One share which has fallen heavily in recent weeks is oil and gas company Hurricane Energy (LSE: HUR). It’s declined by 33% since the start of October, with a weaker oil price sending its valuation lower. After such a large fall, could it be worth buying, alongside another relatively unpopular share which released a trading update on Friday?

Uncertain future?

The company in question is support services and construction business Interserve (LSE: IRV). It released a third quarter update which showed that trading for the current financial year has been in line with expectations. Its Fit for Growth efficiency programme is on track to deliver its target of £15m savings in 2018, while year-end net debt is due to be between £625m and £650m. It expects to make a further announcement regarding its deleveraging plan in early 2019, with its balance sheet still appearing to be relatively weak.

The Interserve share price has fallen by over 50% in the last year, and is showing little sign of delivering a successful turnaround. It has been on a downward trend for a number of months, with a weaker outlook for the UK economy causing investors to become less interested in its turnaround potential. Since it’s highly-leveraged, relative to some of its sector peers, it could have an uncertain future. Therefore, its risk/reward ratio may not be appealing at the present time – especially since investors are somewhat cautious about the outlook for the wider stock market.

Long-term potential

As mentioned, the Hurricane Energy share price has declined significantly in recent weeks. There could be further uncertainty in the near term, since the oil price has the potential to move lower, as fears regarding the world economy’s prospects may hold back investor sentiment. This could reduce investor interest in more speculative stocks within the oil and gas industry. And with Hurricane Energy currently loss-making, its shares could be hit harder in the short run than some of its industry peers.

However in the long run, the company appears to offer investment potential. It’s due to commence production in the first half of 2019, and this is expected to transform its financial performance. Its forward price-to-earnings (P/E) ratio using next year’s forecast earnings is around 14, which suggests that it may offer a margin of safety. And with a ramp-up in production expected over the medium term, it may be able to generate improving share price performance.

Of course, Hurricane Energy’s financial prospects are closely linked to the performance of the oil price. But for investors who are seeking a more speculative oil and gas stock, it could be worth a closer look, in my opinion.

The post Thinking of buying the Hurricane Energy share price after 33% decline? Read this first appeared first on The Motley Fool UK.

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Peter Stephens 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.

Doing this could mean that you’ll enjoy years of rising earnings and dividends, giving you a market-beating return on your original investment.

Today I want to look at two stocks that could fit the bill.

Slow progress?

Outsourcing and construction firm Interserve (LSE: IRV) announced the sale of its scaffolding business this morning, for up to £4.6m. The news follows the group’s recent half-year results. These showed that headline operating profit fell by 29% to £40.1m during the six months to 30 June, compared with the same period last year.

Management tried to put a positive spin on these figures by pointing out that they were better than the second half of 2017. That’s true. But this doesn’t disguise the fact that Interserve ended the period with increased net debt of £614.3m. This is more than six times trailing earnings before interest, tax, depreciation and amortisation (EBITDA).

The company’s lenders won’t allow it to pay a dividend until the group’s net debt-to-EBITDA ratio falls below 2.5x. In my view this is unlikely to happen until the company holds a rights issue to raise fresh cash from shareholders.

What comes next?

Analysts’ forecasts suggest the City holds a similar view. Although adjusted earnings are expected to triple to 19.3p per share next year, the current share price of 56p puts the stock on a 2019 price/earnings ratio of just 3.

In my opinion this indicates that the market doesn’t expect Interserve to deliver a sustainable recovery without raising fresh cash and diluting shareholders. I agree. I believe these shares are simply too risky for equity investors at the moment. I’d stay well away.

A more profitable choice

The integration of the outsourcing firms into the UK public sector shows little sign of slowing down. If you would like exposure to this type of business, one stock I would consider is Serco Group (LSE: SRP).

Serco shares received a boost last week, when the firm said that profits for 2018 are now expected to be ahead of previous guidance. Revenue of £2.8bn is expected to generate an underlying trading profit of £90m-£95m, up by about 30% on last year’s figure of £70m.

Another attraction is that chief executive Rupert Soames has already bitten the bullet and raised cash to reduce debt. As a result, his firm’s balance sheet now looks quite reasonable. Net debt should be less than 1.5x EBITDA this year, which seems comfortable to me.

A long-term buy?

Serco stock currently trades on a forecast P/E of 25, falling to a P/E of 21 for 2019. This may seem pricey, but the group’s profits are recovering from historically low levels.

Mr Soames is taking care to rebuild this business with solid foundations and sustainable profit margins. Dividend payments are expected to restart next year and I believe several more years of strong profit growth should be expected.

