Contrarian Value Buying Opportunity?

Here is a link to the podcast I mentioned and it is Episode 396 if you are visiting the site at a later date. I added a write up of my notes and some charts below if you prefer the written word.

This is Interserve (IRV) a Mid 250 listed support service stock has a market cap. of around £666m and an Enterprise Value (EV) of £951 including a mid range debt figure of £285m from their Q3 guidance range of £270-300m.

Back in August when they reported interims they flagged a likely £10 to £15m hit in 2016 from the new living wage that is due to be introduced in April 2016. I estimated at the time that this would be could around a 10% hit to profits and indeed we have seem their 2016 estimates fall by nearly that much since then, although this years forecast has been upgraded. However, the shares have since then fallen from around 640p to 450p for a decline of about 30% which is much greater than the market and other stocks in the sector over the same time frame. I suppose given that they have some exposure to the Middle East and oil services I guess the market could be worried about downside there. These fears seem over done to me though as in their Q3 update they said that Middle East construction and equipment rental was strong helping to offset weakness in some UK construction contracts. Aside from that they are also increasing their service offerings in the Middle East to offset weakness in oil related activities.  In their Q3 update they also said they had 60 per cent of 2016 consensus revenues secured.

They also had a future workload of £7.5bn with 87% of that on the service / facilities management side and that represents about 2 years turnover suggesting some visibility / stability to the earnings and probably more so than in the past given the changed business mix. This change is from 65% construction and 35% services to the other way round i.e. 65% services and 35% construction related, post the Initial Service acquisition. Arguably this has improved the quality of the business as operating margins on construction are typically in the 1 to 2% region where as on Services it is more like 4 to 5%. Thus the blended margin should probably have moved up from around 2.5% to 3.5% over the cycle or typically 3 to 4% overall in normal times. So it seem odd that the shares seem to have de-rated on the back of this rather than re-rating. It seem to me that the sell off may have been over done as it has left the shares, at recent lows of 450p, valued at just 7 times earnings with a yield of over 5% which is around 2.5x covered by those earnings.

Looking at other similar business on the construction side you have the likes of Carillion, Costain and Kier which trade on multiples of between 8x and 13x or about 8 to 10x if you exclude Costain. So lets say 9x for the construction part. While on the support service side comparable companies like Capita, MITIE and G4S trade on ratings between about 11x to 15x so again if you said say 13x for the service side and blend those together you could come up with a blended multiple of around 11.5x which could give a target price of 734p, which is not far off the peak they reached in 2014. However that may be a bit ambitious, but even a 10x rating on the current 64p of earnings expected for next year could suggest 640p. While if they can achieve a 4% margin on an EV/ Sales basis I could get to a target of around 600p which is where it was trading as recently as October last year. All of which suggests some potential for some upside from the current levels

What about the downside if we are heading for a global down turn / recession. Well in the previous down turn in 2008/2009 their earnings fell by about 20%, but given the changed nature of the business since then it may be more resilient this time. Nevertheless even if you assume earnings did fall by 20% again, that would still leave them on only 8.8x (close to Ben Graham's zero growth rating) and the dividend would still be around 2x covered suggesting that the 5%+ yield could well be maintained. I also note that they have grown the dividend by 5% per annum over the last 10 years a period which included the 2008/9 downturn.

While on the financial side of things the EV is financed 30% by the debt (£270-£300m mentioned at the start) and 70% by equity. They have interest cover of over 5x according to Stockopedia and fixed charge cover of about 2x and they only have small pension deficit of circa £50m which has recovery plan and contributions in place. So the balance sheet also seems OK to me.

Summary & Conclusion
Not perhaps one of the higher quality business compounder that I normally target, but it seems to me the market has been overly harsh in de-rating this one and that on 7x or so with a 5%+ yield it offers value. However, I don't have a monopoly on wisdom so I could be wrong and it could fall more - so as ever always do your own research. Final results for 2015 are due to be announced on 24th February 2016.