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Out of the blue – That surprises happen in the real world of investing should come as no surprise

25/05/2016

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

A support services company that counts construction and waste management among its multifarious business offerings is presumably well used to some high highs and low lows. Even so, the 27% fall in Interserve’s share price that followed a profit update issued by the company earlier this month still counts as a shock. 

The update – as this kind of update usually does – ran through a long list of thing that were very much going to plan before, right at the end, mentioning one thing that was unfortunately very much not going to plan. Furthermore, this one thing quite comfortably undid not only all the things that were going to plan but also the company’s profits for the entire year. 

In this instance, the one thing is the contract Interserve has with waste collection company Viridor to build a £154m plant in Glasgow designed to turn rubbish into biogas to provide electricity to the National Grid. The project has been hit by substantial delays and difficulties with subcontractors to the extent that Interserve will now incur a £70m charge in the first half of its financial year. 

The company has said it expects to crystallise that charge over the rest of this year and next in terms of exceptional cash costs – an important point because such matters are not always addressed in cash terms – and, as a consequence, it now expects net debt to be £35m higher at the end of the year than had been previously stated. 

As Interserve only has a market capitalisation of about £460m, these are some chunky numbers to be discussing but, as is often the case, what really caught our eye here on The Value Perspective was what this all means for the business’s ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortisation). 

On current expectations, that looks set to be 2.3x by the end of 2017 – and, as regular visitors to our site will know, with most businesses we tend to grow nervous when the ratio edges above 2x. For companies engaged in construction and similar activities, however, we tend to grow nervous some way before 2x – for reasons pieces like Cycle path, on the cyclical nature of such businesses, make clear. 

Still, on the bright side, Interserve’s management are talking a good game and, to be fair, they do have a number of ‘levers’ they could pull in order to try and bring the business back on track. To offer just one example, the company owns an equipment rental business it has been talking about selling for a while. Now could be the time. 

The wider issue here, though, is that nobody seems to have seen this coming. Yes, the 27% fall meant Interserve’s share price has now more than halved since it hit a post-financial crisis high two years ago. But really there is almost no way anyone could have foreseen this unless they had day-to-day knowledge of the Viridor contract as well as every other individual contract within the company. 

Even then, that would apparently not have been enough because, until recently, there were plenty of people – not just investors but also analysts and, of course, the company’s management – who had been very confident what this year’s earnings would be. And presumably, if management had seen the problem coming as they prepared to publish Interserve’s results in February, they would have done something about it – or at least tried to prepare the market to soften the blow. 

So something that has managed to wipe out a significant chunk of the company’s equity value in one fell swoop while also putting its balance sheet in a very difficult place has come out of the blue – which is of course just the sort of thing that happens in the real world of business and investment. You can have as much confidence as you like about predictions for the future but the thing about the future, as we never tire of repeating here on The Value Perspective, is it is essentially unpredictable.

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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