Join our community of smart investors

Interserve: The warning signs were ignored

Hindsight is a wonderful thing but signs of problems at Interserve could have been easily identified years before its share price collapsed.
December 13, 2018

The high-profile demise of construction and support services company Carillion last year contained many valuable lessons for investors. Despite several red flags in its financial statements for many years, investors largely ignored them until the company warned that it was in trouble.

The key takeaways from Carillion were that construction and outsourcing businesses are very opaque and that outside investors have a virtually impossible task of really understanding what is going on with them – until something bad happens.

Yet, had investors taken the time to study Carillion’s annual reports they would have found many grounds for concern long before its share price collapse. In particular:

  • Low profit margins.
  • A reliance on acquisitions and cost-cutting.
  • High debts both on and off its balance sheet.
  • A big pension fund deficit that needed large amounts of cash flow to reduce it.
  • A difficulty in converting operating profits into operating cash flow – a classic sign of poor profit quality.
  • Poor free cash flow generation – confirming the poor quality of profits.
  • The need to sell assets in order to maintain and grow dividend payments.

During over 10 years as a City analyst working for stockbrokers and fund managers my experience was that very few professionals read annual reports, preferring instead to rely on company presentations and broker reports. Reading annual reports can be a dry and time-consuming exercise, but is always time well spent in my view. For a diligent private investor, the laziness of others remains a way of getting an information edge.

 

Interserve has many similarities with Carillion. It has a sizeable construction and support services business. It also has a very profitable equipment services business that sells products and services to the construction industry, which means revenues and profits are sensitive to the ups and downs of the economy.

A combination of low profit margins, the opaqueness contained in construction and outsourced contracts and a high level of cyclicality should have served as an immediate warning to any investor looking at Interserve. These are not the hallmarks of a high-quality business.

Many of Interserve’s problems have been self-inflicted. By its own admission, a large proportion of its support services contracts are high volume and low margin in nature. Its business model is inefficient and its cost base is too high to make the kind of profits – which are not very impressive – that its peers do.

Its 'energy for waste' business has had huge problems with constructing new plants and has seen big cost overruns and a huge increase in debts. Despite getting out of this business, Interserve still faces residual risks relating to the operating performance of these plants.

 

Interserve financial performance 2013 to 2018

Interserve (£m)

2013

2014

2015

2016

2017

TTM

Revenue

2582

3305

3623

3409

3667

3456

Adjusted operating profit

86.7

117

131.8

155

74.9

68.7

Reported operating profit

73.7

73

95.9

-76.4

-224.8

-226.4

Operating cash flow incl JV divs

56.9

28.7

52.3

129.4

-118.7

-177.7

Free cash flow

24.8

-17.7

-2.4

62.1

-188

-249

Net debt

38.6

269

308.8

274.4

502.6

614.3

Ratios:

      

Operating margin

3.4%

3.5%

3.6%

4.5%

2.0%

2.0%

FCF margin

1.0%

-0.5%

-0.1%

1.8%

-5.1%

-7.2%

Operating cash conversion

65.6%

24.5%

39.7%

83.5%

-158.5%

-258.7%

Cash dividend cover

0.85

-0.51

-0.07

1.75

N/a

N/a

Interest cover

15.5

10.7

8

8.8

3.3

1.4

Source: Company reports

 

Five years ago, Interserve’s share price was over 700p, but even back then there were signs that all was not well. The company was only converting 65 per cent of its adjusted operating profit into operating cash flow, while its dividend payment was not covered by free cash flow.

Between 2014 and 2016 all seemed well. Underlying operating profits and operating margins were increasing. However, operating cash conversion and free cash flow remained weak. This is something that should have raised concerns and led to many questions about a company’s true level of profitability. Another warning sign was the big differences between its adjusted profit – the number the company wants everyone to focus on – and its reported profit.

In 2017, the chickens came home to roost with big cash flow problems in its UK construction, support services and energy for waste business. Over a year ago, Interserve warned that the rapid increase in its debts could lead to it breaching its banking covenants. Despite implementing a strategy to cut costs and boost profits, the company said this week that its debt restructuring was going to involve a conversion of a large proportion of its debts into equity, resulting in a large dilution of existing shareholders. Its share price has collapsed and investors have been all but wiped out.

You may think that it is easy for someone like me to make these points with the benefit of hindsight. The point I want to make is that the signs of potential trouble where there long before the company’s share price collapsed.

It does not take any special insight or skill to identify these problems. All that is needed is a bit of time to scrutinise a company’s financial statements and calculate some simple ratios. Three ratios in particular – and the trends in them – can tell you a lot about a business and help keep you away from trouble:

  1. Operating margin. Divide a company’s operating profit by its revenue. A figure of 5 per cent or less is a low-margin business. Low-margin businesses can become no-margin businesses if trading performance deteriorates. Staying away from low-margin businesses is a good way of reducing risks for investments.
  2. Operating cash conversion. Divide a company’s operating cash flow by its adjusted operating profit. If the conversion ratio is significantly and consistently less than 100 per cent, you need to start asking some serious questions about the true profitability of a company. Time and time again weak operating cash flow is the equivalent of the canary in the coal mine in helping investors to spot bad companies.
  3. Free cash flow margin. Calculate a company’s free cash flow. Start with its operating cash flow and deduct tax paid, net interest paid and capex (the purchase of tangible and intangible assets). Divide this number by its revenue to get the free cash flow margin. If a business is converting a low proportion of its revenues into free cash flow you need to find out why. If it is due to a period of investment that will produce higher cash flows in the future then this may not be something to worry about. A big concern would be weak operating cash flows and high capex requirements to maintain the existing levels of sales. Staying away from low free cash flow margin businesses – less than 10 per cent – can be another way of avoiding bad businesses.

Nobody wants to be holding a share like Carillion or Interserve in their portfolio when big problems arise. But it is possible to spot signs of trouble and investigate them before any damage is done. Highly paid analysts and fund managers should be able to do this as part of their daily routine, and some do.

Sadly, the investing world is still plagued by complacency and conflicts of interest. Naysayers are given a hard time for pointing out problems with companies while others ignore them and promote them to investors.

An excellent new book written by former City analyst and fund manager Tim Steer The Signs Were There: The clues for investors that a company is heading for a fall - has just been published. It is packed full of case studies of companies that turned bad and how people could have spotted the warning signs.

Avoiding bad companies is one of the keys to investing success. If you want to improve your skills in this area then buying a copy of Tim’s book could prove to be a very shrewd investment.