Shares of construction and support services firm Carillion (LSE: CLLN) slumped 70% to 56p last week after it issued a dire trading update on Monday.
The big question now is whether the market has overreacted to the bad news, making the shares a great buy for a recovery, or whether this falling knife has further to fall.
Key questions
In these situations, before attempting to answer the big question, we need to consider a number of others. What is the nature of the problem that’s caused the sell-off? Is it an acute difficulty that can be swiftly resolved or a chronic disorder that will take time to remedy? Does the company have the financial resources to deal with the problem? What will its balance sheet and profitability look like when the business is back on track?
Shaky finances
Carillion became the most shorted stock in the market over the last couple of years, the number of shares on loan rising to about 30%.
The bear thesis was that the way the company booked long-term contracts looked aggressive. Also, receivables were high relative to its peers (and increased sharply during 2016), there was little tangible asset-backing aside from the receivables, while the use of so-called ‘reverse factoring’ and the total level of indebtedness were high. In short, Carillion’s finances were far shakier than they appeared on the surface and it wouldn’t take much for it all to unravel.
Bear thesis borne out
Last Monday’s trading update shows that the bear thesis was on the mark. The company announced a deterioration in cash flows on a select number of construction contracts and said that after a review of all its major contracts it expects to make a provision of £845m.
Net debt is on the rise, the company has suspended the 2017 dividend and is scrambling to bring in cash. It announced today it’s called in professional services firm EY to provide “an external perspective to our cost reduction and cash collection challenge.”
A separate announcement today that it has won contracts in the government’s HS2 rail project has seen the shares bounce as high as 70p. While this is positive news, the underlying problems with the business and balance sheet remain.
Fundraising ahoy
City analysts reckon Carillion needs to raise funds of £500m to £600m to get the balance sheet on a stable footing. Today’s vote of confidence from the government will help investor sentiment but what would be the result of a fundraising?
A £550m rights issue at a discounted 50p a share would take the number of shares in issue from 430m to 1,530m. Based on the former figure, current-year earnings forecasts are around 27.5p a share. On the latter figure, that would drop to 7.7p. A rating of 10 times earnings would give a fair-value share price of 77p
This appears to offer little margin of safety for investors today, given the risks of further contract provisions, earnings downgrades and a potentially protracted restructuring of the business. As such, I believe Carillion is a stock to avoid for the time being.
