BY JOHN KINGHAM
dividend hunter Who will be the next Carillion?
For many dividend investors, the demise of Carillion was a disaster. Not only did their port- folios lose an important source of income, they also saw a permanent loss of capital. It's easy to see what went wrong with hindsight, and in the August 2017 issue of Master Investor I wrote about some of the key lessons from Carillion's collapse. Hindsight is a wonderful thing, but the problems with Carillion were not exactly hard to spot, even several years be- fore its eventual demise. So rather than do yet another Carillion post-mortem, I thought it would be more useful to apply a little foresight and look for companies with similar "red ľdjv%#zklfk#lqyhvwruv#pljkw#zdqw#wr#dyrlg#ru#jhw#rxw#ri1
There were four key lessons from so the similarities with Carillion are One problem with this business Carillion, so I'll be looking for four clear. The company has also had model is that these contracts are UHGȵDJV /DUJHFRQWUDFWV :HDN its problems, resulting in a recently W\SLFDOO\IRUDȴ[HGSHULRGRIVHYHUDO SURȴWDELOLW\ %LJ DFTXLVLWLRQV suspended dividend and a share years, and when the contract ends, High debts. price which has gone from over the associated revenues and prof- 700p a few years ago to around its disappear as well. This can make Interserve PLC 100p today. large contract-based businesses riskier than other businesses with • Share price: 123p With results like that, many dividend smaller and more frequent sales • Index: FTSE 250 investors will have already sold out. "wins" (such as companies selling • Market cap: £170 million However, I still think it's worth look- soap or toothpaste). ing at Interserve because it's a good Interserve is perhaps the most obvi- example of how these four risk fac- Another problem is that these con- ous "next Carillion", having been in tors can bring previously successful tracts can be very costly if they go the media spotlight shortly after Ca- companies to their knees. wrong. A good example of this is rillion's liquidation. Interserve's Glasgow "energy from Large contracts? YES waste" contract. In May 2016 the Like Carillion, Interserve operates in company announced that problems the cyclical Support Services sector. As a provider of cleaning, security, with the design, procurement and It mostly provides facilities man- construction and other services, LQVWDOODWLRQ RI D JDVLȴFDWLRQ SODQW agement and construction services Interserve needs to win large long- plus challenges with the supply to both public and private clients, WHUPFRQWUDFWVWRJHQHUDWHSURȴWV chain, would lead to overruns and
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“INDUSTRY-WIDE SUICIDE BIDDING LEAVES MANY SUPPORT SERVICES COMPANIES WITH BARELY ACCEPTABLE LEVELS OF PROFITABILITY.”
www.masterinvestor.co.uk | Master Investor is a registered trademark of Master Investor Limited ISSUE 35 – FEBRUARY 2018 | 45 DIVIDEND HUNTER
organic growth with acquisitions". So with the goal of doubling earnings in mind, management went on a massive debt-fuelled acquisition spree.
