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The threat posed by 'zombie' suppliers

Suppliers and financial risk

On 10 July 2017, the construction, infrastructure and facilities management firm Carillion issued a profit warning that resulted in its share price diving by 70% during the following fortnight. But buyers did not share investors’ concerns about the £4.8bn-revenue company’s financial health. The Wolverhampton, UK-based firm continued to win contracts, including a deal with High Speed Two (HS2) as part of a £1.4bn joint venture, a £62m contract with UK rail infrastructure firm Network Rail and a joint-venture deal worth £158m with the Defence Infrastructure Organisation.

 

Fast forward to January 2018, and Carillion is in liquidation, and many people are asking questions. Among concerns about privately financed outsourcing in the public sector, procurement experts are asking why the firm was awarded work after the warning signs were clear and wondering how many other major suppliers are struggling under the weight of financial stress.

 

Jamie Gardner, a senior manager at procurement outsourcing firm Efficio, says Carillion worked on projects that often involved a lengthy procurement process, which required complex design discussions and were subject to European public procurement regulations. As a result, data that outlines the financial risk attached to suppliers is not always up to date.

 

“Just because a company issues a profit warning, you cannot stop the train. There may have been a lot of financial vetting well before the contracts were awarded, but that information can sometimes be up to 12 months old. We are advising clients to do a cash flow test and interview CFOs, so they understand the situation in real time,” says Gardner, who has worked as head of capital procurement for UK utilities provider Thames Water.

 

Procurement functions, however, are not always alert to how quickly the financial status of a supplier can change, he says. “Doing final checks before contract award is not commonplace. They are usually part of pre-qualification or the tender process.”

 

A real threat?

Carillion is unlikely to be a one-off though. Fears are growing over the number of ‘zombie’ companies in the supply base. These firms have been supported by cheap credit following the 2008 global financial crisis, but are beginning to struggle to service debts as interest rates across the world rise.

 

According to independent insolvency firm Begbies Traynor, nearly half a million UK businesses ended 2017 in a state of ‘significant’ financial distress. It says macroeconomic pressures are adding to the financial stress, including rising inflation, stagnant real-wage growth, political uncertainty and rising interest rates.

 

The firm found 121,095 businesses in the UK support services sector were showing signs of financial difficulty at the end 2017, a year-on-year increase of 43%. Meanwhile, the number of UK construction companies in financial distress by 31% to total 62,294 firms.

 

Meanwhile, the corporate debt market offers evidence of signs of strain in the global economy. According to S&P Global, 162 corporate defaults worldwide occurred in 2016 – the most since 2009, up from 113 in 2015. The debt-to-equity ratio of the median S&P 1500 company, excluding financial firms, has almost doubled since 2010 and is now well above its precrisis level. In 2016, nonfinancial-sector debt totalled $135tn – up from $80tn in 2007 – according to World Economic Forum’s Global risks report 2018.

 

The size of suppliers’ debt should cause buyers concern as central banks raise interest rates and the cost of servicing debt increases says Bill Danner, president of financial risk analysis firm CreditRiskMonitor. But a greater concern is that companies carrying relatively large debts struggle to cope with shocks, either to the wider economy or their specific market. “There is a risk that rising rates will cause indebted companies to get into trouble. It depends on how fast they raise rates. We know they will rise, but they will not be allowed to rise quickly,” he says.

 

“The bigger risk with indebted companies is they are not well-equipped to manage with declining revenue and cash flow. They have to pay the debt – it is the one expense that cannot be managed away.”

 

Thinking clearly and correctly

Carillion’s collapse provides lessons procurement teams can employ when managing suppliers in financial distress, Danner says.

 

“Obviously, you don’t want to increase your dependency on a financially weak vendor. But procurement can inadvertently add operational risk for suppliers they are already dealing with. Terms such as no-payment-until-job-completion can increase risk for suppliers. If a supplier goes under, it won’t be procurement’s fault. But it will be its problem and they will have to clean up the mess. The function needs to think about that.”

 

When talking to suppliers and firms bidding for tenders about their financial stability, it is important for procurement to look behind their answers, even if they seem genuine, Danner says. “There is such a thing as ‘the big lie’: sometimes people tell you that they can do something, but they are in a position where they have no choice other than to tell you that. They may even believe it themselves, but you have to ask yourself whether they can really do it.”

 

CreditRiskMonitor estimates that between 15% and 20% of firms are currently in financial difficulty. Understanding which companies are at risk is not difficult for those asking the right questions and doing their research, Danner says.

 

Procurement teams may be dealing with thousands of suppliers at any one time. As such, they should prioritise efforts to understand risk to vendors who are critical – either in terms of the volume or the category of goods and services they provide, he suggests.

 

Carillion may yet be an exception in the supply market. Julie Palmer of Begbies Traynor notes the business was poorly managed and made mistakes in contract pricing, leaving a fatal hole in its accounts. But procurement executives should be alert to the prospect of these ‘zombie’ businesses bidding for work at low prices, and carefully manage those with which they already work.

 

Procurement Leader’s whitepaper, Insight: Financial risk, provides more information on this topic.

 

This article is a piece of independent journalism, written by an experienced journalist and commissioned exclusively by Procurement Leaders.

 

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