In my opinion, Serco shares could be an excellent buy-and-hold pick at current levels.

The post One FTSE 250 stock I’d buy to beat the State Pension in October (and one I’d avoid) appeared first on The Motley Fool UK.

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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.

Difficult period

Shares of FTSE SmallCap firm Renold (LSE: RNO) were trading at over 60p little more than a year ago. However, they reached a low of 22p recently after a difficult period for this global manufacturer of industrial chains and torque transmission products.

I believe the issues faced by the business are eminently fixable. Indeed, recovery is already under way, with the shares jumping over 10% on the release of the company’s annual results this morning. At a price of 26.5p, as I’m writing, the market capitalisation is £60m.

Improving outlook

Revenue of £191.6m for the year ended 31 March was 4.5% ahead of the prior year (3.8% ahead at constant exchange rates). Adjusted operating profit of £14.2m was down 2% due to the company being too slow to pass on increased raw materials costs to customers and some factory disruption. However, these issues have been remedied and it’s notable that £8.2m operating profit in the second half of the year was 9% ahead of the same period in the prior year.

Adjusted earnings per share (EPS) for the year came in at 4.5p, giving a P/E of 5.9, and I expect EPS to advance towards 5p this year. Net debt of £24.3m and a net debt/EBITDA ratio of 1:1 are modest and give me no cause for concern. A pension deficit of £97.4m (down from £102m over the course of the year) is substantial but I believe the outlook for such deficits shrinking is improving. While it does represent a risk, the company’s low P/E and prospects of good earnings growth lead me to rate the stock a ‘buy’.

Disaster

Shares of support services and construction firm Interserve (LSE: IRV) have fallen so far that this one-time FTSE 250 company now resides in the FTSE SmallCap index. At a share price of 74p, its market capitalisation is £110m and its P/E is 5.1 based on forecast EPS of 14.5p.

Interserve’s problems have been largely of its own making. A protracted exit from its energy-from-waste business has been particularly disastrous and is also now the subject of an investigation by the Financial Conduct Authority.

Debt millstone

It looked at one stage as if shareholders might be virtually wiped out in a massive debt-for-equity refinancing. However, new management can be credited for pulling off a deal with lenders that is significantly less dilutive than feared. The deal secured borrowing facilities of £834m to 2021, with lenders also able to buy shares at just 10p, giving them ownership of up to 20% of the enlarged equity.

Interserve’s net debt of £503m will rise considerably before any chance of improvement. Due to the size of this millstone, onerous conditions that are attached to the borrowings and the group’s weak underlying performance, I see the risk here as far too high. As such, I rate the stock a ‘sell’.

The post Interserve isn’t the only stock on a bargain P/E of less than 6 appeared first on The Motley Fool UK.

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G A Chester 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.

No support

International support services and construction group Interserve (LSE: IRV) has given investors an unwanted rollercoaster ride, amid profit warnings and fears over breached banking covenants. Its stock is down 54% over 12 months, up 28% over the last week, and down 13.54% this morning on publication of its annual 2017 results.

Today’s report showed a small rise in revenue, from £3.24bn to £3.25bn, but that was almost the only positive number. Total operating profit halved from £155m to £75m, the group’s loss before tax of £94m widened to £244m amid hefty writedowns, while headline earnings per share (EPS) crumbled by two thirds from 84.5p to 29p.

White stuff

Throw in a near doubling of net debt, from £274m to £502m, and you can see why investors are feeling so queasy. Worse, the group’s debt could rise to £680m in the second half, before improving slightly. Investors are ignoring one sign of hope, that the Berkshire-based group has secured full debt refinancing with committed borrowing facilities of £834m, through to 2021

New chief executive Debbie White claims her “fit for growth” plan will deliver an annual benefit of up to £50m to operating profits by 2020, £15m in the current year.

This is an opportunity for fearless contrarians given Interserve’s lowly valuation of just 6.2 times earnings, especially since it has future workload of £7.6bn, following a string of key contract wins in the year. These include the Ministry of Defence, Ministry of Justice, Department of Work and Pensions, Network Rail and the BBC, amid similar success in the Middle East. Interserve, which has a market cap of £132m, is a gamble, but a potentially rewarding one. My Foolish colleague Peter Stephens finds it tempting.

Capita crash

FTSE 250-listed Capita (LSE: CPI) has also left investors with churned stomachs, its share price crashing from 1,326p in July 2015 to just 187p today, down a thumping 85%. However, it is up 24% in the past week. Could this be your opportunity to hop on board for the next upwards swing?

