Although not as worse as Carillion PLC, Interserve shares did tumble by 50%, but unlike Carillion, Interserve short position is 0.69%, not 22%.Though this doesn’t mean it is in the “all-clear”, if short-sellers identify any “accounts mismanagement” they would be happy to open short positions on the company!
So, why is Interserve facing adversity?
Despite, writing off their waste division and causing £170m in exceptional items. Their latest interim results did cause investors to be very cautious about Interserve going forward.
But, what causes investors to stay cautious?
First, the company has said that year-end net debt will come in at around £475m-£500m, compared to last year £274m, a near doubling.
Second, Interserve’s headline (adjusted) total operating profit has fallen by 30% to £46.1m meaning full-year number could fall below £90m from £117.4m.
Third, the company recorded a net cash flow loss of £66.4m meaning this is the biggest interim loss ever and greater than their previous interim loss of £9.5m in 2010.
Fourth, there are some political risks in their Middle-East division, an area that contributes £675m in sales and £45.6m in operating profits. An escalation between Qatar and its neighbours will cause disruption and would seriously harm the business. That’s because the Middle-East is an operating margin earner of between 6% and 7%, compared to the average 2% and 3%.
Finally, Brexit uncertainties have halted long-term contracts, but details are unclear.
Given the challenges that Interserve faces, are the fundamentals just as bad as Carillion PLC or are there hidden value at Interserve?
We are about to find out.
First, we need to know if Interserve’s sales and profits are believable.
Is Interserve’s Sales and Profits believable?
If you remember my previous post on Carillion, they overstated their receivables by 7%-8% (as a % of sales) from their averages, giving them a £300m-£400m boost to sales per year.
Interserve is different, as both the company’s receivables and payables are fairly reasonable are 1%-2% above their averages.
But the real difference for both Carillion and Interserve is the % of receivables and payables of sales. For Carillion, it exceeds 30% on both measures, but with Interserve, their receivables are below 20%, whereas payables are in the low 20s. That means Interserve hasn’t been aggressively booking credit sales that would boost sales and profits.
Another measure of quality is using the operating cash conversion ratio and over an eleven-year period, Interserve produces a cumulative net profit of £563.7m and cumulative net cash flow of £503.6m, giving a conversion rate of 89.3%! Whereas, Carillion has a conversion rate of 56.6%.
Onto their debt obligations.
Interserve’s Obligations against Fundamentals
To correlate between the company’s obligations (debt, lease and pension deficits, possibly “excess” payables) is to compare it with market capitalisation and sales. The Chart below displays this in abundance.
The idea is to assess if there is a relationship between having high levels of obligations against revenue and whether this impact market valuation.
One thing is certain when Interserve cuts total debt from £160m to £50m during 2009-2012, the share price responded higher (See graph 5) until investors got the wind that they were back to borrowing heavily again and decide to dump their stock!
Now, Interserve is forecast to owe a combined debt and pension deficit close to £575m (which is 200% of market capitalisation!) and represents 0.16-0.18 of sales by the end of 2017.
Moving along to assess capital expenditure.
Interserve’s Capital Expenditure
A). Capital Spending and depreciation
Has Interserve been understating depreciation/amortisation rate to boost profits, like Carillion? The answer is no.
Combining the two rates together against company’s assets (minus the goodwill) shows a fair D&A on their assets. Therefore, it has little influence on accounting profits.
B). Capital Spending and Free Cash Flow
Is Interserve generating free cash flow?
Looking at the graph, the correlation between positive and negative free cash flow is contingent on how much net cash flow gets generated and the levels of capex spending, with minor influences from dividends received and interest paid (both reported in the investing and financing section).
During the eleven-year period, Interserve has produced a cumulative free cash flow of £100m. But, that is according to Interserve’s accounts. However, the company achieved this by reporting “cash interest paid” on the financing section. If you include this cash outflow item it would report £26.9m in cash outflow!
Aren’t we forgetting Interserve was growing?
Interserve’s sales did grow from £1,386m in 2005 to £3,685m in 2016, a 165% growth. This was achieved when capital spending was outpacing depreciation by 2 to 1.
