For 18 months Carillion, a construction and support services group, has been the most popular stock for hedge funds to sell “short” on the UK market.
In that time the share price has dropped more than a quarter, handing large profits to the investors, yet 16 funds still have in place short positions that are large enough to require public disclosure. The Financial Times looks at the anatomy of the trade:
Why was Carillion targeted?
Short sellers look for under-appreciated weakness, companies whose prospects or financial health are less rosy than most investors assume. After Carillion failed to persuade rival Balfour Beatty to agree a merger in the summer of 2014, several hedge fund analysts poured over the company’s financial statements.
What they found were signs of strain. The long term nature of many Carillion contracts means revenues and costs are often recorded based on management estimates of when they fall due, something highlighted by its auditors, albeit as an industry-wide risk.
Trade receivables, a total for revenues recognised but where payment is yet to arrive, were rising even as sales declined. Like its peers, Carillion treated some estimated costs associated with bidding for work as assets that can be recovered, assuming probable success.
Sid Harding of Ballamy, a forensic accounting firm, wrote in a report commissioned by one fund: “The very nature of these costs being ‘probable’ means there is the real risk of manipulation or, at best, unintentional errors in the estimates.”
Then, in December, Carillion surprised some investors by issuing a £150m convertible bond, an expensive form of debt as it can be converted into equity in the future, at a time of year when markets are winding down.
Aggressive management of payment terms with suppliers also suggested a company with substantial debts that might be struggling to generate cash flow. Carillion declined to comment.
How does the trade work?
To sell shares “short” an investor borrows the stock from an institution which holds it, a process usually managed by investment banks. The stock is sold in the market, in expectation it can be repurchased for profit at a lower price in the future.
The short seller pays interest on the loan of stock, as well as any dividends due to the lender, and the cost can increase as the proportion of shares out on loan increases, a figure known as the short interest.
For Carillion, at least 18 per cent of the shares have been on loan since August 2015, according to Markit, and the short interest is now almost 30 per cent.
What are the hedge funds waiting for?
Unlike peers such as Mitie, Interserve, Capita and Serco, there has been no profit warning from Carillion in recent years.
At its recent full-year results the company presented a plan to cut debt, declaring it had a “good platform and clear strategy to develop the business”.
Hedge funds sitting on trading profits simply don’t think the company can do enough. They’re waiting for profit expectations to be cut, and perhaps a sale of new equity to repay borrowing, at the cost of diluting the value of existing shares. Industry struggles also makes the chance of Carillion bucking a trend harder to imagine.
Some point to the example of Aryzta, a heavily shorted Irish food manufacturer with a listing in Switzerland, as how such situations can play out. Over 18 months the share price had halved, but then in January it dropped another third in one day after reporting a profit slump.
Low interest rates have arguably prolonged the situation, helping both short sellers, who don’t face large bills to borrow stock, and indebted companies such as Carillion.
So how much could the short sellers make?
Carillion’s shares are worth £930m, so with net debt of £219m the enterprise value of the group is £1.15bn, or around 4 times estimates for earnings this year, before interest costs, taxes, depreciation and amortisation charges.
However the net debt total is what Carillion reported for the end of 2016, whereas the average figure during the year was much higher. Analysts at UBS argue a more complete total — using the average number and other liabilities such as the pension deficit — is net debt of £1.4bn.
Valuing the group on a similar multiple of ebitda as peers, incorporating the more conservative debt figure, implies a share price a fifth or more lower than today’s 218p.
UBS suggests a “downside scenario, in which profit margins come under pressure in all divisions” of 60p per share.
What are the risks?
Even the most brazenly confident short seller must be aware that many things can go wrong.
Crowding is one risk: if many short sellers rush to buy stock to close their bets a shareprice can be squeezed rapidly higher. Aryzta shares jumped 11 per cent after the group announced executive departures in February, for instance. Carillion shares have periodically rebounded.
Another is a simple improvement in the construction and service industries. If valuations for the whole sector improve, Carillion’s shares could rise regardless of any problems the short sellers believe the company may have.