Now is not the time to buy Redcentric PLC

Updated: 
Stock market falling prices

Yesterday shares in Redcentric(LSE: RCN) plunged by as much as two-thirds at one point, after the company revealed that it had fired its CFO and was working with auditors to restate its financial figures. 

According to data from TD Direct Investing, investors clearly saw the plunge in the value of Redcentric's shares as an opportunity as the stock topped the list of the most brought equities by TD clients on the London market yesterday. However, far from being a contrarian value opportunity, Redcentric could be a value trap. 

Indeed, it's not yet known how serious the company's financial situation is. Yesterday's statement was thin on specific details, as it would appear that even the senior management do not know how long the financial problems have been going on. 

Guessing the damage 

Until there's more colour on the situation from the company and its auditors, investors can only guess how serious Redcentric's problems are. 

City analysts have tried to shed some light on the issue, but their commentary is dotted with phrases such as 'should,' 'maybe' and 'points to', which basically means the analysts are just as much in the dark as investors.  

Still, for the time being, these estimates of the damage are all we have to go on. So what's the City saying about Redcentric's problems? 

Well, for a start, analysts are expecting a restatement to 2016 adjusted profits 35% to 40% with "significant adjustments to previously announced profits". If the company does re-state years of accounts, it could quickly become apparent that Redcentric's declines yesterday were nothing more than a re-rating of the shares. The company may have never been as profitable as historical figures suggest. 

Profit restatements are worrying enough, but they're not as concerning as Redcentric's debt warning. Specifically, the company warned in its Monday statement that the group will have to recalculate its banking financial covenants, which hints at the prospect that the firm could be in breach of its lending terms. 

Dangerous debt 

According to City analysts, primary covenants are net debt to EBITDA of 2.5 times, and a debt service covenant of 1.1 times. In its last trading update, Redcentric announced it was on track to reduce net debt to just under 0.8 times annualised adjusted EBITDA at the half year, falling to 0.6 times, including the proceeds of an asset sale. With such a big jump in debt levels predicted, it's clear there's something big going on here. Analysts predict the company's debt could be £13m - £14m higher than the reported half-year figure. 

What's more, as of yet, there's no real indication of how deep the rot is on Redcentric's balance sheet. Over the years the company has built up a large balance of intangible assets on its balance sheet through acquisitions. If the former CFO couldn't keep track of the group's debt, it's extremely unlikely these intangibles won't be subject to a re-evaluation. But with £92m of intangible assets on the balance sheet and £97m of shareholders equity, Redcentric has little to no room for manoeuvre. 

So overall, rather than speculate on a rebound in the value of Redcentric's shares, it might be wise to avoid the company altogether. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.