Having begun primarily as a construction and equipment services company, the business has gradually transitioned to focus on support services in recent years and this division now accounts for roughly 64% of operating profit.
Of late, Interserve has fallen out of favour with investors due to concerns over its exposure to the Middle East, where decreasing oil revenues seems likely to put pressure on spending budgets and the construction industry. In addition to this, management credibility has come into question following a £70m exceptional provision made on a mispriced construction contract in the UK.
Despite this setback, management continue to focus on the transition towards what is now the core part of the business – UK support services. Drivers of this division seem favourable as more customers want to specialise in their core activities and outsource the likes of cleaning and security in order to reduce costs. With contracts lasting multiple years the business also enjoys relatively good earnings visibility. Furthermore, management have announced a strategic review of the equipment services division, which designs, builds, sells and hires specialist scaffolding equipment for major infrastructure projects. This seems likely to result in its sale and would allow management to simultaneously reduce their Middle East exposure whilst raising funds for reinvestment into the UK support services division.
Investors must consider whether the depressed valuation offers a good entry point into a business that is becoming ever more focussed on UK support services. If this transition can be successfully managed then the shares should earn a significant re-rating from their current valuation. However, investors cannot ignore the potential for deterioration in the Middle East and/or the risk of other contracts becoming unprofitable.
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