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Why I’d dump Interserve plc to buy this cheap 5% yielder

Over the past 12 months, shares in outsourcer Interserve (LSE: IRV) have chalked up a loss of 78% making the company one of the worst-performing large-caps this year. 

In fact, over the past three years, the decline has been so severe that the company’s market value has fallen from over £1bn to just over £100m today. However, despite this drop, the stock looks cheap based on City estimates for growth.

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Unlike other companies that have seen their market values decline by 91% in three years, analysts believe Interserve remains profitable and is set to earn an estimated £52m in pre-tax profits for 2017, followed by £62m for 2018. Based on these figures, the shares are trading at a forward P/E of 1.9 for 2018. 

Too cheap to pass up? 

The current low valuation could be too cheap for some value hunters to pass up. Indeed, if the shares recovered back to a multiple of 8.7 (the five-year average), according to my figures, they would be worth 304p, 353% above current levels. 

Nonetheless, despite the value on offer here, I’m not interested in Interserve. Only a few months ago the firm warned that it faces a “realistic prospect” it will breach its banking covenants following a further deterioration in trading during the third quarter

After this warning, management declared that the group said it had launched a “comprehensive contract review across both the support services and construction businesses,” which will likely result in the business exiting non-core contracts. This leads me to believe that while City estimates for growth look attractive today, they could be downgraded significantly in the months ahead as Interserve engages in damage limitation. If the company does indeed breach its banking covenants, then a rights issue may also be on the horizon.  

So overall, I think Interserve is a sell. A better buy for your portfolio might be power group Drax (LSE: DRX), which is set to return to growth in the years ahead. 

Capital spending starting to yield results

Over the past few years, Drax has transformed itself. The power-generation group has overhauled its portfolio converting its old coal-fired power plants to greener wood biomass pellets. Three of the six plants have already been converted with a fourth in progress. As well as these, it is planning to build a new gas-fired station and one of the most prominent battery storage facilities in the world. These efforts are designed to enable it to provide a more flexible, greener energy source for the 21st century.

This transformation has come at a price, however. The group’s earnings have declined over the past five years from 52p in 2012 to an estimated 2.1p for this year. 

2017 is expected to be the low point for the company, based on earnings forecasts. Next year growth is expected to return with earnings per share slated to expand by 320% to 9p. A trading update from the firm issued today confirmed that it is on track to hit this target. As earnings recover, analysts expect management to rekindle dividend growth. A payout of 14.2p is projected for 2018 giving a dividend yield of 5.4% on the current price. 

All in all, Drax looks to me to be the better buy as its growth picks up over the next few years while Interserve struggles to remain solvent.

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Rupert Hargreaves does not own any share 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.

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