&l;p&g;Another day, another U.K. construction company on the ropes. Following Carillion&s;s failure and Capita&s;s profits warning, the next domino that could be about to fall is Interserve. Its share price &l;a href=&q;http://www.thisismoney.co.uk/money/markets/article-5437559/Now-hedge-funds-target-Interserve-shares-slump-12.html&q; target=&q;_blank&q;&g;was hammered yesterday&l;/a&g;, falling 12% on &l;a href=&q;https://www.telegraph.co.uk/business/2018/02/24/interserve-crisis-grows-debt-talks-stumble/&q; target=&q;_blank&q;&g;a report in the U.K.&a;rsquo;s &l;em&g;Telegraph&l;/em&g; newspaper&l;/a&g; that the company was having trouble refinancing its estimated &a;pound;500 million debt pile. Although the share price recovered somewhat after Interserve&a;nbsp;&l;a href=&q;http://www.cityam.com/281202/interserve-share-price-hits-back-insisting-refinancing-has-not-stumbled&q; target=&q;_blank&q;&g;robustly denied the report&l;/a&g;, the stock is heavily shorted, suggesting that the share price has further to fall. For Interserve, this could be bad news.
&l;img class=&q;dam-image getty size-large wp-image-905907352&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/905907352/960×0.jpg?fit=scale&q; data-height=&q;602&q; data-width=&q;960&q;&g; A general view of signage at Interserve&s;s headquarters in Twyford near Reading in Berkshire, England, as shares in the company plunged amid reports that the Government is keeping a close eye on the outsourcing giant&s;s financial health following Carillion&s;s collapse. (Photo by Steve Parsons/PA Images via Getty Images)
Interserve is experiencing severe cash flow problems, mainly due to its waste management business on which it has been taking heavy losses for some time. In 2016, it decided to exit from this business, and it is now taking on no more work in this sector. But it is still running down a bunch of contracts on which cash outflows are significantly exceeding inflows. Seeing these contracts through to completion is raising Interserve&a;rsquo;s short-term borrowing requirement, forcing it to seek additional funding from banks.
Interserve insists that the problems are short-term, arising only from the run-off of the waste management business. If this is true, then it would be reasonable to extend short-term finance to keep the company going until its cash flow recovers. But Carillion also insisted that its problems were simply short-term liquidity problems due to difficulties with a few contracts, and would be solved in a few months if only someone would bung it some cash. It turned out to be deeply insolvent. Banks that took large losses when Carillion failed are therefore understandably wary of extending more finance to a company that, on the face of it, appears to be in a similar mess.
So, is Interserve similar to Carillion? Is it concealing insolvency under a blanket of cash flow strains, as Carillion was? Not just the banks, but the &l;a href=&q;http://www.interserve.com/about-us&q; target=&q;_blank&q;&g;80,000 people worldwide&l;/a&g; whose jobs would be at risk if it failed, deserve to know the truth.
The &l;a href=&q;http://www.interserve.com/docs/default-source/investors/financial-reports/presentation-results/2016/2016-annual-report.pdf?sfvrsn=8&q; target=&q;_blank&q;&g;2016 full-year accounts&l;/a&g; reveal a deeply distressed company. Interserve made a loss of &a;pound;101 million in 2016, and operating cash flow was significantly negative. However, this was almost entirely due to the waste management business. Since the contracts are loss-making, they have to be run off rather than sold. Consequently, the waste management business did not meet the criteria for &a;ldquo;held for sale&a;rdquo; or &a;ldquo;discontinued operations.&a;rdquo; So Interserve listed it under &a;ldquo;exceptional items,&a;rdquo; implying that expenses from the waste management contracts were one-off items that would not recur.
The notes to the accounts reveal that Interserve&a;rsquo;s management knew perfectly well that this was a fudge:
&l;/p&g;&l;blockquote&g;IAS 1 requires material items to be disclosed separately in a way that enables users to assess the quality of a company&a;rsquo;s profitability. In practice, these are commonly referred to as &a;ldquo;exceptional&a;rdquo; items, but this is not a concept defined by IFRS and therefore there is a level of judgement involved in determining what to include in headline profit.&l;/blockquote&g;
The fudge magically turned a &a;pound;101&a;nbsp;&l;span&g;million&l;/span&g; loss into a &a;pound;94&a;nbsp;&l;span&g;million&l;/span&g; profit, justifying a dividend payment to shareholders of &a;pound;34.1 &l;span&g;million&l;/span&g;.
But the losses turned out not to be &a;ldquo;one-offs that would not recur.&a;rdquo; The company continued to hemorrhage money. By June 2017, &l;a href=&q;http://www.interserve.com/docs/default-source/investors/financial-reports/presentation-results/2017/2017-half-year-report.pdf?sfvrsn=3&q; target=&q;_blank&q;&g;Interserve&a;rsquo;s cash flow was failing&l;/a&g;. Cash from operations turned sharply negative as net cash inflows from other parts of the business dropped while cash continued to drain from the waste management business. Interserve&a;rsquo;s net debt rose by &a;pound;113 &l;span&g;million&l;/span&g;, an increase of some 25% in six months.
