Will Carillion be the only ones to crash and burn this year?

Will Carillion be the only ones to crash and burn this year?

Yesterday we received a timely reminder about the issues confronting domestically-focused businesses a year on from the Brexit referendum.

That reminder was delivered in the shape of a profits warning from outsourcing group Carillion…

Though the phrase ‘profits warning’ hardly does the announcement justice, so calamitous was the news it contained.

The chief executive was to step down; revenues and profits would be well below management expectations; and the cost cutting and debt reduction program the firm had started this year would have to be accelerated, though the inference was that the program was partly to blame firm’s current woes.

It’s a case of ‘damned if they do and damned if they don’t’. And to add insult to injury the company’s dividend payments were cancelled as well.

The shares were hammered yesterday, falling by as much as -39% by the close.

The fact that there were issues at Carillion will not have come as a complete surprise per se, after all rivals Mitie and Capita had both previously warned about Brexit affecting business.

But it seems that Carillion had not kept the market informed of the real state of play until today.

Of course there is a fine line between managing investor’s expectations and divulging privileged information, but judging by the price action Carillion had erred too much on the side of caution.

And they were punished accordingly.

Interestingly, Carillion had been in a bear trend since early December last year in my model, but they been drifting gently back over the last seven or eight months and had shown signs of trying to rally last week before Monday’s news devastated the price.

There is an old market proverb which states that “profits warnings come in threes”. There’s a good deal of truth in that and so it may well be that this is only the start of the problems for Carillion’s remaining shareholders.

For what it’s worth, I think that the problems of Carillion and the other outsourcers have been a long time in the making, and have been caused by years of austerity and a reduction in government spending as much as anything else.

One of the factors that caused Carillion’s problems was a high level of debt. That may become an issue for other UK businesses going forward, particularly if interest rates start to rise significantly just as the economy slows or takes a turn for the worse.

This was a theme that was highlighted in a UK equity strategy note from investment banking house UBS, published yesterday.

The note flagged that UK companies with a high level of debt compared to their enterprise value had been the worst performing group among UK equities in 2017.

In their words “suggesting that investors did not wish to reward businesses” with those characteristics.

At the same time the bank highlighted traits which have been rewarded by investors and which in turn have repaid them.

Factors such as a high return on investment capital, or ROIC and a low debt to enterprise value were among them, effectively the polar opposite of the conditions pertaining at Carillion.

Perhaps surprisingly, given the poor news flow coming from the support services sector, it remains up over the year to date, as the chart below shows.

Click image to enlarge.

Though the sector index has been testing back to support around 7660, a level I will keep a close eye on from here…

I can’t believe that there can be much positivity around the sector in the short to medium-term and a breach of that support may open the floodgates, so to speak.