Description

Carillion plc (ticker: CLLN LN)

Conclusion:

CLLN LN is a UK support services & construction services company that is substantially less profitable, more levered and more expensive than it seems.  The company also seems to exhibit growing contract risk that could catalyze downside in the shares.  Some investors may recall the messy operating performance (and subsequent stock performance) of peer Balfour Beatty (ticker BBY LN) during 2012-2014 as they worked through some problematic construction contracts.  I believe that a similar problem is brewing at CLLN LN, although accounting signals would suggest that the impacts have are possibly larger for CLLN LN relative to the size of the company.

• Profitability & cash flow:  By focusing investors and sell-side analysts on profit and cash flow figures that 1) include unsustainable investment gains and cash proceeds, 2) exclude recurring “non-recurring” expenses and rationalization costs, 3) exhibit inconsistency of depreciation vs capital expenditures, and 4) include cash from reverse factoring, management has been able to present a more profitable company with better cash conversion than I believe is reflective of economic reality.  

• Leverage:  Management’s use / presentation of 1) year-end vs average net debt, and 2) reverse factoring, as well as the presence of substantial retirement liabilities, cause leverage in the business to substantially exceed what is generally perceived.

• Potential contract issues:  Significant buildup of revenues in excess of billings within working capital (obscured by management’s use of reverse factoring, proceeds from the sale of PPP investments), and working capital from JVs, suggests that material contract risk is building.

Business Description:

CLLN LN is a UK services company that reports in 4 segments; Support Services, Public Private Partnership Projects, Middle East Construction Services, and Construction Services (Excluding the Middle East).  The Support Services segment operates facilities management, facilities services, energy services, rail services, utility services, road maintenance and consultancy businesses in the UK, Canada and the Middle East.  The Public Private Partnership Projects segment operates investments made in public private partnerships (PPP) projects in the UK and Canada, including the sale of equity investments.  The Middle East Construction Services segment operates building and civil engineering activities in the Middle East and North Africa.  The Construction Services (Excluding the Middle East) segment operates UK building, civil engineering and development businesses, as well as construction activities in Canada.

Why CLLN LN is Expensive / Misunderstood:

As summarized in my conclusion, due to the accounting treatment and interpretation of results by management, I believe that the profitability, cash conversion, and leverage are substantially worse than generally perceived.  Below is a set of financials that would lead one to believe that CLLN LN is a consistently profitable company, with strong cash conversion and stable capital intensity, trading at a cheap multiple with low leverage.

There are several problems with these financials, as I see it, the main ones being:

• Revenues, profits and cash flows include the impact from the sale of PPP (public private partnership) investments that represent the liquidating of an asset, not a snapshot of a going concern.  As such, I believe these should be stripped out of the operating financials and valued as a financial asset in the enterprise value.

• The company has a history of consistently recording “non-recurring” operating expenses and rationalization costs that impact both profitability and cash flow.  As these seem to be recurring cash costs to restructure the business and integrate acquisitions, I believe they should be reflected in the ongoing operating results of the business.

• When talking about cash conversion the company uses an operating profit number that is after depreciation but then uses a cash flow number that is before capital expenditures.  This is inconsistent.

• Over the past few years the company has been using reverse factoring which has flattered working capital and thus operating cash flow.

• The company reports a net debt number that is substantially below their average net debt throughout the year, suggesting that the year-end close is not the most accurate snapshot of the balance sheet.  The difference between the two is also growing.

• The company has substantial retirement liabilities.

Below is the former set of financials, adjusted for the items listed above.  The resulting company is less profitable, has poor cash conversion, a disconcerting trend in working capital, significant financial leverage, and is quite expensive.

Working capital is worth further discussion, since I think the detail suggests that there is material risk of negative earnings revisions due to problematic construction contracts.  As a start, one can look at the receivables days vs peers and see that they are significantly higher.  Next one can look at the net of “due from customers on contract work” and “amounts owed to customers on construction contracts” to get an idea for revenues booked in excess of billings collected.  This number has been rising substantially for CLLN LN over the past few years.  Over the past few years this amount has grown by >$200m.  Below is revenue in excess of billings, both absolute and as a percentage of revenue, for both CLLN LN and BBY LN.  It should be noted that BBY LN has a much larger construction services business than CLLN LN, which makes the absolute #s at CLLN LN all the more alarming.  It should also be noted that CLLN LN has a greater percentage of mix to support services, which is significantly lower capital intensity, which also makes the CLLN LN numbers more alarming relative to BBY LN.

While the aforementioned trends in working capital are disconcerting, it seems as though they are also understated given management’s year-end cash strategy.  As mentioned previously in the writeup, management discloses an average net debt # in addition to a YE net debt #.  Not only is the average net debt # significantly higher than the year-end, but it has been growing on both an absolute and relative basis (see below).  As such, it would seem that the working capital trend would look even worse over the past few years if the average net debt figure were reflected in the year-end balance sheet.

While the working capital accounts actually look slightly better for YE’15, I believe this is a function of continued use of reverse factoring, as well as working capital from JVs.  Reverse factoring shows up in the “Other creditors” account within working capital, which has been rising steadily ever since revenues in excess of billings started to jump.  Re: working capital from JVs, one can see from the below that while it is typically a wash over time, this was a significant benefit at YE’15.

Below are EBITDA revisions charts for both CLLN LN and BBY LN.  I believe, based on the working capital balances at CLLN LN, and the historical pattern / course of events at BBY LN, that we are currently in a period for CLLN LN that was analogous to mid 2013 to early 2014 for BBY LN.  CLLN LN’s earnings revisions have been more stable up to this point, in large part to significant gains from the PPP investment sales, however the company’s ability to continue that strategy is limited (as evidenced by the substantial fall in the directors valuation of those assets over the past few years as they’ve monetized them).

Earnings Power:

I think the real earnings power of CLLN LN is substantially lower than generally perceived.  First, I think it is prudent to make the adjustments to operating profit that I have discussed earlier in the writeup.  Second, I think there is a good probability that the company will have to take charges on the projects that are causing the disconcerting rise in revenues in excess of billings.

Valuation:

I believe the intrinsic value of CLLN LN is materially lower than the current stock price.  I believe the adjustments to the financials as exhibited above should be used in valuing the company, that there could be significant downwards earnings revisions if problem contracts begin to surface, and that BBY LN gives precedent for a much lower EBITDA multiple being applied to a company with this set of circumstances.

Balance Sheet & Liquidity:

While the balance sheet does not look particularly geared using the year end net debt number, it is in fact quite leveraged when using average net debt (which I believe is a more accurate snapshot of debt load) as well as retirement liabilities and reverse factoring liabilities.

Catalysts:

• Negative earnings revisions on problem contracts.

• Less ability to boost earnings with PPP investment sales as that asset has declined significantly.

• Less ability to cushion working capital with reverse factoring.

• Lower profitability in the Middle Eastern Construction segment as management has already highlighted the increasingly difficult operating environment there.

Risks:

• That I am wrong regarding concern over project risk, and that net funds due from customers on contract work reverses materially after successful project completion and billing.

• That management is somehow able to get acquired, or facilitate a merger that dilutes the risks highlighted in this writeup.

Catalyst

Catalysts:

• Negative earnings revisions on problem contracts.

• Less ability to boost earnings with PPP investment sales as that asset has declined significantly.

• Less ability to cushion working capital with reverse factoring.

• Lower profitability in the Middle Eastern Construction segment as management has already highlighted the increasingly difficult operating environment there.