Small Cap Value Report (Mon 10 Dec 2018) - IRV, debt

Good morning, it's Paul here.

Markets remain grim. I've been taken aback by the speed & severity of recent falls in many small caps. Market timing isn't my thing, and I take a long-term view. So it's really just business as usual from my point of view, painful though it is.

Interserve (LON:IRV)

Share price: 12.8p (down 48% today)
No. shares: 149.7m
Market cap: £19.2m

Deleveraging plan

This yet another outsourcing group to run into trouble. The share price has been in freefall recently, with a further plunge of 48% today on news of major dilution on the way for shareholders.

Today it says;

Interserve and its lenders are engaged in constructive discussions regarding the agreement and implementation of a deleveraging plan which would deliver a strong balance sheet with Interserve targeting leverage of approximately 1.5x net debt/EBITDA.

These discussions also involve proposals to amend the Group's current financing agreements, including the extension of the maturity dates and repayment profiles of the existing facilities.

What's interesting about that, is that it echos a comment I made in one of last week's SCVRs, that banks are reducing credit in difficult sectors. In the previous few years, banks seemed comfortable with debt up to about 3 times EBITDA. Note above that they are seeking a reduction to only 1.5x EBITDA for Interserve.

Maybe at some point, the banks might realise that using a multiple of EBITDA really isn't very sensible at all. It's the wrong measure. Bank debt surely be based on a measure which accurately shows how it can be paid off - free cashflow would make sense as the starting point.

Here's the dilution coming;

Although the form of the deleveraging plan remains to be finalised, it is likely to involve the conversion of a substantial proportion of the Group's external borrowings into new equity, an element of which may be sold to existing shareholders and potentially other investors.

If implemented in this form, the deleveraging plan could result in material dilution for current Interserve shareholders.

A debt for equity swap usually all but wipes out existing shareholders, but that depends on how brutal the lender wants to be, as they're now calling the shots (debt ranks ahead of equity).

The one glimmer of hope is that existing investors (and potentially others) may be prepared to put in more money. That at least gives them some negotiating power when the pricing of the debt for equity swap is agreed.

Trading update - the group says that it is trading well;

Interserve continues to trade well and in line with its expectations for the year ending 31 December 2018.

My opinion - the writing has been on the wall for Interserve for over a year. My article here in Oct 2017 rang the alarm bells loud & clear, with me cataloguing the disasters that had befallen the company, and ranking it as uninvestable.

Graham updated us here in May 2018, also pointing out the very low StockRank at the time of only 15.

Yet again, the curse of a weak (negative NTAV) balance sheet, and sky-high bank debt, has struck home. 

You would imagine that the Government would require large companies bidding for public sector contracts, to have strong balance sheets. Apparently that thought doesn't seem to have occurred to politicians or civil servants. Which confirms the impression that this country really does seem to be run by muppets.

Investors need to to avoid companies which could face a credit crunch. Therefore, in my view, it makes sense to focus investing mainly in companies which have;

• Sound balance sheets, with little to no debt (I think 1x EBITDA is probably a sensible cut-off point, to reject anything above that)
• Good, and consistent free cashflow
• Good net profit margin, which is evidence of pricing power

If you apply those 3 simple tests, it should eliminate almost all problem companies. I say almost all, because fraud cannot always be detected - as Patisserie Holdings (LON:CAKE) demonstrated.

Above all, this is definitely not a time to be blase about debt. Overly indebted companies today are the emergency rights issues of tomorrow.