Between 2010 and 2014, the company spent about £430 million in cash ac- quiring other businesses, including £250 million (in cash and shares) for Initial Facilities, the facilities manage- ment business of Rentokil Initial PLC. Over the same period the company JHQHUDWHG SRVWWD[ SURȴWV RI DERXW £210 million, or less than half the amount it spent on acquisitions. That ZDVDVHULRXVUHGȵDJDFFRUGLQJWRP\ acquisition rule:
ACQUISITION RULE: Only invest in a company if it spent less on acquisi- tions over the last ten years than it PDGHLQDGMXVWHGSRVWWD[SURȴWV
averaging just 7.7% over the last dec- Why might this make Interserve the ade. With the FTSE All-Share returning next Carillion? Because a) companies “THE about 7% per year over the long-term, being acquired don't exactly shout Interserve's rate of return is not exactly about their problems from the rooftop; SIMILARITIES impressive, although it did just about b) acquisitions add complexity and can WITH CARILLION PHHWP\SURȴWDELOLW\UXOH distract the acquirer from their own (often weak) core business; and c) ac- ARE CLEAR.” PROFITABILITY RULE: Only invest in quirers often overpay because of over- a company if its ten-year average optimistic beliefs about synergies, cost return on capital employed is above VDYLQJVDQGRWKHUSRWHQWLDOEHQHȴWV delays with an expected cost of £70 7% million. In February 2017 that expected cost was increased to £160 million and In terms of Interserve being the next today it stands closer to £200 million. &DULOOLRQZHDNSURȴWDELOLW\LVDVLJQRI To put that in context, Interserve's av- weak or non-existent competitive ad- HUDJHQHWSURȴWRYHUWKHSDVWGHFDGH vantages. Companies with weak com- has been £40 million to £50 million per petitive advantages are vulnerable to year. industry downturns because they have little or no pricing power. They must :HDNSURȴWDELOLW\"<(6 undercut the suicide bidders and hope that somehow they can still eke out a Yet another problem with large con- SURȴW7KDWLVQRWDJRRGSRVLWLRQWREH tracts is that they tend to attract "sui- in. cide bidders" – i.e. companies who will bid for a contract at a price which is Big acquisitions? YES almost certain to produce a loss, just High debts? YES VR WKDW WKHLU VWD KDYH VRPHWKLQJ WR When a company wants to grow but do. This may seem daft, but it's usually cannot grow its core business, one With £430 million spent on acquisitions EHWWHU WKDQ KDYLQJ VNLOOHG VWD VLWWLQJ easy way to boost short-term growth is between 2010 and 2014 and total prof- around doing nothing. It's also better to acquire other companies, and that's its in that time of £210 million, it was WKDQ OD\LQJ WKHP R RQO\ WR KDYH WR exactly what Interserve set out to do in always going to be hard for Interserve re-hire them at a later date (assuming 2010. to pay for that lot using spare cash they haven't found a better job with a WKURZQ R IURP LWV H[LVWLQJ EXVLQHVV competitor). In that year's annual results, the com- The answer, of course, was to borrow pany announced its intention to dou- the money instead. Industry-wide suicide bidding leaves ble earnings per share, from 40p to many support services companies with 80p, by 2015. The results also stated The bulk of those borrowings came in EDUHO\DFFHSWDEOHOHYHOVRISURȴWDELOLW\ that the company's then-reasonable 2013 and 2014, when the company's ΖQWHUVHUYH ȴWV WKDW GHVFULSWLRQ ZLWK borrowings of £121 million gave it total borrowings went from £50 million post-tax return on capital employed WKH ȴQDQFLDO VWUHQJWK WR VXSSOHPHQW to £370 million. That debt expansion
