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A source of woe

Building and outsourcing company Carillion went into liquidation in January, leaving shareholders with nothing. The collapse of the former FTSE 250 stock highlights the risk of investing in even quite large companies.

Later in the month, fellow outsourcer Capita Group also revealed problems, announcing that its 2018 profits would be well short of investors’ expectations. As if the resulting 47% fall in the company’s shares price wasn’t enough, Capita further disappointed shareholders by suspending its latest dividend payment.

These high-profile difficulties have shone a light on the viability of investing in the outsourcing sector.

On the face of it, these companies make attractive investments. They take on large, long-term contracts from a government to either build or maintain key parts of the UK’s infrastructure, thereby guaranteeing a constant revenue stream, which should generate steady profits for investors in the form of dividends.

Carillion’s activities included building and maintaining hospitals, roads and rail lines, while Capita’s responsibilities include a plethora of government contracts, including National Health Service administration and the collection of BBC licence fees.

 

The outsourcing model

So what went wrong and what can investors learn from these episodes?

It’s worth taking a brief look at the history of outsourcing companies as investments. In the UK, one of the first examples of these ventures was the Channel Tunnel. The project was one of the country’s most significant engineering achievements of the 20th century, but investors did not fare well.

In the end, it was Sir Alastair Morton, the co-chairman of Eurotunnel, who ensured things got back on track after costs spiralled from £5 billion to £10 billion. In this instance the actual engineering complexity proved to be the least of the company’s problems. It was the financial complexity – that is, the desire to complete the project without public money – that was a major sticking point. That, allied with unanticipated safety and environmental costs, ate away at the initially rosy outlook for returns.

The underestimation of the costs involved in various big projects lay behind Carillion’s demise.  In particular, it incurred cost overruns and delays with two hospitals it was building in England and with the construction of the Aberdeen bypass.

A succession of warnings that profits would fall short of analysts’ estimates should have rung alarm bells. There were three such warnings in five months between July and November 2017.

And yet, the government continued to award contracts to Carillion. Since that first July profit warning, according to market intelligence company Tussell, Carillion won contracts worth more than £1 billion. These included the design and build of a 50-mile section of the High Speed Two (HS2) railway and the supply of catering and other services for UK military sites.

There have been allegations that Carillion knowingly bid too little for contracts. That may present an attractive proposition for the government, which has a duty to protect taxpayers by negotiating the best deals it can. But some have voiced the suspicion that Carillion needed to keep the money coming in the door at all costs, in order to make payments to suppliers and lenders as they fell due.

 

Balfour Beatty bid

It is also worth casting our mind back to the bid that Carillion made for Balfour Beatty in 2014. At that time, Carillion was taking advantage of a company on the back foot, caused by, would you believe it – poorly-managed construction contracts. A review by auditors KPMG on behalf of Balfour Beatty confirmed what some investors already suspected – that contracts had been tendered for at prices that were too keen. The result was a loss of £317 million.

Nevertheless, Balfour Beatty presented a robust defence, and ultimately, the Carillion bid was unsuccessful. Much of Balfour Beatty’s defence focused on Carillion's plan for the enlarged group to shrink the combined UK construction services business while growing the combined services business. Balfour Beatty rejected the plan as presenting “unacceptable operational and financial risks”.

 

What next?

There will undoubtedly be enquiries following the demise of Carillion.  These enquiries need to differentiate between mistakes made specifically by Carillion, and the nature of outsourcing businesses in general. In these situations, companies make assumptions about the complexity of the task at hand, estimate costs, add a small profit margin and then price the job. There is clearly significant scope for error.

The story unfolding at Carillion is a tragedy for many – for shareholders, bondholders, staff and contractors. It is also a tragedy for the reputation of private sector involvement in public contracts. This latter impact may, unfortunately, be the most enduring.

 

Lessons learnt

Lessons will be learnt from the Carillion collapse – but it seems unlikely that the nature of these businesses will change. If they are to do so, this will necessitate an even bigger change of collective mind-set among government, shareholders and managements than we have seen to date.

For investors, this highlights the importance of doing adequate research.  However, most people investing in the stock market do so via a fund that contains many companies. The manager of any fund investing in the likes of Carillion and Capita should have heeded some of these warnings. There have been share price falls in other outsourcers in recent weeks, the accounts of which will be being poured over by anxious analysts and fund managers.

Individual investors have to trust their fund manager is working hard to avoid the Carillions of the future. It is important to bear in mind that investing is never risk free, but it is possible to reduce the risk of these corporate collapses by investing in a range of funds that contain a wide selection of companies from different countries and sectors. Holding investments in unrelated assets, including bonds and property will also help reduce the effect that these high-profile news stories can have on investment return.

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at February 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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