Long-time readers of this site will remember my failed investment in Carillion – a leading international construction businesses that collapsed under the weight of its debts and ended up in bankruptcy back in 2018. At the time, I largely penned up the collapse of Carillion to poor management and a weak balance sheet but recent poor performance in my investments in both Babcock and Senior (both of which largely operate under a similar contracting model to Carillion) have caused me to reevaluate the business model behind these companies.
Contracting as a business model
Under a contracting business model, a company provides goods or services under a fixed contract designed to incentivise a particular outcome for a client. There are multiple variations of contract models, including fixed price, time-based and cost-plus amongst others. These variations typically incentivise different behaviours from suppliers.
For example, under a fixed price contract, a supplier’s payments are capped (hence the name ‘fixed price), which incentivise the quickest resolution of the contract terms (the longer the supplier takes, the more money they will spend). By comparison, on a time-based contract, a supplier would be more likely to take a long time to complete the contract as they’re being paid by the day – the more days the contract takes to complete, the more they will be paid.
Contracting models are typically used for high value and complex procurements in industries such as construction or professional services that require significant technical expertise and management to deliver a desired outcome.
As an investor, I am seeking to invest in companies with reasonably stable, steady and predictable cash flows. For investments with very small margins of error (for example, a bond) the return is relatively low, but as the predictions become more complex, the potential for return increases. This is based on the idea that if your prediction is incorrect and the company wildly outperforms, the value of your investment will significantly increase. Unfortunately, this unpredictability can work two ways and consequently also increases the risk that the company will fail to hit revenue and profit targets, or perhaps even make a loss, causing the share price to decline.
Companies such as Babcock and Senior provide investors with forecasts of expected revenue from contracts. For example, if Babcock receives a five-year contract worth £100m from the Ministry of Defence to provide engineering support for the Army Land Rover fleet, they might reasonably forecast expected revenues of £20m for five years, even though that money won’t be received in full until the end of the five-year period. In addition, Babcock provides forward guidance on the expected profits they will make from that contract – perhaps to deliver a £100m contract will cost them £15m a year, which after tax works out to an annual profit of say £3m or an expected profit of 3%.
Of course, investors are now entirely dependent on Babcock’s management having correctly calculated the costs of delivering the contract. If, let us say in the third year, something goes wrong and the costs increase, Babcock’s profit will be less than that £3m they forecast – they may even generate a loss.
The costs of a contract can be broken into a number of categories which suppliers typically use in an attempt to calculate their costs. Operating costs include the costs of running a facility, paying staff, providing equipment and so on. On top of this, you have the cost of management overheads – HR, marketing, IT and accounting functions, in addition to the cost of inefficiency which comes from sickness, travel time, holidays and poor management. Finally, the organisation will have a profit margin (in construction this typically hovers around the 1-2% mark for most contracts).
Effective organisations are constantly fighting to slash these costs (excluding, of course, their profit margin) as they all have a tendency to inflate over time. The larger an organisation becomes, the greater that inflationary pull. Organisational in-fighting and empire building are natural consequences of size. Ineffective workers have more places to hide. Management becomes gradually more and more difficult as every decision becomes ‘run by committee’.
In addition to this, effectively pricing a contract requires a holistic overview of all the different factors that will affect delivery, in addition to the technical expertise to understand and interact with those factors. As contracts and services increase in complexity, the potential for an information imbalance also increases. For example, on our fictional contract with Babcock, let us say that the Ministry of Defence is aware that the Land Rover fleet is powered by engines that have a higher than standard failure rate and that as a result, Land Rover has decided to discontinue the model. As a result, the cost of spare parts has been increasing each year but Babcock’s commercial manager is unaware of this and fails to price it into the contract. When Babcock becomes aware, they sue the MoD for failing to disclose material facts about the terms of the contract. The MoD denies ever having knowledge of it and decides to fight the case which drags on for three years and costs Babcock millions of pounds in legal fees. There are a few potential outcomes to this situation;
- The court finds in favour of Babcock and the MoD is forced to reimburse all legal fees, pay a penalty and renegotiate the terms of the contract.
- The court finds in favour of Babcock but the MoD is only forced to reimburse legal fees and pay a penalty defined by the court which is insufficient to cover the increased cost of the parts.
- The court fails to uphold Babcock’s case, causing them to lose money on both the contract and the legal fees.
Depending on which variation comes to pass, Babcock could make a profit, make a loss or just cover their costs – but I have no way of knowing which outcome will occur.
As an investor, this presents me with a significant problem because this complexity spreads across the entirety of the business model. No matter what the contract is, the complexity and length of it causes significant uncertainty for an investor attempting to value the business.
This has been reflected in both my investments in Babcock and Senior. I bought both companies in 2019 – Babcock at about £5.44 a share and Senior at £1.82. As of January 2021, Babcock is hovering around £2.20 and Senior is at about 97p. Since then, both companies have suspended their dividends and written off tens of millions in contracts. Senior’s aviation business has been decimated by both the COVID pandemic and an unfortunate series of problems with the Boeing 737 (two of which fell out of the sky causing the rest of the fleet to be grounded).
In my pantheon of investments I wish I’d not bothered with, both of these come pretty high up the list and reflect a poor level of complacency on my part as to the operational risks of the companies I invest in. Broadly speaking, I believe both companies will recover with time – Aviation will grow after the pandemic and the UK government isn’t likely to stop defence spending so I suspect the price will be higher in the future than today. Babcock trades on the forward P/E of 4.8 and prior to the Boeing issues, Senior was on a P/E of 7 (today they have a negative P/E due to making a loss in 2020 but I am expecting them to return to profit by 2022).
Despite this, I am now increasingly wary of businesses operating under a contracting model; these two positions are worth less than 1% of my portfolio between them and I have no intention of making either them, or businesses like them, a core holding.