4 lessons from the collapse of Forge Group

You probably know by now that mining services company Forge Group (ASX: FGE) collapsed, after major issues with two of its power station contracts overwhelmed the company’s ability to keep operating.

Construction overruns and issues in the cost estimates for the Diamantina (DPS) and West Angelas power station (WAPS) contracts resulted in writedowns, and according to the administrators Ferrier Hodgson, a loss of $326.5 million for the seven months to end of January 2014, and debts of more than $207 million (not including insurance bond facilities drawn to $265 million).

Ferrier Hodgson noted the following issues between what the company had budgeted for and what actually occurred.

  • Actual work in progress income for the period was $126m below management’s forecast.
  • Labour costs were $70m over budget.
  • Material costs were $55m over budget.
  • Work-in-progress Overheads were $22m over budget.

But how the company ended up in that situation appears to lie at the feet of management.

Both power station contracts were acquired when Forge bought out CTEC in 2012. But according to the administrators, the due diligence conducted on CTEC appears insufficient or the issues raised were overlooked by Forge – including major concerns over CTEC’s ability to complete the DPS project at forecast margins.

Forge still went ahead with the acquisition.

And that may well have been driven by Forge executives incentivised based on earnings per share (EPS) growth, and their lack of significant holdings of shares in the company.

Lesson 1

Bonuses and salary based in part on EPS growth can be achieved relatively easily by acquiring new businesses. The result is instant growth in earnings, but most acquisitions do not end up adding value — as Forge found out.

Lesson 2

Forge management held very few shares in the company and the CEO none. As a result, they were not incentivised to think as shareholders. If the CTEC acquisition was highly risky, why continue with it? As the administrator stated, “We note the absorption of CTEC into the Group increased the risk profile of an already high risk business model.”

Lesson 3

Given the issues raised over the DPS contract, you would’ve thought that Forge management would have kept a closer than usual eye on the project for any signs that it was not performing as expected. It seems that the risk management practices, policies and systems employed by Forge were inadequate, given how quickly the project blew up.

In any contracting business, management of those contracts and their inherent risks is enormously important, and the buck stops at executive management and the board. Leighton Holdings Limited (ASX: LEI) reported major cost blowouts in its Victorian Desalination Plant and Brisbane Airport Link last year.

Lesson 4

What’s reported in the income statement, balance sheet and cash flow statements means nothing if investors don’t understand the business, including both external and internal risks to its earnings. Calculating the intrinsic value of a company using this historical data with no consideration for its future outlook is high risk in nature and about as practical as tossing a coin.

Foolish takeaway

While Forge fell over thanks mainly to issues in the two power station contracts, the company was also suffering from the downturn affecting the whole mining services sector. It may well not be the first or last company to fall, with Boart Longyear (ASX: BLY) and Emeco Holdings Limited (ASX: EHL) two of many in the sector with large debt balances.

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Motley Fool writer/analyst Mike King owns shares in Leighton Holdings. You can follow Mike on Twitter @TMFKinga

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