Carillion - Shocking Fallout

Tuesday, 16th January 2018 07:54 - by David Harbage

The company has captured general, as well as financial, news headlines as weekend talks with lenders and HM Government failed to reach a rescue deal. Employing some 20,000 people, but indirectly supporting as many again, the fallout from this failing construction business - with numerous build and maintenance contracts in both the public and private sectors - will be complicated and painful.

In terms of immediate stock market impact, statements today from fellow contractor Balfour Beatty and hybrid contractor cum housebuilder Galliford Try resulted in falls of 3.3% and 7.3% in their respective equity. Both companies operate in a joint venture with Carillion on a £550m Aberdeen Western Peripheral route contract and the remaining partners will have to complete the deal at a cost to Balfour and Galliford of between £60-80m. Balfour is also involved in other road building contracts (A14 in Cambridgeshire and at the M60/M62 junction) with Carillion.

This writer has always been particularly wary of companies whose business model is opaque and building contractors, who invariably operate on wafer-thin margins, come into that category. Although Galliford Try has significant house building operations (via Linden Homes and regeneration partnerships, as the group built almost 3,900 units in their last accounting year to 30 June 2017), its construction business was barely profitable (profit margin of 0% last year) despite turnover of £1.5bn. While the theory of diversification away from the perceived more cyclical residential build seems sensible, poor returns from contracting has been the depressing reality.

Following today's correction, investors may be wondering if valuation for either firm appeals? Balfour Beatty is a £1bn contracting and engineering company which has a history of profit warnings and frequent management changes. Profits were set to recover and progress  in the current year and next, until today's warning, with EPS (earnings per share) of 23.7p forecast for 2019 putting the shares on a PE (price to earnings) ratio of 13.1x - close to the overall market average. The shares would yield 2.9% if brokers' expectations of an 8.8p dividend were paid.

Galliford Try is of very similar size, but brokers forecast 188p of EPS in the accounting year ending 30 June 2019 - putting the shares on a PE ratio of 6.8x, which equates to half that of the overall UK equity market and much closer to that of a typical house builder. However, seekers of income might be more attracted to Galliford shares as its income yield was set to reach 7.9% based on the consensus forecasts of a 188p dividend for that year - albeit an estimate made by just three brokers.

While logic might suggest that the contractors who remain to bid for future work, post-Carillion, are likely to benefit (less competition should lead to higher pricing and profitability), Balfour Beatty stock appears overvalued and may weaken further. By contrast, Galliford Try equity had appeared somewhat neglected before this announcement and, after today's markdown, might be closer to reaching fair value. The latest, recently released national survey data on the construction industry does little to encourage investors to buy the contractors and today's unfortunate news on Carillion will only reinforce the reservations that many of us have concerning the quality of management in the sector. By contrast, as readers of this blog will be aware, the author of this blog views house building as more of a consumer sector, the business model is significantly clearer and finds valuation more appealing.

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.