There is always something fascinating about the spectacle of a falling knife because it raises this compelling question: should I grab it?
International support services and construction company Interserve(LSE: IRV) looks particularly compelling after dropping 50% in a single day earlier this month. The share price is now bouncing back, but exactly what kind of bounce is this?
Interserve has suffered not one, but two, precipitous drops this year, after its first profit warning in mid-February when it plunged from 352p to 227p. The second was on 13 September when it crashed from 152p to 73.75p. This neatly illustrates the danger of catching falling knives, if you jumped in after February's drop, you would now be nursing a major loss on your supposed bargain.
What a waste
Today, Interserve trades at 116p, a rise of 57% from its low of 73.75p. So what happens next? The September collapse followed a severe profit warning blamed on spiralling costs, with the company facing a £2m loss in the first six months of the year, and full year 2017 set to be significantly below expectations. New regulations have hit its services business, while the post-Brexit lull in government procurement hit construction, amid a wider sector slowdown.
Continuing costs from its exited Energy from Waste business are likely to "significantly exceed" the £160m already put aside, with some analysts pencilling in an extra £30m. Interserve, which has gross revenues of £3.7bn and a workforce of circa 80,000 worldwide, is now scaling back its activities to get back on track.
The current bounce has partly been driven by bargain-hunting investors, and partly by Wednesday's news that it has won a place on the Homes and Communities Agency's £8bn 'Delivery Partner Panel 3' four-year framework, which aims to build residential and mixed-use developments on public sector land.
This shows that Interserve is far from dead and gives senior management something to cheer but investors should still approach with extreme caution. This looks more like a reflex recovery after a share price has fallen too far, than the start of a sustained rally.
Although it isn't hard to see why investors might be tempted to rush in. The business currently trades at just 1.8 times earnings, a low I have rarely seen. Earnings per share are forecast to drop 25% in full-year 2017, but they are expected to rise 9% in 2018.
New chief executive Debbie White has to sort out the company's debts and make sure it really does operate within its banking covenants for the rest of the year, as promised. She needs to clean up the Energy from Waste deal, and as senior analyst Tom Selby at AJ Bell recently demanded, she must improve transparency and clean up the accounts. His view was withering: "Interserve needs to end the slew of exceptional charges that are not exceptional, stop restating the numbers and use language which people can actually understand." Would you invest in a company like that?
What we are seeing today is a dead cat bounce. If White does her job then Interserve should bare its claws again, but investors should brace themselves for more volatility first.
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Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.