I was as shocked as most people to hear of the demise of outsourcing and construction specialist Carillion.
Profit warnings are bad news at any time, but they’re especially troubling when they come from a company with massive and rising debts. At 30 June 2017, Carillion’s net debt had reached £571m, up from £291m a year previously — and total debt topped at £1.5bn at the time of the firm’s collapse.
What did for Carillion now appears to be some serious overstretching based on a largely debt-funded business model, and with not enough resources to get through short-term tough periods including delays to several large projects.
There’s a big question now hanging over the whole of the construction and outsourcing industry. Are other companies at risk of a domino effect similar to that which crushed the banking sector?
Contagion
A report in the Financial Times on 17 January revealed that the government is “worried” about Interserve (LSE: IRV) and has assigned a team of officials to monitor the company’s financial situation.
Interserve shares dipped sharply when the market opened that day, but I was surprised to see a rapid recovery. In fact, over the past month, the shares are up 35% to today’s 123p, though we’re still looking at a 67% fall over 12 months as the firm has issued its own profit warnings.
We had one in February 2017, and another in September which told us that “outturn for the year will be significantly below … previous expectations.” Things got worse in October, when a further profit warning appeared and Interserve announced a “realistic prospect” that it would breach its banking covenants.
That crunch has been avoided for now, as December’s update told us the company had “secured additional short-term committed funding” of £180m, and that its lenders had agreed to delay the next loan covenant testing date until 31 March.
Soaring debt
A full-year trading update in January suggested that operating profit should be “ahead of current market expectations” and that “discussions with lenders over longer-term funding are progressing.”
At the same time, we were told that year-end net debt will be around £513m, with the company putting it down to “the significant outflow in the year relating to Energy from Waste, a normalisation of trading terms with our supply chain and exceptional costs.“
It sounds like Interserve’s current debt situation is caused by short-term issues — but short-term liquidity problems are precisely the kind of thing that can finish off an overstretched company. As it stands, the current debt is getting on for three times the company’s market capitalisation, which I find scary.
Covenants
At the halfway stage at 30 June 2017, with net debt standing at £387.5m, the firm reported a debt-to-EBIDTA ratio of 2.5 times, with its maximum covenant ratio standing at 3 times. We don’t know what the full-year EBIDTA figure will be, but net debt has ballooned by 32% since then.
With profit warnings suggesting to me that EBIDTA could be significantly less than twice the first-half value, I can see that covenant debt-to-EBIDTA maximum being blown out of the water — I’ll be surprised if it comes in at less than four times.
On forward P/E multiples of four and under, Interserve shares look like they’re priced to go bust — and I think that’s a definite possibility.
