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Carillion's hidden debt offers lessons for the market

Mar Beltran

Carillion’s demise into liquidation has not only disrupted and unsettled the UK’s construction and FM industries but has also dredged up the debate around the success of private finance initiatives.

Yet the fall did not come without warning: as early as 2013, lobbyists had urged the UK government to exclude Carillion from future PFI contracts, when it emerged that the company was systematically delaying payment to subcontractors to 120 days.

The turbulence turned severe in July 2017 when a profit warning followed the news that Carillion’s deleveraging target would go unmet; a balance sheet review had prompted management to put aside provisions in excess of £1bn, of which almost £850m related to the construction segment. Richard Howson stepped down stepped down as chief executive as a result, causing a sell-off that wiped out 70 per cent of the company’s market value in just two days.

Two further profit warnings came before November 2017, ahead of Carillion’s application for compulsory liquidation in January this year.

What exactly caused the collapse?

Among the main culprits are the significant impairments to projects and decreasing operational margins, which both suggest failures in risk management policies.

Carillion’s first-half 2016 financial reports could not mask the declining operating margins despite often showing increased revenues. This seems the harbinger that some projects were underperforming and that projects it won in later years were less profitable than ones before.

“Reverse factoring therefore served to mask large parts of Carillion’s debt, which should have been significantly higher”

Investors responded soon after: Carillion was the market’s most heavily shorted stock in December 2016 amid heightening concerns around the company’s rising average debt levels and weakening profitability.

True picture

A closer look at Carillion’s financial reports tells a fuller story. At the end of 2016, working capital significant grew to almost double (£1.4bn) – an unsurprising outcome given the material increase in construction revenues over that period.

However, there was no similar increase in trade payables (the amount billed by Carillion’s suppliers). At the same time, one particular item in the financials, listed as “other creditors”, almost tripled to £761m compared with £263m in 2012.

The Commons Briefing paper states that the “other creditors” included reverse factoring – a supply chain finance scheme introduced by the UK government to boost growth. Carillion acknowledged that it used reverse factoring as an ‘early payment facility’, but did not quantify its extent – and nor did it report the negative impact on its financial statement.

If we assume this to be the case, Carillion’s true working capital might have been drained by almost £600m between 2012 and 2016, rather than the £100m that was reported. Reverse factoring therefore served to mask large parts of Carillion’s debt, which should have been significantly higher. Some of these debts would’ve been used to aggressively fund shareholder dividends and pension liabilities, too.

What can the market learn?

Carillion’s earnings before interest, taxes, depreciation and amortisation (EBITDA) from 2012 to 2016 remained below the 6-11 per cent range considered average for the construction sector.

“To ensure a fair representation of financial statements, construction companies should become increasingly transparent over their use of reverse factoring”

Like many construction markets in the developed world, the UK market has fine margins – mostly due to the high levels of competition and fragmentation. On this evidence, it cannot be ruled out that some Carillion projects won in the past five years were mispriced.

Some argue that Carillion’s fate was pronounced due to extraneous events: it is true that the company’s significant revenue concentration in the UK market meant that confidence had been edging lower.

Construction output, according to the Office for National Statistics, had fallen for nine consecutive quarters, largely in response to the UK’s looming withdrawal from the European Union. In turn, analysing geographical risk has become a greater consideration for market players.

To ensure a fair representation of financial statements, construction companies should also become increasingly transparent over their use of reverse factoring. Carillion did not disclose the exact amounts used in reverse factoring.

Had Carillion been a rated entity by S&P Global Ratings (it was not rated at the time of collapse), its use of reverse factoring to extend trade payable days would’ve been considered in our credit quality judgement.

In our view, audit committees, auditors and regulators alike must do more to ensure supply chain finance practices are fairly disclosed.

Mar Beltran is senior director and sector lead for infrastructure, EMEA, at S&P Global Ratings

Readers' comments (1)

  • Main contractors should be declaring their “Early Payment Facilities” (reverse factoring) to the market place, and how by much it adjusts its working capital and debt figures. Many main contractors operate these schemes, and they should be aware that it is seen in the market as a desperate act taken by a contractor that is in trouble - no matter how much they try to talk down the issue.

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