Ever since shares of Interserve (LSE: IRV) fell by 32% in a single day in February, investors have been wondering how to value this outsourcing and construction group.
The shares currently trade on a forecast P/E of less than 4. It’s tempting to see this as a bargain, but this price tells me that the market doesn’t expect Interserve to solve its problems without being refinanced.
Today’s interim results suggest to me that my cautious view is probably wise. Although management expects full-year results to be in line with forecasts, the figures don’t look great to me.
Good, bad and ugly
The good news was that the group’s adjusted ‘headline’ performance was broadly as expected. Revenue for the six months rose by 1.5% to £1,647.7m, while headline pre-tax profit fell 33% to £36.5m.
Headline earnings per share for the half year were 21.5p, down from 32.3p for the same period last year.
The bad news was the higher costs that are eating into the group’s already slim profits. The National Living Wage is having a big impact on companies like Interserve, which has a high number of low-paid staff. Underperforming construction contracts also caused problems, resulting in a small loss for this division.
However, cost pressures and contract issues such as these are generally manageable, for companies with strong balance sheets. The problem is that in my opinion, Interserve doesn’t have one.
The company reported net debt of £387.5m on 30 June, which represents a multiple of 2.5 times earnings before interest, tax, depreciation and amortisation (EBITDA). That’s high, but it’s below the limit of three times set by its lenders.
However, the group expects year-end net debt to be £400m-£425m. I estimate that this will be uncomfortably close to the firm’s borrowing limit.
In my view, a fundraising remains likely. I expect this may happen after September, when the company’s incoming chief executive is due to start work. For now, I think the shares are too risky to be worth buying.
This one could be a buy
Companies without any obvious route to growth are often valued cheaply by the market. Connect Group (LSE: CNCT) is a good example. This is a group of businesses operating in areas such as newspaper distribution and parcel logistics. The firm’s shares trade on just 6.5 times 2017 forecast earnings, with a prospective dividend yield of 9%.
Normally I’d argue that this valuation is too good to be true. But in this case I’m not sure.
Connect’s dividend payout should be covered 1.7 times by earnings this year. The firm’s historic performance suggests that the payout should also be covered by free cash flow. So this dividend yield probably is affordable and sustainable.
On the other hand, Connect carries quite a lot of debt for a group with limited growth potential. Net debt was £149.9m at the end of February, equivalent to around 1.8 times EBITDA. This multiple should now be lower, as the sale of the Education & Care supplies business completed recently, providing cash to repay borrowings. But this disposal doesn’t solve the problem of where growth will come from.
Overall, I think Connect Group could be worth a closer look for high-yield investors who are prepared to accept some risk.
