Could Connect Group plc be the next Carillion?

Over the past 12 months, shares in distributor Connect Group (LSE: CNCT) have taken a beating as investors switched off from its turnaround story. 

Since mid-January 2017, the shares have fallen around 50% and it seems not even the company’s market-beating 9.5% dividend yield can entice investors back. 

Struggling to turnaround 

Management has been working to turn Connect around for several years. As part of this drive, the firm has invested heavily in moving away from its traditional business of supplying newsagents and into logistics and parcel delivery. City analysts were expecting this investment to begin to show through in the company’s results for fiscal 2018, with earnings growth of 31% expected.  

However today, Connect has warned that pre-tax profit for the full-year is now expected to be in the range of £42m-£45m, against City expectations of £49m. Management is blaming this poor performance on “combination of delays to contracts in Pass My Parcel, weaker margins, market uncertainty in Mixed Freight, and slower than anticipated realisation of cost reductions from the group’s integration strategy.

In a double blow to shareholders, it was also announced today that the sale of Connect’s books division, which was expected to raise £11.6m, is no longer going ahead. Despite agreeing on the deal, private equity firm Aurelius has now decided to pull out, even though it’s legally required to complete the transaction. Management is pursuing legal options to assess its next steps. 

Weak balance sheet 

Connect’s biggest problem is its balance sheet. It seems that like failed outsourcer Carillion, Connect has been paying out more than it can afford to shareholders as profit margins contract. Even though net debt fell by 42% to £82.1m for the full-year to 31 August 2017, substantially all of the firm’s free cash flow went on paying its dividend and pension fund contributions. Debt was reduced through asset sales. If we take away the £100m of intangible assets from the balance sheet, shareholder equity is actually negative £75m. 

Even though I have recommended Connect’s dividend in the past, this was based on the company hitting its growth targets. Now it’s clear that the firm’s problems are far from over, I think investors should avoid the business until it reduces debt further, or cuts its dividend. 

Pricing shock 

Another recovery play I’d stay away from is funeral care business Dignity (LSE: DTY). At the end of last week, Dignity shocked the market by announcing that it was slashing the prices of its funerals as competition for deathcare services has intensified. 

City analysts have tried to estimate how much this could cost the firm. Some are calling for earnings to fall by as much as 50% following this move. However, the biggest problem for investors is now uncertainty. Dignity has built its business around acquisitions, consolidating the highly fragmented funeral business. This strategy has paid off,  with net profit rising at a rate of around 11% per annum for the past six years. 

Unfortunately, now earnings are set to come under pressure, Dignity is going to have to deal with a nasty adversary: debt. 

With net debt of £520m on the balance sheet, this now exceeds its market value of £480m, which does not give management much room for manoeuvre. For this reason, I would avoid Dignity until it can improve the balance sheet. 

Slow and steady wins the race 

In my view, Connect and Dignity should be avoided due to their falling earnings and weak balance sheets. I’m more positive on this basket of defensive income shares, which has been compiled by our analysts here at the Motley Fool. 

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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