Not only did Interserve&a;rsquo;s net debt rise, but the average maturity shortened too, as short-term borrowing rose by &a;pound;155 &l;span&g;million&l;/span&g;. For me, sharply rising short-term debt is always a red flag, especially when combined with negative cash flow. But Interserve was sanguine about it all. It cheerfully forecast that the company&a;rsquo;s cash position would improve in the second half of the year.
It didn&a;rsquo;t. In September, two weeks after the new CEO, Debbie White, started work, the company issued its &l;a href=&q;http://otp.investis.com/clients/uk/interserve/rns/regulatory-story.aspx?cid=720&a;amp;newsid=924887&q; target=&q;_blank&q;&g;first profit warning&l;/a&g;. Here&a;rsquo;s what it said:
&l;blockquote&g;Trading in the UK in July and August was disappointing, particularly in support services, but also in the construction division. As a result of this, the Board now believes that the outturn for the year will be significantly below its previous expectations.
Further progress continues to be made on contracts within our exited Energy from Waste business. However, the anticipated timing and complexities of completion mean that the Board now considers it likely that the final costs will significantly exceed the &a;pound;160&a;nbsp;&l;span&g;million&l;/span&g; currently provided&l;span&g;.&l;/span&g;&l;/blockquote&g;
So Interserve&a;rsquo;s profits warning was not primarily due to losses on a few contracts, although the losses were bigger than expected. It was due to a general downturn in two of its core U.K. divisions. This is beginning to look a lot more like Carillion, isn&a;rsquo;t it?
The company issued a &l;a href=&q;http://otp.investis.com/clients/uk/interserve/rns/regulatory-story.aspx?cid=720&a;amp;newsid=941191&q; target=&q;_blank&q;&g;further trading update&l;/a&g; in October 2017, in which it admitted that third-quarter trading was even worse than in the first half of the year. It said that profit for the second half of the year would only be half that of the second half-year in 2016, and warned that it was potentially going to breach its loan covenants, the next test for which would be in December.
This was a game changer. The share price, which had fallen off a cliff after the first profit warning but then recovered somewhat, fell again and remained low until December, when the company &l;a href=&q;http://otp.investis.com/clients/uk/interserve/rns/regulatory-story.aspx?cid=720&a;amp;newsid=958019&q; target=&q;_blank&q;&g;announced&l;/a&g; that it had deferred the loan covenant test until March and had secured additional bank financing of &a;pound;180&a;nbsp;&l;span&g;million&l;/span&g; for three months.
&l;img class=&q;size-large wp-image-2940&q; src=&q;http://blogs-images.forbes.com/francescoppola/files/2018/02/Interserve-share-price-1200×801.jpg?width=960&q; alt=&q;&q; data-height=&q;801&q; data-width=&q;1200&q;&g; Interserve share price
But it is the reason for the second profit warning that should give everyone pause for thought &l;em&g;(my emphasis)&l;/em&g;:
&l;blockquote&g;In &l;strong&g;U.K.&l;/strong&g;&l;strong&g; support services&l;/strong&g;, this was driven by the &l;b&g;continued employment cost pressures in the business, the cost of contract mobilizations, margin deterioration driven by a cost base which has not been flexible enough and contract performance in the justice business&l;/b&g;. Our &l;strong&g;U.K.&l;/strong&g;&l;strong&g; construction business&l;/strong&g; has seen further deterioration in operating profit as &l;strong&g;challenging market conditions and cost pressures as well as operational delivery issues have continued to impact performance&l;/strong&g;.&a;nbsp; Our equipment services business is performing well and as anticipated, the international support services business has started to improve versus the first half performance and in international construction we have maintained a stable performance.&l;/blockquote&g;
The primary cause of the company&a;rsquo;s collapsing profits is rising costs, low margins and poor contract performance in two of its three core divisions. Waste management doesn&a;rsquo;t even get a mention.
I don&a;rsquo;t know why experienced analysts such as &l;a href=&q;http://www.bbc.co.uk/news/business-42902066&q; target=&q;_blank&q;&g;the BBC&a;rsquo;s Simon Jack&l;/a&g; are still saying that its problems mainly stem from its loss-making waste management contracts:
&l;blockquote&g;Carillion had a number of major projects that went sour whereas Interserve&s;s problems stem primarily from one line of business – its energy-from-waste business – from which it is extricating itself.&l;/blockquote&g;
That&a;rsquo;s not what the figures or the company&a;rsquo;s trading updates say. Interserve&a;rsquo;s immediate problem is the financing cliff edge that it faces in March. But the underlying issue is that its core businesses are performing extremely badly.
Like most companies of its kind, Interserve&a;rsquo;s balance sheet is made up largely of intangible assets. And it is very highly indebted. The profitability decline in its core businesses therefore threatens its solvency &a;ndash; and the jobs of 80,000 people.
Interserve cannot continue to pretend that its problems are simply cash flow. It needs to deleverage rapidly, and that means tapping shareholders for cash. The new CEO announced a restructuring program last September, but the behaviour of the share price since then does not suggest that investors have a great deal of confidence in her plans. The share price has fallen from 236 pence per share a year ago to 60 pence per share now, and the company&a;rsquo;s market cap is a paltry &a;pound;92 &l;span&g;million&l;/span&g;. The question now is whether the new CEO has left it too late for the rights issue and radical restructuring that is so evidently needed.