Why I would still sell Interserve plc at under 120p

Shares in troubled outsourcing group Interserve (LSE: IRV) fell by 15% when markets opened this morning, after a report in the Financial Times revealed that the government already has a team of officials monitoring the group's financial situation. Ministers are said to be "worried".

Slightly to my surprise, the shares have bounced back since then and are only down by 4% at pixel time. After the collapse of Carillion, I'd have expected investors to be more wary. My review of Interserve's figures suggests that there are some similarities between the two firms.

I'm not here to offer investment advice. But I'd like to explain why I think Interserve shareholders are likely to regret their decision as the year unfolds.

Is this Carillion mk2?

It now seems likely that Carillion may have been using upfront payments from new contract wins to fund some of its obligations on older, unprofitable contracts. This is a bit like being on a treadmill. However fast you run, you can't get ahead.

I'm concerned that a similar situation might apply at Interserve. Since 2013, the group's annual revenue has risen from £2.2bn to almost £3.3bn -- an increase of about 50%. Yet over the same period, its operating profit has fallen from £73.7m to a loss of £17.2m.

The group's net debt has risen from £38.6m at the end of 2013, to £513m at the end of 2017. Management expects borrowing to 'peak' -- a nice way of saying to rise further -- during the first half of 2018.

Interserve is in discussion with its lenders about "longer-term funding arrangements". But these talks have been going on for some time and a deal may prove difficult. I estimate that the group might need to raise £250m-£300m in order to reduce its borrowings to an affordable level.

This figure is well above the group's current market cap of £170m, so raising this much through an issue of new shares could be difficult. And any such fundraising would probably reduce the value of existing Interserve shares to almost nothing.

Interserve could pull through

Perhaps I'm being too pessimistic. Last week's trading update from new chief executive Debbie White seemed reasonably encouraging. 2018 operating profit is now expected to be "ahead of expectations". Cost saving measures launched by Ms White are expected to provide a £15m benefit this year.

The Reading-based firm's lenders have agreed to defer covenant testing of its borrowings until the end of March and have provided interim funding while talks continue. In contrast, Carillion's lenders effectively chose to pull the plug last weekend.

Interserve may survive. But the reality is that even if it does, survival is likely to come at a big cost to shareholders, who rank below the group's lenders and other creditors.

In my opinion, owning its shares at the moment is a dangerous gamble that's likely to end badly. The situation is unpredictable and could change rapidly, as we saw last weekend with Carillion.

Interserve shares have fallen by around 70% over the last year. But they could still have a lot further to fall. If I owned this stock, I'd sell today.

Avoid these costly mistakes

Holding on to troubled stocks isn't always a good idea. Many successful investors say that one of the secrets to their success is knowing when to cut their losses.

Here at the Motley Fool, we want to help you avoid costly mistakes. That's why our top analysts have been persuaded to reveal some of their worst investing errors.

We've put these experiences together into an exclusive report, Worst Mistakes Investors Make. I believe following the advice in this free, no-obligation guide could save you a lot of cash. To download your copy, just click here now.

Roland Head 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.

///>

Advertisement