The £1.25bn company’s numbers are absolutely all over the place, with a rock bottom valuation of just 3.3 times earnings, combined with a dizzyingly high yield of 16.9%. Don’t be fooled by that final number, the forecast for 2018 is a rather less rewarding 0%.

Comeback kid?

The recovery process may be slow and we are only in the early stages, as Capita changes its business model and launches a rights issue to generate extra capital. EPS are still expected to crash a massive 44% this year, and another 5% in 2019. Revenues may also dip slightly, although pre-tax profits may pick up a little, suggesting the stock has comeback potential.

Like Interserve, Capita has fallen so low, many will feel that the only way is up. History shows that companies take a long time to recover from such a bumpy ride, so if you are tempted, brace yourself for further highs and lows.

The post Are these 2 bargain stocks unmissable buys after rising 25% in a week? appeared first on The Motley Fool UK.

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Harvey Jones 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.

One example of a cheap stock at the present time is support services and construction company Interserve (LSE: IRV). It has faced a difficult recent past, with its profitability coming under severe pressure. After a fall in its valuation of 63% in the last year, could it now represent the bargain of 2018?

Challenging outlook

While Interserve is expected to report its second consecutive year of profit declines for 2017, things could go from bad to worse. Amidst difficult trading conditions, the company is forecast to post a fall in its bottom line of 39% in the 2018 financial year. This could hurt investor confidence – especially since its earnings forecasts have been downgraded in recent months.

Looking ahead, trading conditions within the UK outsourcing and construction space are expected to remain tough. This could lead to a further downgrade in the company’s financial outlook and cause its share price to come under additional pressure.

Turnaround prospects

Despite the risks that Interserve faces, it is still expected to deliver a successful turnaround. In the 2019 financial year its bottom line is forecast to rise by 12%, which could have a positive impact on its valuation. And since it trades on a price-to-earnings (P/E) ratio of around 4.5, it appears to offer a wide margin of safety at the present time.

Certainly, there are less risky investments available right now and the prospects for the company are difficult to predict. However, with such a low valuation and the expectation of a turnaround as the company delivers on its efficiency programme, it could prove to be a worthwhile buy for less risk-averse investors.

Improving performance

One company operating in a similar space to Interserve which has been able to deliver significantly improved performance is Balfour Beatty (LSE: BBY). It reported a number of profit warnings and has experienced difficulties with legacy issues. However, it has moved from loss to profit and is now expected to report bottom line growth of 28% in the next financial year.

This has the potential to catalyse investor sentiment and send the company’s share price higher after what has been a challenging three months for investors. The company’s shares have moved 10% lower and this means that they now trade on a price-to-earnings growth (PEG) ratio of just 0.4, which suggests that they could deliver improving levels of capital return.

Since Balfour Beatty has international exposure, it may be able to offer improving financial performance even if the UK economy’s prospects are downgraded. While risky and still not fully recovered after a difficult past, the stock appears to offer a favourable risk/reward ratio.

The post Is the Interserve share price the bargain of the year? appeared first on The Motley Fool UK.

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• Is the stock market correction a once-in-a-decade chance to target a million-pound SIPP?
• How to target a £10k annual income from just one year’s £20,000 Stocks and Shares ISA allowance

Peter Stephens 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.

Interserve employs more than 25,000 people in the UK, where it manages the Ministry of Defence’s estate and is involved in healthcare and probation services. Yesterday’s deal appears to provide additional borrowing capacity for the group, along with extended repayment deadlines.

This looks promising

The Reading-based firm has agreed an extra £291.6m of borrowing facilities. These won’t mature until September 2021. Most of the group’s existing debt will also be restructured so that it isn’t due for repayment until that date.

If the deal is approved, it will provide the company with total cash borrowing facilities of £834m,, subject to certain “step-downs” during that period. This compares to expected net debt of £513m at the end of 2017.

The group’s lenders will also be able to subscribe for new shares at 10p per share which, if taken up, will give them a 20% stake in the firm.

Although this deal suggests those lenders are keen to support a turnaround, yesterday’s statement didn’t include an update on current debt levels. This means that we don’t know how much of these new borrowing facilities will already be used up when they’re approved.

Nor do we know the full costs of this refinancing. Interserve said that pricing on existing debt has been renegotiated but didn’t specify the new interest rates. All we know is that interest payments in 2018 are expected to total £56m, of which £34m will be cash.

My view

Interserve hopes to reduce debt by cutting costs and selling parts of its business. But I think there’s still a risk that shareholders will be asked to provide extra cash.

If I was one of them, I’d probably hold on after Wednesday’s news. But I wouldn’t buy any more shares at this time.

