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3 big reasons to stay away from Carillion plc

Shares in troubled construction and support services group Carillion (LSE: CLLN) have fallen by as much as 76% since the start of the year. The company finally admitted on 10 July that some of its construction projects had run into problems and warned that its first-half profits would come in well below expectations.

Looking ahead, more uncertainty could lie ahead for the firm and here are three reasons why I remain bearish the stock.

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Dilution

The first reason I’m staying away from Carillion’s shares right now is the risk of being diluted from a need to raise funds to support a restructuring.

The company wallows in £695m of net debt — that’s up by 18% since December, and set to get even worse as a result of a deterioration in cash flows on its construction contracts, combined with higher working capital outflow going forward.

As such, some analysts reckon Carillion might need to raise at much as £500m via a rights issue or a debt-for-equity swap. By all accounts, that would represent a massive dilution for existing shareholders as the company’s market capitalisation currently stands at £244m.

Counterparty risk

Looking ahead, Carillion could struggle to keep contractors onboard and win new contracts due to concerns about higher counterparty risk, given the company’s overextended balance sheet and delays to payments on public-private partnership contracts.

Already, Oxfordshire County Council said it would end in September a 10-year deal with the company to build schools and supply property management services, a contract reportedly worth around £500m.

On a more positive note though, Carillion did recently win some lucrative work to build and design part of the HS2 rail project as part of a joint venture with Kier and Eiffage.

Further writedowns

Carillion has so far made provisions for a £845m writedown, but further writedowns are possible as a new management team takes a thorough re-examination of its legacy construction contracts. As many of these contracts are typically long term, there’s a great deal of uncertainty over the eventual profitability of these construction prospects, and as such, there’s huge potential for further revisions on its provisions.

With these three risks, I’m happy sitting safely on the sidelines.

Mitie

Meanwhile, rival outsourcer Mitie (LSE: MTO) may be a better pick. After announcing its own profit warning around a year ago, it now has in place a new management team with an ambitious turnaround plan.

CEO Phil Bentley is betting heavily on technology to drive a recovery in the outsourcer’s financial performance. It has invested in a major transformation programme to improve its customer proposition and is already halfway through its £45m cost-saving programme.

While uncertainties remain, I reckon there’s considerable upside potential as the benefits of its investment programme could well feed into top-line growth and margin improvement. As such, Mitie seems to me like a lower-risk option at the moment.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.