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took the company's borrowings from G4S PLC enough security personnel and, at the just over one-times its then-average last minute, thousands of troops had SURȴWVRIDERXWePLOOLRQWRDOPRVW • Share price: 291p to be brought in to make up the num- WHQWLPHV 7KDW ZDV DQRWKHU UHG ȵDJ • Index: FTSE 250 bers. As a result, the CEO and other according to my debt rule: • Market cap: £170 million senior management lost their jobs and the company lost around £90 million DEBT RULE: Only invest in a cyclical G4S is another company operating in on the contract. company if its total borrowings are the Support Services sector. It's the OHVVWKDQIRXUWLPHVLWVȴYH\HDUDY - world's leading security services com- This is precisely why large con- HUDJHDGMXVWHGSRVWWD[SURȴWV pany, born from the merger of Securi- tract-based businesses are risky and cor and Group 4 in 2004. It's a company why they should be treated with care. By that standard, Interserve had gone that only seems to make the headlines G4S makes around £200 million per from prudent to reckless in just a cou- when things go wrong, such as Group \HDU LQ SRVWWD[ SURȴWV DQG LW ORVW ple of years. In fact, things have be- 4's problems with escaping prisoners around £90 million from a single con- come considerably worse since 2014, in the 1990s or G4S's failure to provide tract. And of course, the long-term with the company's debts ballooning enough security personnel during the damage to its reputation may be far to more than £460 million (and po- 2012 Olympics. more serious than the short-term tentially much more in the soon to be damage to its bottom line. released 2017 results), which is more Large contracts? YES than ten-times its latest average prof- :HDNSURȴWDELOLW\"<(6 its. Exactly why institutional investors *6HDUQVLWVSURȴWVE\SURYLGLQJVHFX - VLJQHG R RQ DOO WKLV LV EH\RQG PH Ζ rity services (such as security personnel The average post-tax return on capital guess they get paid either way). or security systems and technology) to employed across all 220 companies clients through sometimes large and on my stock screen is 11% and, as I've And it gets worse. On top of that £460 long-term contracts. I've already out- already mentioned, the long-term ex- million (or more) debt-pile, Interserve lined the potential problems with this pected return of the FTSE All-Share is has a pension obligation of more than business model, so rather than go over about 7% per year. £1,000 million. That is a literally unbe- them again let's have a look at what OLHYDEOHȴQDQFLDOREOLJDWLRQIRUDFRP - happens when things go wrong. How does G4S compare to those pany that makes barely £50 million or benchmarks? Not too well. Over the so each year. It's also yet another red Remember the London Olympics last decade its return on capital em- ȵDJDFFRUGLQJWRP\SHQVLRQUXOH LQ " $V RɝFLDO VHFXULW\ VHUYLFHV ployed has averaged just 5%, which is provider for the games, G4S was in a very unimpressive. It's return on share- PENSION RULE: Only invest in a com- JRRG SRVLWLRQ WR XVH WKLV KLJKSURȴOH holder equity is better, with an average pany if its total pension obligation is FRQWUDFWWRLQFUHDVHLWVSURȴWVDQGLWV of about 18%. However, that higher re- OHVVWKDQWHQWLPHVLWVȴYH\HDUDY - reputation around the world. Sadly, it turn on equity is only possible because HUDJHDGMXVWHGSRVWWD[SURȴW didn't quite work out that way. Rather returns have been boosted with large WKDQ LQFUHDVLQJ LWV SURȴWV RU UHSXWD - amounts of borrowed money (which I'll Of course, the pension fund has assets, tion, G4S lost money and reputation at cover in a moment), and that increases EXWWKHIXQGVWLOOKDVDGHȴFLWRIPRUH the 2012 Olympics. It failed to provide risk as well as returns. than £50 million, and given the £1,000 million size of the fund it's possible the GHȴFLWFRXOGJHWDORWZRUVH7KLVGHȴ - cit is nowhere near as bad as Carillion's astonishing near-£600 million pension GHȴFLW EXW LW GRHV WDNH ΖQWHUVHUYH V FRPELQHG GHEW SOXV SHQVLRQ GHȴFLW "borrowings" to more than £500 mil- lion, which is way too high in my opin- ion for a £50 million per year company.
Is Interserve the next Carillion?