Although the forecast P/E of 3 may seem tempting, it’s actually a reflection of the group’s high debt levels and distressed state. And while the firm’s lenders will probably make a profit from this situation, shareholders might not.

A 65% faller I’d buy

You might not think of temporary power provider Aggreko (LSE: AGK) as an outsourcing firm. But its business enables customers to outsource the supply of electricity by simply telling Aggreko what they need and paying the firm to provide it.

This business has suffered from weaker demand and bad debts over the last five years, during which the shares have lost 65% of their value. However, I believe conditions could soon start to improve.

Emerging market economies and the oil, gas and mining sectors all appear to be gaining strength. At some point I think this should generate additional demand for temporary power.

In the meantime, Aggreko’s performance seems to have stabilised. The recent 2017 results showed revenue rose by 4% to £1,730m last year. Excluding the impact of problematic legacy contracts in Argentina, revenue was 9% higher, with operating profit up 13%.

Debt looks comfortable to me and cash generation improved last year. The unchanged dividend of 27.1p was covered by free cash flow, excluding acquisitions.

Analysts expect earnings to be largely flat in 2018. With the shares trading on a forecast P/E of 13 and offering a 4% yield, I believe Aggreko could be a profitable turnaround buy.

The post Should you buy as Interserve share price rises 35%? appeared first on The Motley Fool UK.

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• Is the stock market correction a once-in-a-decade chance to target a million-pound SIPP?
• How to target a £10k annual income from just one year’s £20,000 Stocks and Shares ISA allowance

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.

Finsbury Food (LSE: FIF), which released its latest half-year results today, is another stock I have tagged as a ‘sell’. This speciality baker has been a considerably more solid performer than Interserve and there’s a different reason for my negative view on its buoyant shares.

One big problem

After a string of operational problems, poor trading and boardroom changes during 2017, Interserve issued better news in January. It said it expected operating profit in 2018 to be “ahead of current market expectations,” with new management confident it has identified initiatives that will “contribute at least £40m-£50m to group operating profit by 2020.”

For 2018, City analysts are forecasting a bottom-line profit of £48m, so with a market cap of £124m at the current share price, Interserve’s forward price-to-earnings (P/E) ratio is an incredibly low 2.6. However, I don’t believe this is the bargain it appears, due to the company’s massive net debt of over £500m.

I’m not quite as pessimistic as my Foolish friend Alan Oscroft, who has argued Interserve could go the way of Carillion, leaving shareholders with nothing, but I do think the shares could fall considerably lower than their current level. The Telegraph reported earlier this month that since the start of the year, private equity outfit Emerald Investment Partners has been quietly buying up Interserve’s debt from the likes of Lloyds and Barclays “for as little as 50p in the pound” and “may now own as much as a third of [the] loans.”

When debt is changing hands at such a discount, it’s generally bad news for existing equity. Emerald clearly sees a viable business but I believe a refinancing of Interserve, including a debt-for-equity swap, would likely come at a heavy cost to current shareholders.

Multiple headwinds

Finsbury Food has no such problems with debt. At a share price of 116p (unchanged on the day), its market cap is £151m, while net debt stands at just £16.6m. In addition to its strong balance sheet, the company is trading pretty well, with today’s results showing low single-digit top-line growth and mid single-digit bottom-line growth.

For Finsbury’s full financial year to 30 June, City analysts are forecasting a net profit in the £30m region, giving a P/E of 11.6. And there’s a dividend yield of 2.8% on a forecast payout of £4.3m.

The company acknowledges it faces Brexit uncertainties and a number of continuing challenges, including increased commodity prices and the annual above-inflation increase in the National Living wage. While management is working hard to “mitigate” the headwinds and believes it has a “resilient” business, I don’t see a P/E of 11.6 and dividend yield of 2.8% as sufficient reward for mitigation and resilience.

Finsbury is a decent, well-managed company but one which will have to run just to stand still in the prevailing challenging environment. In these circumstances, I believe the risk of earnings downgrades is significantly higher than the potential for upgrades and I see more appealing investment propositions elsewhere in the market.

The post Interserve plc isn’t the only stock I’d sell today appeared first on The Motley Fool UK.

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• Recent BT share price performance is jaw-dropping but can it continue?
• Is the stock market correction a once-in-a-decade chance to target a million-pound SIPP?
• How to target a £10k annual income from just one year’s £20,000 Stocks and Shares ISA allowance

G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. 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.

