by Edward Chancellor
The collapsed UK construction firm’s problems may look idiosyncratic. But its problems with “onerous contracts” were exacerbated by a balance sheet stuffed with intangible assets and ultimately shaky assumptions. These issues are not peculiar to Carillion.
Large corporate failures provide interesting insights into what’s been going on in the business world. Enron, which collapsed in late 2001, showed how skewed executive incentives, when combined with complex financial engineering, can have disastrous results. Lehman’s failure, seven years later, exposed the reckless behaviour which lay behind the subprime crisis.
At first glance, the problems which have brought down the UK construction firm Carillion look idiosyncratic. A handful “onerous contracts”, to use the company’s phrase, produced massive losses and pushed the firm towards bankruptcy. There’s nothing unusual about construction companies running into trouble. Yet Carillion’s story also reveals a number of fragilities shared by many corporations, on both sides of the Atlantic.
On the surface Carillion’s financials seemed reasonably robust, at least until a string of profit warnings in the second half of last year: interest and dividend cover were ample, reported leverage was low, return on equity was stable, and a large cash pile provided an apparent margin of safety. Retail investors, comforted by these metrics and starved for income, piled into its high-yielding stock. Yet appearances proved deceptive.
For a start, although Carillion’s dividends were less than reported profits they exceeded operating cash flow over a number of years. Excessive corporate payouts are the norm nowadays. In the US, cash returned to shareholders through buybacks and dividends has soared, while investment has been weak. At the margin, generous distributions to shareholders have been funded with debt.
Nor was Carillion’s balance sheet as strong as it seemed. Let’s start with the assets. At the end of 2016, tangible fixed assets were just over 3 per cent of total assets, while intangibles were more than 10 times greater. There has been a longstanding trend towards companies reporting a greater share of intangible assets on their balance sheets. This is not to say that all intangibles are dubious – spending on research and development and advertising, which is generally expensed, often delivers long-lasting benefits and ought to be recorded as an intangible asset.
In Carillion’s case, however, most of the intangibles came from goodwill related to past acquisitions, notably its 2008 merger with fellow UK construction firm, Alfred McAlpine. In the old days, goodwill was amortized. Now it sits on the balance sheet until accountants deem it impaired. This can result in sudden large losses. Last year, Toshiba wrote down $6.4 billion of goodwill after its Westinghouse nuclear unit filed for bankruptcy. A Bloomberg study last year estimated that aggregate goodwill on corporate balance sheets around the world exceeded $7 trillion. Given that recent mergers have been taking place at high valuations, there’s a good chance of more large write-downs during the next economic downturn.
Carillion provides a glimpse of how bad things can get. At the beginning of last year, the company reported intangibles on its balance sheet of more than £1.5 billion. Last summer, at the time of its first profit warning, Carillion took a small impairment charge of £112 million. Now the company has entered into liquidation it appears that the rest of Carillion’s goodwill, along with its large cash pile, has gone up in smoke.
Carillion’s liabilities were also somewhat murky. Much of its debt appears on the balance sheet as “trade and other payables,” thereby reducing Carillion’s reported financial leverage. Last summer, the construction firm’s pension deficit was estimated at £587 million. The size of this deficit gyrated wildly in response to tiny changes to discount rate and inflation assumptions. It is now estimated that the cost to the UK Pension Protection Fund, which is taking over Carillion’s pension plans, may exceed £800 million despite the fact that beneficiaries will receive lower distributions.
A pensions crisis, exacerbated by the decline in interest rates and inadequate historic contributions, has been festering in the corporate world for many years. In aggregate, FTSE 100 companies have estimated pension deficits running to tens of billions of pounds. A huge dollop of fudge has been applied to cover up this problem. US corporations assume absurdly high returns on investment which allows them to reduce the reported size of their pension deficits. Carillion’s defined benefit plan was around 50 per cent invested in equities. That’s pretty high by today’s standards. Still, it’s pretty much inevitable that corporate pension deficits will balloon once again during the next bear market.
It would be nice to think that financial engineering, which brought down Enron, was less of a problem today. Yet Carillion, which was spun out of the old Tarmac construction conglomerate, had morphed into something of a virtual company; with little by way of fixed assets, most of the company’s value derived from a web of complex contracts. This inevitably involved a lot of guesswork. The word “assumption” crops up frequently in Carillion’s financial statements: assumptions relating to the earnings of its “cash generating units”, the value of its stock options grants, goodwill, deferred tax, the discount rate applied to its pension liabilities, and so forth. Carillion’s profits derived from internal estimates of contract completion. When those assumptions proved mistaken, the company turned out to be doomed.
There’s another aspect which makes Carillion a true representative of our age. The company’s slender profit margins have been ascribed to its operating in a cutthroat sector with low barriers-to-entry. Leverage was high, albeit largely hidden from sight. The firm is said to have chased low-value contracts in order to keep itself afloat. In short, Carillion has many of the characteristics of a zombie company.
Zombie companies are identified by an inability to service their debts. The era of ultra-low interest rates has swelled the number of the corporate walking dead. Last year, the OECD estimated that 6 per cent of Italian firms and 10 per cent of Spanish belonged to this category. Zombies are bad for economic growth, since they crowd out more efficient firms and invest little for the future. Their prospective bad debts pose a threat to financial stability, when interest rates eventually rise. The fact that Carillion didn’t even meet the OECD’s definition of a zombie firm suggests the size of this problem may be far greater than is generally recognised.
*Edward Chancellor is a financial historian, journalist and investment strategist. His book “Devil Takes the Hindmost: A History of Financial Speculation” was named “A New York Times Notable Book of the Year”.
The article was first published on breakingviews.com.