Obviously, I have no idea whether In- terserve will go into liquidation like Carillion. Its situation is bad, but not as bad as the jaw-droppingly bad state RIDDLUVDWWKDWRWKHUFRPSDQ\+RZ - ever, I think the situation is bad and a rights issue of several hundred million pounds could be the best option, as- suming shareholders are willing, which they may not be. www.masterinvestor.co.uk | Master Investor is a registered trademark of Master Investor Limited ISSUE 35 – FEBRUARY 2018 | 47 DIVIDEND HUNTER
Big acquisitions? NO
In recent years, and especially follow- “G4S’S DEBT AND PENSION OBLIGATIONS ing the 2012 Olympic disaster, G4S has RELATIVE TO ITS PROFITS ARE IN THE shied away from large acquisitions. The last really big acquisition was in SAME BALLPARK AS CARILLION’S WERE 2008, when it purchased Global Solu- JUST BEFORE IT COLLAPSED.” tions Limited for £355 million. That acquisition cost more than an entire \HDU V SURȴW RI DERXW e PLOOLRQ DW The company also has a massive pen- it collapsed, so the company certainly the time) so it was big, but 2008 is an- sion obligation totalling some £2,700 seems to have the right characteristics cient history now so this acquisition million. That gives the company a pen- to be the next Carillion. However, G4S doesn't bother me. VLRQREOLJDWLRQWRSURȴWUDWLRRIZHOO has put out positive trading statements above my preferred maximum of ten. recently and has so far maintained its High debts? YES dividend, unlike Interserve which has already suspended its dividend. G4S's return on capital employed is very weak, so it uses large amounts A maintained dividend might reassure of debt to boost shareholder returns. investors, but it's exactly what I would This is a legitimate strategy, but also a expect to see. Long experience has risky one if the debt burden becomes taught me that CEOs will almost al- too large. ways paint a positive picture and, more importantly, maintain the dividend. As I've already mentioned, I prefer cy- They'll do this even when it seems ob- clical sector companies to keep their vious that the sensible thing to do is total borrowings below four-times to suspend the dividend and use the WKHLU UHFHQW DYHUDJH SURȴWV )RU *6 cash to reduce debt and pension obli- ZKLFK KDV DYHUDJH SRVWWD[ SURȴWV RI gations (and perhaps even raise a little about £185 million (there has been extra cash through a rights issue). OLWWOHRUQRSURȴWJURZWKRYHUWKHODVW This huge pension also comes with decade) that would mean a debt-ceil- D KXJH GHȴFLW RI e PLOOLRQ WDNLQJ But what is sensible and what keeps a ing of about £740 million. In fact, the G4S's combined debt plus pension CEO in their job is not always the same company announced total borrowings GHȴFLW OLDELOLWLHV WR DOPRVW e PLO - thing, as Carillion's shareholders know of more than £2,500 million in its latest lion, which is a vast amount for a com- all too well. annual report. pany generating less than £200 million LQSURȴWV$QGGRQ WWKLQNWKLVLVMXVWDQ Of course, I'm not saying that G4S or But is this enough to make G4S the accounting anomaly with no impact on Interserve are going to go bust or that next Carillion? It's possible, especially FDVKȵRZVEHFDXVHLWLVQ W*6LVFXU - their management are incompetent, given that G4S has almost three times rently obliged to pay around £40 mil- but both companies have a lot of char- as much debt as Carillion on a debt-to- lion per year into the scheme to close acteristics which make them look very SURȴWEDVLV$QGWKHIDFWWKDWLWVGHEW the funding gap, with that amount in- similar to Carillion. That's why I won't interest payments are equal to about creasing by 3% per year. be buying either company, no matter RILWVSRVWWD[SURȴWVLVQRWH[DFWO\ how low their share prices go. And just a good sign either. Is G4S the next Carillion? as importantly, I'll be looking to avoid any other companies with a similarly This massive debt burden is more than G4S's debt and pension obligations risky combination of large contracts, enough to make G4S a very risky prop- UHODWLYH WR LWV SURȴWV DUH LQ WKH VDPH ZHDNSURȴWDELOLW\ELJDFTXLVLWLRQVDQG osition in my opinion, but it gets worse. ballpark as Carillion's were just before high debt and pension obligations.
About John
John Kingham is the managing editor of UK Value Investor, the investment newsletter for defensive value investors which he began publishing in 2011. With a professional background in insurance software analysis, John's approach to high yield, low risk investing is based on the Benjamin Graham tradition of being systematic and fact- based, rather than speculative.
John is also the author of The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio .
His website can be found at: www.ukvalueinvestor.com.
48 | ISSUE 35 – FEBRUARY 2018 Master Investor is a registered trademark of Master Investor Limited | www.masterinvestor.co.uk