Why I'd swap Carillion plc for this turnaround champion
Shares in construction and support services firm Carillion(LSE: CLLN) have plummeted from over 230p in January to just 19p today in what can only be described as an annus horribilis.
The company operates in notoriously tricky sectors where competitive bidding processes often results in wafer-thin margins. As a result, it has averaged an operating margin of only 5% over the last five years.
To make matters worse, the fees for these lengthy and complicated contracts are often agreed upfront and are therefore vulnerable to cost increases or unforeseen issues. Combined, these factors leave little room for error.
Most recently, management announced that delays to both a significant contract and to PPP disposals means the company will close 2017 with between £875m and £925m in net debt and will certainly be breaching banking covenants. Given that the firm only made £124.2m last year, that's a significant chunk of debt. There's also no guarantee that it can return to these levels of profitability.
The balance sheet therefore needs significant rebuilding. The banks are onside for now and have extended the deadline for it to hit all-important financial targets to 30 April 2018. Carillion may have bought itself some breathing space to recapitalise, but I expect the imminent and essential fundraising to be incredibly dilutive to shareholders after the collapse in share price.
Because of this virtually inevitable increase in share count, investors would be foolish to value the company on historical price-to-earnings ratios. Until the balance sheet has been repaired, I consider the shares un-investible. After all, the company's financial fragility would put me off hiring it for any long-term contracts.
A more favourable turnaround play
IT company NCC Group(LSE: NCC) has had a tough time of it recently too, but unlike Carillion, I believe its future could be very bright. The shares have fallen from highs of 350p in September last year to 226p today, but I believe the the company's refocused strategy and growth headwinds in its markets means now could be a good entry point for investors.
It has two segments that provide services, rather than products, creating repeat income. These are Escrow and Assurance.
Assurance provides cyber security services including strategy building and testing. NCC claims that 90% of businesses have been the victim of some form of cyber crime and points out that a common DDoS attack costs on average £275,000 to recover from. The Assurance market is growing and NCC expects double-digit revenue growth form the department.
The Escrow business acts as an intermediary between software users and developers, maintaining a copy of the original source code and therefore ensuring a business does not suddenly find itself unable to use a mission critical program. It is a cash-cow business with high-margins that is expected to show mid-single-digit growth.
The company has struggled to integrate a number of acquisitions. Over the next few years, it plans to focus on 'self-help' measures, indicating a break from bolt-ons until performance can be smoothed out.
It trades on a P/E of 30 but given its impressive growth track record, I believe this is a fair price to pay for a good business in a growing sector.
Don't reach for yield
I've always found Carillion a confusing investment proposition. It has pumped out significant dividends for years now, rather than building an emergency fund to see them through tough times. Investors who reached for the 6%+ often on offer are surely regretting it now.
NCC, thanks to repeat revenue, has held its dividend through recent tough times. That's why I believe investors should pay close attention to business models when searching for superb income stocks.
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Zach Coffell has no position in any shares mentioned. The Motley Fool UK owns shares of NCC. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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