come home to roost. Accounting rules allow contractors some leeway in exactly when they book revenue and profit on jobs, and former Balfour Beatty UK construction chief executive Mike Peasland says Carillion had always been seen by peers as on the aggressive side in this sense. 鈥淲hile everyone else has struggled in recent years Carillion has kept on going at a decent margin. It looks like they鈥檝e been squeezing the pips and they鈥檝e been found out.鈥� Carillion declined to comment on whether it had been too optimistic in the way it accounted for projects, but Cochrane told analysts it had made the provision now because of the scale of deterioration of cash coming in, and following 鈥渄ialogue with customers we鈥檝e experienced in recent weeks.鈥�
Carillion says the UK problems largely relate to three PFI projects, which again it has declined to name. However, they are widely understood to be the Aberdeen Western Peripheral Route, the Royal Liverpool hospital project and the Midland Metropolitan hospital project. While none of the clients will comment on the extent of cost rises on the jobs, all of the projects have seen delays of at least six months due to unforeseen construction issues (see Carillion鈥檚 possible problem projects in box).
Ex-Balfour chief executive Peasland says it is not surprising, therefore that costs are adding up: 鈥淥n PFI projects liquidated damages for delays can commonly be hundreds of thousands of pounds a week. And with your additional site costs, that can easily turn into half a million. It doesn鈥檛 take long to rack up.鈥� Carillion is now withdrawing from bidding for PFI projects, and in its presentation to analysts admitted it had allowed projects to go ahead with 鈥渁 high degree of uncertainty around key assumptions鈥� and where its success was 鈥渃ontingent on the performance of others not under our control.鈥�
Tricky situation
All of which leaves Carillion in a difficult situation. The crash in its share price gives the business a current market value of just 拢250m at the time of going to press, meaning in practical terms it can鈥檛 call on shareholders to give it the half a billion it needs. But, according to Cammack, its borrowing comes from a range of different banks, meaning negotiating a debt-for-equity swap with its banks could be fiendishly difficult. Meanwhile attempting to shrink the business to a size more appropriate to its balance sheet would suck cash out, meaning that can鈥檛 be done quickly.
Which leaves the option of other outside investors either buying the whole business or carving it up and taking constituent elements. But purchasers may be put off by the size of the pension fund deficit, with the firm already paying 拢50m a year to the fund, and a 鈥渢riennial review鈥� ongoing to determine if that figure needs to be increased.
The fact is it鈥檚 too big to fail. You鈥檇 be a brave business secretary to let it fall over
Mike Peasland, Balfour Beatty UK
The chairman of the pension fund trustees, Robin Ellison, declined to comment when asked whether the fund would seek a share of any equity raised by Carillion. But Rawlinson said: 鈥淯nless the pension trustees make clear their position investors will not invest just to see their new money be absorbed by the pension [鈥the pension issue could be crucial in the months to come.鈥�
Carillion declined to say whether the pension fund trustees would seek extra money in the triennial review, but group finance director Zafar Khan told analysts 鈥渁ny future [pension] recovery plan will clearly need to take into account our current balance sheet position.鈥�
Besides this, few of Carillion鈥檚 UK peers look in the right shape to attempt such an acquisition anyway. Overall, Cullen concludes it is 鈥渁 bit of a zombie company鈥� in its current shape, and Cammack says this combination of factors makes it 鈥渧irtually impossible鈥� to put a value on the company until the balance sheet is secured.
In the meantime, there is the risk the firm will lose senior operational staff concerned about their future in the business. The rival plc chief executive says: 鈥淭he CVs of people from Carillion are all over the place. It鈥檚 not a flood yet but it鈥檚 a constant flow.鈥�
Another senior executive at a rival says: 鈥淎t the level below the top leadership, we鈥檝e been flooded with CVs.鈥� Cammack says this is a concern, as it is experienced Carillion executives who have the best chance of negotiating reasonable settlements of contracts. 鈥淲e don鈥檛 want a blood-letting of senior people. These are the people they need.鈥� Carillion declined to comment on whether it was concerned about the possibility of losing experienced staff.
Carillion鈥檚 possible problem projects
Chief executive Keith Cochrane told analysts that four individual projects were responsible for about half of the total 拢845m contract provision. He said one stemmed from the Middle East, and three were PFI projects in the UK, though he declined to identify the specific contracts, saying it would jeopardise Carillion鈥檚 chances of getting what they believe they鈥檙e owed. However, there are three obvious contenders for which UK jobs are the guilty parties. These are:
- The Royal Liverpool hospital PFI project, worth 拢335m. The Royal Liverpool and Broadgreen Hospital Trust said in March that opening of the Hospital had been delayed by a year from summer this year to summer 2018. At the time, a Carillion spokesperson blamed the discovery of more asbestos than anticipated, poor weather, and cracks found above beams in the building, requiring remedial work. 鈥淲e are disappointed that the opening of the new Royal Liverpool hospital has been delayed,鈥� the spokesperson added.
