3th December 2018: Interserve

The Financial Times reported that Interserve was looking for a deal to refinance its debt which would mean lenders
taking a significant loss while public shareholders would be “virtually wiped out”. Its share price dropped to a
30-year low last month.
Ahead of the Monday’s open which could with no doubt see investors rushing to the exits we look at Interserve and
evaluate the company and some strategies that could benefit investors.
Interserve constructs and maintains government buildings, and provides services, from nursing in people’s homes
to managing probation for the Ministry of Justice. It has a turnover of £3.2bn, 70 per cent of which comes from the
UK government.
The company has seen better days: in the last two years alone the share price has fallen more than 90%.

 

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This week we have heard of unofficial updates that the contracting outsourcing company Interserve seems to be in quite a bit of trouble.

The Financial Times reported that Interserve was looking for a deal to refinance its debt which would mean lenders taking a significant loss while public shareholders would be “virtually wiped out”. Its share price dropped to a 30-year low last month. Ahead of the Monday’s open which could with no doubt see investors rushing to the exits we look at Interserve and evaluate the company and some strategies that could benefit investors.

Interserve constructs and maintains government buildings, and provides services, from nursing in people’s homes to managing probation for the Ministry of Justice. It has a turnover of £3.2bn, 70 per cent of which comes from the UK government. The company has seen better days: in the last two years alone the share price has fallen more than 90%.
Below is the graph of the company as of Friday 7 December close:

 

 

 

 

The key issue with this and most companies that operate in this sector is debt- the company has approximately £650 million worth of debt that it needs to bring down, and slight variations in profitability forecasts for projects can see Interserve swing into losses very easily.
Operating on razor thin margins is one of the main reasons companies like Kier, Interserve, G4S etc win government contracts. Companies of this size also win these contracts because they have the infrastructure and resources to get the job done and completed on schedule.

Interestingly though, these companies’ business models when put under scrutiny reveal serious flaws, such as having hardly any tangible assets, high levels of gearing and debt and large amounts of goodwill. These three key components are what hedge funds look at when taking short positions in the market. Carillion had been heavily shorted since early 2015 and this was no secret; investors need to know where to look to gauge short interest.

Castellain Capital have provided short interest data, as shown below, it can be seen that Kier is the number 1 “shortest” company in the UK. Often it is not immediately apparent why a company is being shorted, but normally hedge funds, through extensive research and utilizing the vast resources they have at their disposal, can spot weaknesses in a company long before
the average retail investor.

Interserve are clearly in a bad situation and historical shareholders may want to prepare for taking a big write down, as the days of £1 plus a share may not return.

Investors could look to mitigate losses if they choose not to sell out of the position by opening shorts themselves, and this limits the damage on the shareholding they already have, assuming the company continues to fall. We know from the story of Carillion that these kinds of scenarios often make for good short-term trading opportunities, after the initial large fall an investor could may 20-30% regularly trading on bounces in the stock. Timing and knowledge of the rapidly changing situation is key here to do this well.

The government is unlikely to want another Carillion situation so to avoid the bad publicity they will most likely come to a deal and this could lead to a big bounce in the share price, depending on how dilutive the options are.

Finally, an alternate view would be to buy one of Interserve competitors, but the listed options are very limited, they also are heavily indebted and operate on thin margins.
These are the likes of Mitie, Serco, G4S and Kier to name a few, but if we had to look at one in particular, Serco stands out as having the least amount of debt and is best placed operationally to take on Interserve’s remaining operations. The government has asked companies in this sector to draw up “living wills” in the case of these companies going bust as they are key to development and infrastructure projects around the UK.

This highlights the rather poor state construction services are in, and there will be money to be made here by opportunistically trading the falls or rises, but caution is advised, as Carillion gave little in the way of warning before going under.

So, for now, Interserve may want to be viewed as nothing more than high risk penny share trading on AIM, definitely not one for the long-term investor.

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