The collapse of construction and support services group Carillion (LSE: CLLN) has seen the firm’s stock lose 65% of its value in just one month. For a company which was a FTSE 250 stock, this is a shocking decline.
Of course, it’s possible that this stock — now trading at 70p — may offer value for new buyers. Indeed, the share price has risen by 21% over the last five days, suggesting investor demand.
However, my view is that this stock is still more likely to be a falling knife than a bargain buy. In this piece I’ll explain why I’m still staying away from it.
Uncertain earnings
Carillion’s business model involves subcontracting almost all of its work. Companies which operate in this way need very tight control of contract pricing and costs, and a good credit rating.
We’ve already seen the company fall down badly in terms of contract profitability. The trading statement on 10 July advised investors to expect a contract provision of £845m relating to underperforming contracts. That’s equivalent to about seven years’ profits, based on last year’s earnings.
This shocking news leads me to question whether the firm’s historic profits will be repeatable over the next few years.
Things could get even worse if potential customers stay away from the firm, due to concerns about its debt-laden balance sheet. The Financial Times recently reported that Oxfordshire County Council will now terminate a 10-year, £500m project with the company in September, five years early.
Although Carillion has announced contract wins for the HS2 rail project, this cash is a long way in the future. In order to survive that long, the company needs to address its financial problems.
Debt disaster
The main reason why I’m staying away from it is debt. Average net debt for the first half of 2017 is expected to have risen to £695m, up from £586m last year. Both figures are much too high, in my view.
Indeed, substituting this net debt figure into last year’s accounts suggests to me that the stock’s book value could be as little as £200m. That’s about 30% below the current market cap of £301m.
Carillion also has an £805m pension deficit which could complicate matters, as the pension trustees may have to agree to any refinancing plan.
Press reports suggest the company has already stretched its payment terms for subcontractors to 120 days. Further increases are unlikely to be possible. It seems almost certain to me that a major fundraising will now be required.
Fundraising = dilution
The big risk for shareholders is that they will face significant dilution if Carillion is forced to reduce its debt burden by issuing new shares. I believe this is very likely to happen.
Until we know more, I think that its uncertain financial situation makes investing in this stock highly speculative. I think there’s a real risk the shares could fall further.
I’m going to stay away until the firm’s financial situation becomes clearer, when I’ll take a fresh look at the investment case.
