When the stock market opened on Friday morning, shares of outsourcing and construction group Carillion fell by as much as 60%.
This fall was triggered by a warning from the company that profits would be below expectations. The board has now admitted that the group will “require” some form of recapitalisation. In my view, shareholders are likely to be heavily diluted when this happens.
Why am I mentioning this?
Carillion’s downfall has strong similarities to the debt-fuelled collapse of its smaller peer, Interserve (LSE: IRV). Both companies have debt levels that appear unsustainable to me. And both companies are trading on around two times forecast earnings. That’s usually a sign that the market is expecting further problems.
I warned in October that Carillion was almost certain to need refinancing. I believe the same risk applies to Interserve. In October, the firm advised investors that it is at risk of breaching its lending covenants in December and said that it’s having “constructive and ongoing discussions with its lenders”.
I wasn’t surprised by this news. Average net debt for the current year is expected to be £475m-£500m. That’s nearly 10 times the group’s forecast profit for this year of £55m.
This is a serious financial burden — over the last 18 months, the Reading-based firm has had to spend around 25% of its operating cash flow on interest payments alone. Personally, I don’t see how this debt can be repaid without some kind of refinancing.
If I held shares in Interserve today, I would sell without hesitation. I expect the stock to fall much further yet.
What would I buy instead?
Not all companies in this sector are performing badly. One exception is Kier Group (LSE: KIE), whose operations are focused on property construction and infrastructure services.
Kier shares have fallen by 25% over the last year, but today’s update suggests that shareholders can sleep easy. Profitability remains high in the group’s property business, which the firm says is delivering a return on capital employed (ROCE) of more than 20% “on an increasing capital base”.
The group’s residential housing business has also seen an increase in ROCE, while its construction and services businesses have both secured more than 95% of the revenue targeted for the year to 30 June 2018.
According to today’s update, the Board expects Kier’s full-year results to be in line with expectations. This puts the stock on a forecast P/E of 8.6, with an expected dividend yield of 6.9%.
Importantly, net debt is expected to be less than one times earnings before interest, tax, depreciation and amortisation (EBITDA) at the end of June. That’s well below the level at which it might become a concern, in my view.
I’m tempted by Kier’s diversity and its strong balance sheet. The only risk I’d point out is that the dividend is only expected to be covered 1.7 times by earnings this year. For a business of this type, I don’t think that’s especially high. Although the payout is affordable at the moment, it might be vulnerable to a cut in the event of a UK recession.
Despite this risk, I view Kier as a reasonable buy at current levels.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.