Can Interserve clean up its mess, or is it destined for the same fate as its failed rival Carillion?
It feels like we’ve been here before, doesn’t it?
It was almost a year ago when outsourcing giant Carillion collapsed, and now there are some worrying signs that rival FTSE firm Interserve could wind up suffering the same fate, serving a huge blow to UK businesses and the livelihoods of its 75,000 employees.
On Sunday evening, Interserve’s management confirmed that it was in talks with lenders to come up with a rescue plan, which includes restructuring some of its debt agreements by extending some maturity dates on finance deals.
The company’s chief executive Debbie White may have described the discussions as a “positive step”, but unsurprisingly the news spooked traders, prompting Interserve’s share price to plunge by 52 per cent on Monday morning. Indeed, for investors, the fear set in when it was revealed that the deleveraging plan meant that current Interserve shareholders could see a “material dilution” in the value of their stake as the firm issues more shares.
Here are the parallels to Carillion which are getting traders hot under the collar.
Share price plunge
Carillion’s first profit warning came in January last year, which sparked a downward spiral for the firm’s share price, wiping hundreds of millions of pounds off its share value. Despite numerous profit warnings after that, Carillion continued to win new contracts, digging itself into an even deeper hole.
Interserve’s share price shows a similar story. It’s been struggling all year, declining from 112.3p in April to 10.33p yesterday – a fall of about 78 per cent. On Monday alone, around £22m was wiped off the company’s share value just as the markets opened.
Again, despite concerns about the firm’s future, Interserve continues to be awarded new government contracts. In fact, just yesterday it was granted a £25m contract to assist with the £36m redevelopment of Prince Charles Hospital, which is being funded by the Welsh government.
There are calls for Interserve to be banned from being awarded more government deals. Labour MP Jon Trickett says: “Interserve must be prevented from bidding for public sector contracts until it proves it is financially stable and there is no risk to the taxpayer.”
Thin margins
Like Carillion, Interserve largely focuses on the construction industry, but also operates services in various other sectors such as cleaning and catering. Some analysts worry that, without specialising on one sector, these outsourcing businesses are spreading themselves too thinly. And while Interserve says that it plans to dispose of “non-core businesses”, could it be too little too late?
Meanwhile, the outsourcing sector faces a tricky financial balancing act as companies cut prices in a bid to secure contracts. This means that many contracts end up being unprofitable in the long run.
Laith Khalaf, senior analyst at Hargreaves Lansdown, says that part of the problem is that profit margins in the sector are “wafer thin”, while the contracts involved are large-scale and prone to uncertainty and delays. “There’s not a great deal of margin for error in the business model,” he adds.
Tim Steer, retired fund manager and author of The Signs Were There, says: “As we know from Carillion, construction companies find it so difficult to quantify expected outcomes on complicated long-term contracts, and rarely get it right at the first or indeed second stab.”
Credit crutch
In 2016, Carillion reported a market cap of £1bn. But just a year later, it wrote off £1bn in contracts as it struggled under the strain of its huge debt pile. By the time it went bust, it had £29m in cash, and was £2bn in debt.
By comparison, Interserve’s net debt has risen to £614m, more than doubling in a year, according to Neil Wilson, chief market analyst for Markets.com.
“With more than £400m in deleveraging for a company with a market cap of around £10m, it’s fair to say that existing shareholders face wipeout,” he says.
Indeed, it is estimated that Interserve’s debt pile could hit £650m by the end of the year.
“While profits can disappear quickly, debts are not so easily shrugged off,” warns Khalaf. “Interserve now needs to convince its lenders that if they continue to back the company, there is some light at the end of the tunnel.”
It’s clear that the fate of Interserve now lies in the hands of these creditors, and at the moment, lenders seem resigned to the fact that they may have to write off some loans. Wilson argues that the business should struggle on, adding: “The company will likely survive, but a major cash call was inevitable.”
Dealing with delays
Before its demise, Carillion ran into trouble with a number of huge construction projects, including a £1bn project to build a bypass in Aberdeen (which is only expected to open this week after almost a year-long delay).
Interserve has also struggled with similar problems. In fact, it was only the end of November when it announced that there would be additional delays to some of its Energy from Waste projects.
Khalaf points out that the firm faces penalties over the delays, which therefore reduces the cash the company can expect to collect from these projects.
Is there hope?
Former fund manager Steer says the warning signs about Interserve have been there since 2017, when it recorded costs of a massive £299m in respect of its “dreadful decision” to enter into a number of problematical contracts, including several tricky waste to energy projects.
“In the previous year, it incurred similar costs of £227m relating to pretty much the same issues,” he says. “These items are the reason debt had soared to such a level that its repayment was quite impossible in view of the paltry profits being generated elsewhere in the group.”
Despite discussions, a deal between Carillion, the government, and its lenders was never reached. By comparison, Interserve’s prospects look slightly more hopeful. The saving grace is that the government seems willing to step up to save Interserve from suffering a similar fate.
The Interserve debt-to-equity deal will come to light next month. But despite some small flecks of hope, there are certainly signs that suggest yet another construction company could end up buried under a pile of debt.
What’s clear is if we are to avoid the mistakes of the past, things need to change.