Shares in embattled support services firm Carillion (LSE: CLLN) barely paused for breath yesterday after the company reported two contract wins. The long-term deals were awarded by the Defense Infrastructure Organisation and are expected to contribute £158m to core revenue over the next five years. If Carillion can take advantage of all periphery opportunities, it believes this figure could double.
The company will provide ‘soft services’ including catering, retail and leisure at 233 military establishments in the North of England, Scotland and Northern Ireland over the next five years. Contract wins are the lifeblood of services firms but the total revenue potential of these deals pale in comparison to the £845m provision for underperforming contracts, the £700m net debt pile and the £805m pension deficit that currently dog this one’s financial performance.
To discount these wins as irrelevant would perhaps be a little hasty however, as I believe they could help build the momentum Carillion needs to survive.
A Bearish Bounty
Carillion is the most shorted stock on the exchange and has been for a year and a half. The shares have already fallen 75% this year but, according to the FT, 16 funds are still shorting it today. The bear case rested on the company’s revenue recognition policy.
Revenues are calculated through a process of estimates and can, therefore, differ heavily from cashflows over the course of a five-year contract. Many costs can fluctuate in such a time period, including labour, machine rental, raw materials and more.
Delays are a cost of doing business too, but are hard to quantify ahead of time. For example, the company’s Public Private Partnership deals, originally considered safe sources of cashflow, have encountered significant amounts of asbestos at great cost.
Depending on how aggressive forecasts are, this can lead to sudden profit warnings as we’ve seen at Carillion. On top of that, it is hard to form a competitive advantage, aside from scale, in the services industry. Margins are often paper thin and it often doesn’t take much to shunt a company from a profit to a loss.
Contract critical
That said, recent business wins at Carillion are promising. Because these contracts can drag on for years, customers are acutely aware of their service provider’s finances. You wouldn’t want the firm going bankrupt halfway through a contract now, would you?
Carillion’s balance sheet is weak. Most tangible assets are receivables that – if certain press articles are to be believed – may not be received in full. However, a £500m fundraising should be enough to see it fighting fit again, but that’s a huge ask given the £260m market cap.
Potential customers might avoid it due to its financial frailty. In turn, investors may be unwilling to provide the necessary injection of capital given the poor business outlook. The recent contract wins help reverse this vicious cycle and in doing so increase the chance of a favourable fundraiser.
But in its current state, I still consider Carillion unworthy of an investment. Even if it wasn’t mired in uncertainty I’d be put off by the industry itself. Contracts often go to the lowest bidder and it seems inevitable that working on long-term, low-margin contracts will go wrong for all but the most experienced of management teams.
