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Indebted Interserve walks a tightrope

The support services group expects costs from existing contracts to substantially exceed expectations
September 21, 2017

Interserve (IRV) is fighting a battle on several fronts. The support services and construction group has suffered due to delayed public sector procurement, underperforming construction contracts and rising operational costs. The problems stretch back to the beginning of 2016, but management has now revealed that matters are worse than initially thought.     

IC TIP: Sell at 102p

The company warned that trading at both its UK support services and construction divisions had continued to disappoint during July and August, leading it to expect the out-turn for the year to be significantly below its previous expectations. In addition, the timing and complexities of exiting its long-troubled energy-from-waste (EFW) contracts mean the associated costs will “significantly exceed” the £160m provisioned. 

This brief trading statement was enough to knock more than 50 per cent off Interserve's share price on the day of its release. The magnitude of this latest decline in the share price is unsurprising given management’s seeming inability to draw a line under its EFW contracts, in particular. 

Management initially set aside an exceptional £70m provision against its EFW operations in May last year. The issues related to the design, procurement and installation of its Glasgow gasification plant, along with one of its main design subcontractors, Energos, entering administration. Then, in February, management announced that the sum to cover its exit from EFW would be insufficient, more than doubling it to the £160m it now says won’t cover the cost.

One of the most concerning consequences of exiting these contracts has been its impact on the group’s debt position, which had already been steadily rising. In August management increased forecasts for average net debt – measured as an average of month-end net debt balances – at the year-end to between £475m and £500m, from the £450m outlined in February. At the end of June net debt stood at £388m, or 2.5 times adjusted cash profits against an upper limit of three times.  

Interserve has debt facilities of £640m with a weighted average expiry of April 2022. In its latest update management said it continues to believe the group will operate within its banking covenants for this year. However, it seems very likely that net debt will climb higher again from the range estimated in August, and further towards the limits in its covenants.

At the time of the group’s interim results, delays in government procurement thanks to this year's snap general election was one reason given for flat revenue at the UK support services division, and profitability was hit by national minimum wage increases. On the first count, it would be reasonable to think public sector contract outsourcing activity could recover, even if that itself is an area of growing competition. Meanwhile, the UK construction business will take a more selective approach to the contracts it bids for, focusing on projects with a value of less than £10m.

Unsurprisingly the latest warning was met with earnings downgrades by analysts. Peel Hunt cut its pre-tax profit forecast for the current financial year by 23 per cent to £77.5m, giving EPS of 44.8p. That forecast assumes that the UK support services division delivers flat year-on-year revenue and that net debt comes in at £435m at the year-end, or at an average of £500m for the year as a whole.