黑洞社区

John McDonough is taming his gremlin. Since the Carillion chief executive orchestrated the 拢313m takeover of Mowlem just over a year ago, he has been forced to make writedowns totalling 拢90m on problem contracts unknown to him before the acquisition. The City got nervous, questioning Carillion鈥檚 due diligence process. The mischievous creature that is Mowlem threatened to ruin its new owner鈥檚 reputation.

Now over the worst, McDonough is in a relaxed but defiant mood as he sits in Carillion鈥檚 office in the West End: 鈥淐learly, we are human beings and we were very disappointed but, in my language, we drew a line under it.鈥�

The disappointment was buying something different from what he thought he was buying, and ultimately not at the price negotiated. But Carillion has turned things around: its share price is now well over 拢4, compared with less than 拢3 last June, it is assimilating Mowlem, and this is the tale of how it did it.

What happened?

When the acquisition was completed last February, Carillion insisted Mowlem was a perfect strategic fit. Arguably, what this really meant was that McDonough got his hands on Mowlem鈥檚 拢12bn Allenby and Connaught project for the Ministry of Defence (MoD), the UK鈥檚 largest ever PFI deal. 鈥淚t was better than we thought,鈥� says McDonough. 鈥淚t was the Koh-i-Noor diamond.鈥� And just to sweeten the deal a little more, it gave Carillion a much more significant relationship with the MoD.

The City recognises all this. However, at least one critic thinks the MoD work is the only good thing in the deal, given that Mowlem announced a 拢73m pre-tax loss in September 2005. 鈥淭he relationship with the MoD is the only outstanding thing that Mowlem has brought to the party,鈥� says kevin cammack, analyst at Kaupthing Singer & Friedlander. 鈥淚t is the one thing that Carillion could not have delivered itself.鈥�

One of the problems with the deal was that McDonough had spent his previous five years as chief executive moving Carillion away from traditional building work to higher-margin construction services. In 2006, 拢960m of Carillion鈥檚 non-Mowlem turnover 鈥� almost half 鈥� was in support services. This business yielded a 4.8% margin, compared with 0.8% in construction. That compared with Mowlem鈥檚 1.1% in support services and 0.6% in construction. In the first half of the financial year, Mowlem contributed zero profit to its new parent.

McDonough says he plans to transform Mowlem in the way he did Carillion, but there is an argument that the deal is regressive. 鈥淚t was a backward step,鈥� says Cammack. 鈥淗aving spent five years moving towards services, it has bought the best part of 拢1bn of lower-quality or traditional work revenues.鈥� What Carillion does have to watch out for is an exodus of Mowlem people concerned that it is not committed to construction in the long term. One insider says that about 1,000 former Mowlem staff have left the group since the takeover, although Carillion says that departures have been in line with the year before.

McDonough accepts that Mowlem鈥檚 reliance on low-margin work is far from ideal and adds that there is no quick fix for this: 鈥淭his is not about waving a magic wand. It is about being selective with projects and clients and making overhead and supply-chain savings.鈥�

He wants to raise construction margins to what he describes as 鈥渢he holy grail of 3%鈥�, while growing the top line in support services.

The gremlins emerge

More significant than Mowlem鈥檚 low margins were its hidden problems. In 2005, Simon Vivian, then chief executive, wrote off 拢72m, and many in the City felt he had taken an ultra-conservative approach while associating the problems with his predecessor, Sir John Gains. Carillion then wrote down another 拢45m of problem contracts when it agreed the takeover at the end of 2005. Few, if anyone, thought there could be more problems.

The 拢90m that got missed was announced last April. The main problems were on the Dublin Port Tunnel, Europe鈥檚 second longest urban motorway project, and a 拢95m Exeter schools PFI scheme. Chris Girling, Carillion鈥檚 finance director, said the problems were worse than expected at the former and a surprise on the latter 鈥� even though 黑洞社区 had reported eight months earlier that the schools were behind schedule. In effect, this added 拢90m to the 拢313m Carillion had already forked out.

Then came another nasty surprise: one morning in March, just two weeks after the takeover, there were knocks on the doors of Mowlem鈥檚 west London and Nottingham offices. The Office of Fair Trading (OFT) was 鈥� and seems still to be 鈥� investigating whether they had been parties to bid-rigging.

It is hard to avoid the feeling that Carillion should have done its homework better. But it had a rival for Mowlem: Balfour Beatty. McDonough says Carillion had to get the deal done fast to win the prize: 鈥淎n acquisition is a risky business. It was a competitive due diligence with Balfour Beatty, so we could only spend a certain amount of time on it.鈥�

I鈥檒l catch the beast myself

One year on, McDonough has ridden out these problems. The most impressive part of the story is the speed with which Carillion has digested Mowlem: at the time of the takeover, it said it could make savings worth 拢15m a year. In fact, the figure will be 拢26m. Not bad, given that Carillion doubled its numbers to 40,000 and increased its market capitalisation to almost 拢1.7bn, not far behind Balfour Beatty鈥檚 拢2.1bn. 鈥淲e did the integration ourselves,鈥� says McDonough. 鈥淲e didn鈥檛 bring in a bunch of management consultants.鈥�

A lot of the savings have been in IT, insurance and legal advice, not to mention the disposal of Mowlem鈥檚 head office in Bracknell, Berkshire, and other property in Leeds. According to McDonough, the 300 redundancies resulting from the merger were dealt with in the first six months and no more are planned. He says it was surprisingly easy to get Mowlem staff onside: 鈥淭hey鈥檇 had a torrid 18 months of profit warnings and not paying suppliers. We knocked down all the walls.鈥�

Carillion also decided not to shy away from the OFT investigation. Fifty-seven contractors were implicated in the OFT investigation. Mowlem was one of just two that admitted it (Morgan Sindall was the other). Carillion ensured the agency had access to all the information it needed, meaning it should have a reduced penalty if wrongdoing is proved.

Most importantly, financial prospects for the combined group look good. Even the gremlin looks likely to make a contribution. Howard Seymour, analyst at Bridgewell Securities, is predicting that growth in Mowlem鈥檚 margins in construction and support services will push Carillion鈥檚 overall growth rates up 20% in 2007 and 15% in 2008.

Seymour adds that Mowlem鈥檚 regional building will be a great boost: 鈥淩egional construction activities will also fare well, as much of the spending in the public sector especially is filtered down to local levels.鈥�

According to Seymour, all this means that Carillion鈥檚 current share price of about 415p undervalues the company and that it should trade at 455p to 460p.

Of course, McDonough鈥檚 working life has changed now that he is running a business twice the size of the one he joined: 鈥淚鈥檓 not as hands on as I was. I鈥檓 not sat here with a glass of champagne smoking a cigar, but it is a lot less frantic than it was five years ago.鈥�

Despite all the headaches that Mowlem brought, McDonough is sanguine. Maybe he realises that there is some truth in the words of a senior City figure, who said: 鈥淢illions of pounds of writedowns and they don鈥檛 seem to have been punished. They got away with it.鈥