With concerns building about the sustainability of the outsourcing business model, investors have dumped shares in Capita (LSE: CPI) and Interserve (LSE: IRV), sending them plunging to multi-year lows. However, after falling by more than 60% in the space of 12 months, the shares have started to attract bargain hunters, but is it worth taking a punt on these turnarounds or is it best to stay away ahead of further declines?

Two key problems

Capita and Interserve both face two primary issues. Firstly, these firms have been beset by rising costs on legacy contracts. For example, during the past year, Interserve has issued two profit warnings related to spiralling expenses on an energy-to-waste contract. Capita’s turnaround is also being weighed down by these legacy contracts, which can be difficult to restructure and were agreed when costs were much lower.

The second issue these companies are having to grapple with is their weak financial position. Capita has a debt pile of more than £1bn to contend with, as well as a £381m pension deficit. Meanwhile, City analysts believe that Interserve’s debt could hit £600m by the end of 2018, compared to its current market value of £107m.

To try and fix its balance sheet, at the end of January Capita announced a £700m rights issue and suspended its dividend until it can generate a “sustainable free cash flow.” This highlights another problem with the outsourcing business model. Cash flow generation is generally very poor and managements has only exacerbated this issue over the past five years by pursuing unsustainable dividend policies, which have been funded by debt. For example, over the past five years, Interserve generated £175m in cash from operations but paid out £152m in dividends to investors, leaving little left over for debt repayment or funding capital spending. Capita’s financial situation is similarly troubling. Over the past five years, the company has paid out around £700m more in dividends to shareholders than it has generated from operations after deducting capital spending and other investing cash outflows.

A better investment 

These problems lead me to conclude that, despite the fact that these shares look cheap, the industry is still plagued by problems, and it will take some time for these companies to turn themselves around if they can convince their creditors to give them breathing space. Overall, the risk/reward ratio just does not look attractive here. Plenty could go wrong for Interserve and Capita as they struggle to return to growth and it may be many years before investors see a return. There are other better opportunities out there.

The post Is it now time to buy Capita plc and Interserve plc after falling 60%? appeared first on The Motley Fool UK.

More reading

• A SIPP seems to offer investors free money – is there a catch?
• Here’s what £10,000 invested in Greggs shares a year ago’s worth now
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• Is the stock market correction a once-in-a-decade chance to target a million-pound SIPP?
• How to target a £10k annual income from just one year’s £20,000 Stocks and Shares ISA allowance

Rupert Hargreaves owns no 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.

Clearly, the company remains highly volatile, and its outlook is uncertain. But alongside this ‘hidden’ growth stock, it could deliver a 100% return over the medium term.

An improving outlook

While trading conditions have been tough for Interserve, it seems to be implementing a number of self-help measures which are expected to lead to rising profitability. For example, it’s in the process of cutting costs as it seeks to become more efficient. This could make it a more competitive and flexible entity able to generate rising profitability.

In fact in the current year, the stock is expected to return to growth with its bottom line forecast to rise by 23%, and by a further 33% next year. This is obviously strong and shows that while its shares are down 67% in the last year, even after its recent gain there could be upside potential on offer. That’s especially the case since it trades on a price-to-earnings growth (PEG) ratio of only 0.1.

Certainly, Interserve’s financial position is highly uncertain. There could be further problems ahead in this area, which means it remains a high-risk stock. But with a wide margin of safety and clear turnaround potential in terms of its earnings growth forecasts, the stock could perform well in future months and years.

More growth prospects

Also offering significant upside potential is food producer Cranswick (LSE: CWK). The company released a positive third quarter trading statement on Thursday which showed that it’s making good progress with its strategy. Both total and like-for-like revenues increased, with each of the company’s categories delivering positive volume growth. In fact, its trading in the period was slightly ahead of expectations, which caused its share price to move 3% higher following the update.

This new valuation takes Cranswick’s share price rise to over 200% in the last five years, which is an exceptional result. After all, its defensive status puts it in a grouping where many stocks have been proving relatively unpopular among investors in recent years. However, with the company being able to generate double digit growth in each of the last three financial years, its rising share price may have been warranted.

Looking ahead, the company is due to report further growth in its earnings. Its bottom line is expected to rise by 15% in the current financial year. With it trading on a PEG ratio of 1.5, there could be further capital growth ahead. Therefore, with its resilient and stable business model providing a relatively low risk outlook, its risk/reward ratio seems attractive.

The post You could double your money with Interserve plc and this ‘hidden’ growth stock in 2018! appeared first on The Motley Fool UK.

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Peter Stephens has no position in any 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.

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.

The post Why I think Interserve plc could go the way of Carillion in 2018 appeared first on The Motley Fool UK.

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Alan Oscroft 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.