Carillion rings an uncertain tune

Tuesday, 13th September 2016 16:12 - by Eric Chalker

As I write, this company in the support services sector is showing a dividend yield of 6.9%.  At its 52 week high, it was 5.4%.  So you might think it was in the 25 stocks I mentioned in my ‘rewarding strategy’ article, but it wasn’t.  This was because, even though it is in the particular portfolio I mentioned in that article, I cannot be wholly confident of the dividend’s sustainability.

 This is a share consistently rated a ‘buy’ by Investors Chronicle and it has been so rated by Questor in The Daily Telegraph.  But it also happens – as both MoneyWeek magazine and the FT have reported – to be one of the most consistently shorted stocks.  This puzzled me.  On the face of it, a company with a sustained and well covered dividend, albeit increasing only by an average of about 1.5% annually, surely ought not to be so disliked.  Should I be getting out?

I am not an accountancy expert, so I probably miss things in a company’s accounts that those who have been professionally trained can readily spot.  But sometimes certain things stick out and so it was when I examined Carillion’s 2014 annual report with more diligence than normal.  What I found prompted me to write to the chairman, Philip Green CBE.  Whereas in September 2015 the interim report stated, “the balance sheet remains strong,” my reading of it was the opposite.  It is all to do with intangible assets.

Intangible assets are a bête noire.  They can inflate a balance sheet spuriously, so if their relative size seems unduly large it is worth having a deeper look.  What are they and what is happening to them?

When Carillion’s intangible assets are deducted from net assets, the result is negative: minus £676m at the end of June.  What really disturbs me is that goodwill, which Mr Green acknowledges comprises “the vast majority of the intangible assets on Carillion’s balance sheet,” is not being depreciated at all.  This doesn’t break any accountancy rule, because with each set of accounts the directors claim that its value is unchanged, but the question I put to Mr Green was, “Can the company survive long term unless it does write down its nominal intangible assets to a more realistic figure relative to tangible assets?”

Because Carillion has negative net assets when intangibles are discounted, this has to be matched by borrowing.  Because their value is more or less constant, as are net current assets (barely positive), so too is the need for borrowing.  This borrowing cannot diminish unless profits are used to repay the debt, but this isn’t happening.  Profits are used to pay dividends, make additional investments and reduce the pension deficit.

Carillion’s debt

Broadly speaking, Carillion’s debt appears to be at a constant level and this is evidently deliberate.  As I put it to Mr Green, it seems analogous to a household bearing an interest-only mortgage with no means or plan to repay it, which common sense tells me cannot go on for ever.  Given the number of years it would take Carillion to produce undistributed operating profits sufficient to wipe out the intangibles figure, I concluded that it was floating on air.  While its ongoing business is producing satisfactory operating profits and cash for its shareholders, it is permanently dependent on lenders’ goodwill – unless bailed out by a highly dilutive issue of new shares. 

Carillion’s chairman was unbothered by my conclusions.  “The Board remains confident that Carillion (has) a strong balance sheet with more than sufficient funding available to support the group’s strategy for growth.”  Even so, Philip Green saw “no consistent reasons to explain the current level of short selling.”  That was a year ago, but I don’t imagine his perception has changed.  And yet, since Carillion’s half-year results were published at the end of August, announcing a 24% increase in PBT, the share price has fallen by approaching 13%.  Could this have anything to do with what, according to the interim report, is an increase in net borrowing of £91m?  Rather slyly it seems to me, but no doubt inadvertently, the borrowing rise from £199.6m to £290.6m is described on page 3 (Key financial figures) as minus 46%!

It bothers me that I see end year ‘Net borrowing’ of £169.8m in the 2015 financial review, whereas the balance sheet shows total borrowing at £632m.  It bothers me too that, try as I might, I cannot relate figures for 2015 in the five-year review at the back of the annual report to figures elsewhere in the report.  Perhaps this bothers others too, but there seems little doubt that distrust of Carillion hinges on its indebtedness and apparent inability to escape from it.  The dividend yield is consistently attractive, but it is barely growing and remains dependent on the company’s ability to maintain sufficient borrowing to support its intangible assets.  What will happen when interest rates rise and money becomes scarcer?

Although recently down 15% since purchase 3 years ago, I continue to retain Carillion shares in the portfolio I have mentioned above, but I cannot give it a ringing endorsement because I find the balance sheet suspect 

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.