Three lessons to learn from Carillion’s fall from grace

Constriction firm Carillion has fallen into liquidation, putting thousands of jobs at risk and leaving shareholders with large losses. 

For some time, financial markets have been unconvinced about Carillion, and for the last couple of years it has been the most heavily shorted UK-listed stock as various hedge fund managers bet that the company's indebtedness would weigh on margins. They have ultimately been proved correct, as the firm failed to agree a deal with creditors to come up with a restructuring plan for its debt, which totals £1.5 billion. 

Below we look at some of the warning signs from which investors can learn. 

High dividend yields are far from guaranteed 

High dividend yields look attractive on paper, but should be treated with a healthy dose of scepticism. As share prices and yields have an inverse relationship, a high yield is more often than not a sign that a stock, for whatever reason, is out of favour. And sometimes that’s for good reason. 

Carillion is a case in point. At the start of last year the firm was offering a dividend yield of over 7 per cent. Despite its woes, some income investors will have been tempted, particularly when taking into account Carillion’s strong dividend track record – it had increased dividend payments every year since it was founded in 1999. But in July last year the winning streak was halted, as the dividend was scrapped after the board issued a profit warning. 

The lesson for investors here is that while having a strong dividend track record is admirable, there are no guarantees that income cheques will be written indefinitely. As Russ Mould, investment director at AJ Bell, points out, high yields can ‘be the market’s polite way of saying it does not believe the earnings forecast or the dividend forecast (or both)’.

Dividend danger zone: are these 5% plus yields a trap?  

Big pension deficits 

Pension fund deficits don't just pose a problem for members of final salary pension schemes - income investors too may feel the heat if they are invested in a company that decides to forgo dividend payouts in order to cover their pension black hole. This is exactly what happened at Carillion. The dividend cut last summer came at a time when the firm’s pension deficit ballooned to £580 million. 

The pensions ‘lifeboat’, the Pensions Protection Fund, will likely take over the pension scheme and safeguard pension payments for those who have retired. But, as far as shareholders are concerned, the pension deficit was a headwind that contributed towards the firm’s downfall. In October 2016 we highlighted 11 dividends in danger because they had the biggest pension deficits – and Carillion topped the table.  

Debt can be deadly if profit margins are thin

A third lesson centres on the danger of backing a share that has a big debt mountain to clear. Debt is not necessarily a bad thing, in fact when invested wisely it can help businesses grow organically and expand their presence in the field in which they operate. But if profits disappoint, debt can be deadly.

According to Mould, a company’s business model must be suitable – in other words demand must be fairly predictable and margins consistent or preferably high, so that the interest can be paid without difficulty. 

He adds: ‘Utilities and tobacco stocks can take on a lot of debt pretty comfortably. Tech stocks tend to avoid it, as they need to keep investing in research, so their fixed costs are high, and construction firms tend to avoid debt, too, to ensure they have a nice cash buffer in case a big project goes wrong and they are hit by cost over-runs. 

‘Carillion did not take this precaution and it was further hobbled by a huge pension deficit with disastrous consequences. In 2016, it generated a stated operating profit of £146 million on sales of £4.4 billion for a margin of just 3.3 per cent - and that operating profit had to fund £60 million of interest and pension payments, tax and £79.8 million in dividends, so there was little margin for error.’ 

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