Carillion collapse: what went wrong?

Construction and services giant Carillion collapsed under £1.3 billion of debt this week.

The first public sign that the company was in serious trouble was an announcement on 10th July 2017: profits would be hit to the tune of £845 million. Its chief executive resigned and it was announced that there would be no dividends that year. Shares lost 70% of their value over the announcement and the following two days.

Although the July 2017 profit warning marked the beginning of the end for Carillion, it is poor decisions in the years leading up to it that caused the collapse. The announcement said so, in corporate English:

  • Deterioration in cash flows on a select number of construction contracts led the Board to undertake an enhanced review of all of the Group’s material contracts, with the support of KPMG and its contracts specialists, as part of the new Group Finance Director’s wider balance sheet review.
  • This review has resulted in an expected contract provision of £845m at 30 June 2017, of which £375m relates to the UK (majority three PPP projects) and £470m to overseas markets, the majority of which relates to exiting markets in the Middle East and Canada. The associated future net cash outflows in respect of these contracts is £100m-£150m (primarily in 2017 and 2018).

What had happened?

Borrowing multiplied

Over the eight years from December 2009 to January 2018, the total owed by Carillion in loans increased from £242 million to an estimated £1.3 billion – more than five times the value at the beginning of the decade.

Source: Carillion’s annual financial statements; * Interim financial statement for the six months ended 30 June 2017; ** Financial Times (16 Jan 2017)

Note: Total loans is the sum of bank overdrafts, bank loans, finance lease obligations and other loans.

Carillion also ‘borrowed’ large amounts of money in less conventional ways, by taking longer to pay its invoices, for example. The total owed within a year to unspecified ‘other creditors’ jumped from £212 million at the end of 2009 to £761 million at the end of 2016. This is effectively a form of short-term borrowing. It is risky because it makes the company much more vulnerable to a cash crunch.

Little valuable investment

Carillion’s borrowing was not mainly used to invest in the company. In fact, while Carillion’s debts rose by 297%, the value of its long-term assets grew by just 14% between 2009 and 2017.

Source: Carillion’s annual financial statements; * Interim financial statement for the six months ended 30 June 2017

Note: Long-term assets is total non-current assets less deferred tax assets

Declining revenue

Nor did Carillion manage to grow its revenue. The group’s revenue actually fell by 2% between 2009 and 2016. Revenue is likely to have fallen further in 2017 – by as much as 12% compared to 2009, if one projects the 2017 interim results linearly. At the lowest point, in 2013, revenue was 26% lower than in 2009.

Source: Carillion’s annual financial statements; * Loans value reported by Financial Times (16 Jan 2017) and full-year revenue projected by the Library based on Interim financial statement for the six months ended 30 June 2017

Note: Revenue is the group revenue

Aggressive bidding and accounting

Carillion has been criticised for its aggressive bidding and accounting. ‘Aggressive accounting’ is the practice of declaring revenue and profits based on optimistic forecasts, before the money has actually been made. All is well if the forecasts are correct. But if costs rise and revenues fall (say, because of delays and defects), expected profits turn into actual losses.

Because aggressive accounting means declaring profits before receiving the money, it shows up in company accounts as a fall in the actual cash that the company makes compared with the profits it declares. Carillion’s accounts are a case in point.

Chart shows declared profit vs cash generated

Source: Carillion’s annual financial statements and restated 2016 figures from 2017 Interim financial statement

Note: Profit is group operating profit; Cash is net cash generated from operations

The chart below shows how sharply profits can turn into losses when these projections are not realised:

Chart shows declared profit vs cash generated

Source: Carillion’s annual financial statements; * Interim financial statement for the six months ended 30 June 2017

Note: Profit is group operating profit; Cash is net cash generated from operations

In its 10 July 2017 profit warning, Carillion announced that it had undertaken ‘an enhanced review of all of the Group’s material contracts’ which resulted in a ‘contract provision of £845m at 30 June 2017’. In other words, Carillion had been £845m too optimistic about its contracts.

On 29 September 2017, Carillion’s half-year financial statements revealed a total hit to the company’s worth of £1.2 billion – enough to wipe out the profits from the previous eight years put together.

Dividends paid out

Carillion’s aggressive accounting also drove up its borrowing. Dividends illustrate this well.

Dividends are a distribution of profits and there are great pressures on companies to, at the very least, maintain dividend payments. While declared profits can be based on expectations, dividends are paid out in hard cash.

When dividends are paid on the basis of expected profits, the company is effectively borrowing money to pay its shareholders.

Table shows Carillion dividends vs cash

Source: Carillion’s annual financial statements;

Note: Cash is net cash generated from operations; dividends is dividends paid to equity holders of the parent

Note: Dividends in respect of one year are paid in two instalments. The second instalment (the ‘final dividend’) is paid in arrears, the following year. The two lines of the table shaded in light green show the real timing of the dividend payments in respect of 2016.

In the eight years from 2009 to 2016, Carillion paid out £554 million in dividends, three quarters of the cash it made from operations. In the five years from 2012 to 2016, Carillion paid out £63 million more in dividends than it generated in cash from its operations.

Dividends in respect of a year are usually paid in two instalments, with the second payment made in arrears the year after. The light green shading in the table reflects the actual timing of the 2016 dividend, of which £54.4 million was paid on 9 June 2017. Taking that into account, Carillion paid out £333 million more in dividends than it generated in cash from its operations in the five-and-half-year period from January 2012 to June 2017.

Dividends is not the only thing that companies need to generate cash for. Net cash from operations also needs to pay for investments and interests on debt (Carillion’s interest charge was £30 million in 2016).

 

Read more in our new Research Briefing ‘The collapse of Carillion

Image credit: Office Construction, Huntingdon – geograph.org.uk – 1425607.jpg by Michael Trolove. Creative Commons Attribution-Share Alike 2.0 Generic license.