- The Aberdeen Western Peripheral Route and Balmedie-Tipperty road, together worth 拢745m under a PPP deal in joint venture with Balfour Beatty and Galliford Try. The Scottish government revealed in December 2016 that opening of the Balmedie-Tipperty road was being delayed by almost a year from spring 2017 to winter 2017/18, because earthworks could not be completed before the winter period.
- The Midland Metropolitan hospital PF2 project, worth 拢430m. In May, Sandwell and West Birmingham NHS Trusts admitted that delays to M&E work meant the building鈥檚 opening would be delayed from October 2018 to 鈥渆arly spring鈥� 2019, with an exact opening date to be confirmed this summer. Carillion project director, David Hollywood, said at the time: 鈥淭he mechanical and electrical (M&E) design, which covers building systems such as heating, lighting and ventilation, is behind schedule and we are working closely with the Trust and our specialist design consultant to complete the M&E design and confirm a new completion date.鈥�
The clients of these buildings declined to comment to 好色先生TV on what impact the delays had had on project costs, because under PFI deals, all cost increases are absorbed by the PFI consortiums themselves.
In terms of the Middle East, several analysts spoken to by 好色先生TV believe the problem project is the 拢395m Msheireb Properties Downtown Doha scheme. A spokesperson for Msheireb Properties said the firm did not comment on speculation.
There have also been suggestions Carillion has faced difficulties on the 拢400m Battersea Power Station project and the Sheffield Tram-Train project, on which Network Rail鈥檚 budget has increased from 拢15m in 2012 to 拢75m today. Battersea Power Station鈥檚 chief executive Rob Tincknell recently told 好色先生TV Carillion had 鈥渄one a brilliant job鈥� on the contract but said he did not know if the contractor had made money.
Carillion declined to comment on any specific schemes.
Good news
Despite all of this, there are number of factors in Carillion鈥檚 favour that mean there are fortunately few 鈥� if any 鈥� in the sector who think the firm will ultimately fall. Most obviously, there is the quality of its support services business, which makes up half its income and three-quarters of its profit, and where revenue is secured for many years ahead, with no major contract renewals until 2019. In addition, there is no immediate risk of it breaching banking covenants, and its four big problem contracts are all within 18 months of completion.
But even more important is the sheer scale of the business, which makes it in the interest not only of the industry but of the government too that it survives. Carillion is one of the 30 named 鈥渟trategic suppliers鈥� that government most relies on to deliver its services and is a linchpin of an industry worth nearly 10% of GDP.
鈥淭he fact is it鈥檚 too big to fail,鈥� says Peasland, while Jefferies鈥� Cullen says: 鈥淵ou鈥檇 be a brave business secretary to let it fall over.鈥� Since Carillion鈥檚 announcement, two major government contracts have been awarded to the firm 鈥� a 拢158m facilities management contract for the Defence Infrastructure Organisation, and 拢1.4bn worth of HS2 work in joint venture 鈥� which has been seen as a sign of government support. Mark Farmer, founder of consultant Cast, says: 鈥淭he selection process would have pre-dated this news. But someone has taken a conscious decision to award contracts that could have been delayed. It鈥檚 the right thing to do politically.鈥�
Consequently, while it has been reported that major customer BT Openreach is investigating whether Carillion will be able to fulfil its 拢1.5bn contract, there have been few signs of customers or suppliers walking away from the business. One specialist who is a significant supplier to the firm told 好色先生TV that 鈥淚t鈥檚 an amber light at the moment, but it鈥檚 not a red light.鈥� Another major customer said it was not reducing business with the firm at the moment: 鈥淲e are concerned, but Carillion is doing everything it can to make us feel comfortable.鈥�
The analysts鈥� consensus is that Carillion 鈥� which has already announced cost cutting measures, cancellation of the dividend and the sale of 拢125m of its businesses to bring in cash 鈥� will devise a plan to slowly rebuild its balance sheet 鈥� probably by calling on both shareholders and lenders. Rawlinson says: 鈥淲e remain positive that Carillion will avoid the fate of Jarvis, Spice, Connaught and others but it will take time and an early accommodation with the banks and some customers.鈥�
For his part, Carillion鈥檚 Cochrane says he intends to 鈥渟implify鈥� the business and remains positive given Carillion鈥檚 鈥済ood market positions, great capabilities and excellent people. However, we must look afresh at the way we operate, [and] learn the lessons of our recent challenges.鈥�
This doesn鈥檛 mean its problems won鈥檛 impact the sector. Peasland says: 鈥淚t鈥檚 a bit of a disaster anyway. People will look at the industry and say 鈥榠f it can happen to them then it can happen to anyone.鈥欌�� It also, he says, raises questions about the sustainability of the current PFI model.
For Cast鈥檚 Farmer, however, the whole sorry tale has a wider significance, symptomatic of an industry in trouble. 鈥淭his reinforces the idea that the contracting business model looks increasingly broken,鈥� he says. 鈥淢anaging contracts to lump-sum fixed prices is increasingly risky. Ultimately, the ability for contractors to take risks on behalf of their clients and offer them an outcome looks compromised.鈥� Whether Carillion鈥檚 travails will act as a wake-up call to others remains to be seen.
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