The key signs of financial weakness in a stock

Carillion’s end has focused investors’ minds on the importance of robust finances. Sam Brodbeck explains what to look for

Britain’s corporate history is littered with spectacular, highprofile failures that left household names in ruins, investors nursing heavy losses and former employees fearing for their pensions. Few predicted the sudden demise of textile giant Polly Peck, engineering firm Ferranti, Robert Maxwell’s media business – or Carillion, which imploded last week, putting thousands of jobs at risk.

In the run-up to each collapse the firms displayed “red flags” that stock market professionals can sometimes spot among today’s companies.

Telegraph Money asked Russ Mould, a respected and experienced City analyst, to identify the large quoted firms that showed signs of financial weakness. The aim is to give readers with a stake in the financial strength of a company – whether as a current employee, a member of its pension scheme or an investor – a means to form their own judgment of that firm’s robustness. While pensions are to some extent guaranteed by the Pension Protection Fund, those yet to retire and those on high salaries would see benefits cut if the firm collapsed.

Mr Mould regularly drew the attention of readers of The Telegraph’s Questor column to Carillion’s weakness and advised them to avoid the shares.

Telltale signs of financial weakness

Mr Mould, investment director at A J Bell, the stockbroker, said: “Potential warning signs to watch out for include the dreaded trio of acquisitions, excess debt and a pension deficit, especially if the company has thin profit margins or a potentially volatile revenue stream.”

He said investors should be wary of stocks where cash flow is unpredictable and those that combine a very low price-to-earnings ratio, a commonly used measure of valuation, with a high yield.

“This is often the market’s polite way of saying it does not believe the earnings or dividend forecasts and that the p/e will in reality come out higher, as profits disappoint, and the yield come out lower, as the dividend is cut,” he said.

Below we list the companies that Mr Mould advises readers to avoid if they are looking only for the safest investments. We are not saying the firms listed are on the verge of failure – the idea is to give readers a sense of the challenges they face.

Support services firms

This sector has struggled in recent years with several firms, including Carillion, disappointing investors with severe share price falls. Mr Mould picked out Interserve as the most exposed of those still standing.

He said that while the company had been able to issue positive trading updates in recent months, it still had more than £500m in net debt. He added: “Even a pension deficit of £52m, small by today’s standards, is no laughing matter for a company valued at barely £170m.” He said investors were “unlikely to relax” until a line was firmly drawn under a problematic energy-from-waste contract. In September 2017 the firm admitted that costs relating to the contract would be “significantly higher” than the £160m already set aside.

A spokesman for Interserve said: “Last week we announced that we expect our 2017 performance to be in line with expectations outlined in October and that our transformation plan is expected to deliver £40m-£50m benefit by 2020. We expect our 2018 operating profit to be ahead of current market expectations and we continue to have constructive discussions with lenders over longer-term funding.”

Cheap-looking stocks

Stocks trading at low p/e ratios can suggest good value but may also indicate that the market is sceptical over their ability to maintain

profitability. Mr Mould singled out Debenhams, which is trading at 7.6 times earnings. He said debt levels were low and that the staff pension fund was one of the few in surplus, but warned that operating margins were “quite low” at less than 5pc and pointed to “huge lease obligations – over £4.5bn in payments over the next 20 years”.

Debenhams declined to comment but a 2017 strategy update said: “We have no tail of loss-makers in our 176 store estate, and many are highly profitable, but we want to ensure they are fit for the future.”

Mothercare is also being held back by leases on its bricks-andmortar stores, said Mr Mould. “It has stock worth more than £120m and a market value of just £83.7m. It should be tempting to raid the company and strip it – but a buyer would inherit its debt and leases.”

A spokesman for Mothercare said the firm had “a highly flexible store lease structure, with an average lease length below five years”. He added: “Our UK business comprises a mix of stores and online, with a growing focus on the latter, which now represents in excess of 40pc of total UK sales. We have closed nearly 100 stores since the beginning of the transformation in 2014.

“Based on year-end outlook we have sufficient funding. We have taken decisive action to significantly reduce our central cost base, the benefits of which will materialise within the next financial year.”

Media group Trinity Mirror has a p/e ratio of 2.2 and is being weighed down by its £407m pension deficit, said Mr Mould.

“It needs to address the deficit as it transitions from print to digital and addresses how consumers get news and advertisers showcase their wares,” he said. However, he conceded that the firm seemed to be in a good position to cover interest payments on its loans. Trinity Mirror declined to comment.

Pub company EI Group has reassuring profit margins and cash flow and only a small £2m pension deficit, but “uncomfortably hefty debts”, said Mr Mould. These totalled £2.3bn, according to the most recent figures. EI declined to comment.

Takeover overload

A history of acquisitions was one of Carillion’s problems.

Mr Mould said DCC, a FTSE 100 support services group, appeared to rely on acquisitions for growth. Most recently it bought a US liquid petroleum gas firm in a £152m deal in November 2017. The flurry of deals, coupled with low operating margins, put question marks over the stock’s p/e ratio of 24, Mr Mould said. “That’s a huge premium to the broader market.”

On the plus side, he said, the firm has little debt and a manageable £4.9m pension deficit. DCC declined to comment.

Mr Mould said a stream of acquisitions by RPC, the FTSE 250 plastic packaging firm, had contributed to debts of £1.4bn (including pension liabilities).

He said operating margins and RPC’s ability to pay debt interest were “healthy” but warned that a clampdown on plastic packaging “could be a problem for the firm, while the reliance of deals for the bulk of its growth and accounts that focus heavily on underlying rather than stated profit are both potential warning signs”. RPC declined to comment.