If Interserve were to lower capex, will it sustain positive FCFs?
It depends on the competitiveness of the sector and how much governments are willing to spend.
Linking the fundamentals and investors’ perceptions of Interserve can be difficult, but that what causes great undervaluation or overvaluation. To understand the level of under/-over valuation you need to use this method: Earnings Power Value. It helps you to understand the change in Interserve’s fundamentals and the change it would inflict on the share price, which ignores investors sentiment and future outlook (unless you create a forecast).
You see Interserve’s share price (investors’ sentiment) against their EPV per share counterpart, their periods of overvaluation (when share price exceeds EPV per share) and undervaluation. (Based on latest data), Interserve is currently fairly undervalued, and the difference is shown in the grey line. A ratio above 1 signals fair value and a ratio above 2 is under value, but anything below 1 is an overvaluation in terms of today’s fundamentals (fundamentals can continue to improve or deteriorate in the future).
Over a ten-year period, Interserve saw EPV, as % of the share price (ratio) rose above 2-2.5 back in 2009/10, and marks the beginning of their bull run, till early 2015 as ratio fell below 1.
I made a forecast in 2017’s (using available data from their interim results and estimating post-tax EBIT), that resulted in the EPV per share falling from £6.14 to £3.95, their worse decline.
If we use Interserve’s enterprise value and compare it to their implied EPV, we get this:
Despite, the falling share price, new additional debt has kept enterprise value high. More importantly, at a share price of £2.03, Interserve got a little expensive in my 2017’s forecast.
Notes on my EPV calculation for Interserve
I use the following to calculate EPV per share:
- With rising debt and a reasonable pension deficit, I decided to use a required rate of return of 9%. You may want to use a higher interest rate, but it would result in lower EPV per share.
- On operating profits, I used the post-tax normalised numbers because you would want to ignore the non-cash impairment charges, which varies widely year-on-year.
- The forecast 2017’s EPV per share of £3.95 involves estimated data of £500m in net debt and £75m in pension deficit.
Another valuation measure is to use an equation formulated by Warren Buffett, the equation is P/B*P/E < 22.5 signals fair value or a buy.
I did a forecast for 2017, assuming headline earnings would fall to £75m and shareholders’ equity of £310m and using market capitalisation of £295.77m. This resulted in Interserve being the most undervalued ever! Sure, equity value could collapse and headline earnings could get decimated to blow up my forecast!
Is Interserve a buy today? Or, is it better to wait?
During the depths of the financial crisis, Interserve’s share price touched below £1.60 at one stage, before making a slow recovery. Total debt was £100m and pension deficit fell thanks to rising bond yields. Their net cash profit has dropped to £3.8m and the biggest impairment charge is £20m.
Conclusion: The market was the main driver of Interserve’s share price decline.
Now, their half-year net cash flow recorded a £67m loss cash outflow (their biggest ever) and with total debt and pension deficits are estimated at £575m. But shares trade around £2, as the market is close to all-time highs!
Conclusion: The bull market is holding Interserve up! Hypothetically, if market conditions were like the financial crisis, it would trade below £1.
Sums of its parts
I did a segment analysis of Interserve. It looks at the individual divisions of Interserve to find gold nuggets within the group. But, the question investor should ask is: “Will these gold nuggets fetch enough to reduce debt to reasonable levels to justify market valuation?”
Last year, the sums of its parts came to a market equity of £480m. The stand out division being equipment services (valued at £500m). Their UK construction services are the worse with an expected write down of £250m.
Using segment information from their interim results, my forecast valuation of Interserve fell to £734.5m for next year, but due to high net debt, this drag the value down to £159.6m! (Check out the details of my analysis HERE.) Below current market value.
Earnings Power Value
Both the EPV per share and share price has fallen.
Given Brexit uncertainties, and political risks in the Middle-East and higher debt levels. Then, I recommend holding off from investing in Interserve for the next six months, until we see some stabilisation of the company’s operations and performance.
Also, total debt is too high, if levels of debt don’t fall, then expect a Rights Issue or equity financing.
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I have a segment analysis on Interserve HERE.
Thanks for reading.
The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.