Stockwatch: A bear squeeze on London's most shorted stock?

by Edmond Jackson from interactive investor |

A near-8% dividend yield and scope for macroeconomic context to improve make this stock worth studying. 

Thursday's 7% rise to 380p for shares of John Wood Group (LSE:WG) is notable. Wood, a venerated old name providing engineering and support services to the oil, gas and power generation industries, has contemporary distinction for 11.2% of its stock now out on loan.  That's more even than Thomas Cook Group prior to its demise!

Within a list of the world's leading hedge funds betting against Wood, a majority have lately upped their stakes. Surely after the hedgies were proven right on Carillion it must be madness to contest them?

Another weak, over-indebted support services group?

I suspect short-sellers regard Wood as another of a kind they've profited from in the past. If the global economy slows under a US/China trade war, Brexit and a sluggish EU, Wood's debt-fuelled takeover of Amey Foster Wheeler in 2017 could prove the classic "deal too far" – support service type groups have a history of indulgence.  Wood's equity market cap is £2.6 billion while its enterprise value is typically quoted at £4.5 billion, implying a business bloated on debt.

But unless auditors have been duped to make a Patisserie Holdings (LSE:CAKE) style, false assessment of cash, there's a substantial buffer here. A positive trading update (in a recently tough environment) coincided with a silver lining suddenly for trade talks.  

Source: TradingView Past performance is not a guide to future performance

We're told that Wood's 2019 operating profit remains "broadly in line with consensus, despite the impact of a slowing macro environment. Financial performance is benefiting from cost reduction... our expectations on cashflow are broadly unchanged." Risks with swallowing this are that "broadly" can mean trending lower overall, and the macro situation can get worse.

Finally, a compromise breakthrough on trade?

But the US and China have reportedly agreed to take down tariffs on a pro rata basis if a trade deal can be agreed. Hard-nosed logic would suggest that, while the Trump administration seeks to be tough on China as part of resetting its relationship, it also knows the futility of prolonging the stand-off, thus creating economic harm in a presidential election year.

A deal would be a major breakthrough for financial confidence both in equities and company investment decisions. Crucially, it would be supportive for oil prices to which demand for the likes of services Wood Group provides, is closely correlated.

Such a development in fundamentals is potent in context of Wood issuing a "steady eddy" update and the stock's technical position of a three-year decline from about 900p – now with a whopping short position.

It doesn't take much to prompt a spike on the upside, and obviously a contrarian needs care not to over-react too positively, lest weak fundamentals prevail and it proves a rally in a bear market.

Yet reasons exist to doubt the hedge funds' conviction, where the 7% price rise suggests it is now sensitive to change – some preferring not to push their luck with the stock down at this level, versus a company reporting "in line". That's my hunch and, as yet, the disclosures don't reflect any short closing on 7 November.

If you wanted to be cute you could spy a double bottom around 334p before the stock has rallied, though it's a snapshot view.

Can the forecasts be trusted here?

Numbers surrounding Wood can be frustrating to interpret and weigh up, given it reports in US dollars (oil and related services' industry convention). However, sterling figures also get bandied about in reports. 

Consensus forecasts I've seen project $313 million (£244 million) net profit in 2019, rising to $367 million in 2020. In sterling terms, and at the current share price of 385p, that implies a 12-month forward price/earnings (PE) of about 8.8 times and helps cover a 36 cent dividend by about 1.5 times for a 7.7% prospective yield. Given $168 million operating profit (before exceptionals) was achieved in the first half of 2019, this scenario looks confident but hardly outlandish.

At interims last August, management said 87% of 2019 revenues were secured, hence given a context also of margin improvement then an overt profit warning seems unlikely. A risk is the latest "broadly" in line remark leading to a shortfall if trade talks hit trouble again and oil prices resume falling. But overall risks surrounding these forecasts are reducing if macro stabilises and at the micro (company) level management continues to cut debt.

A 7.7% yield says the market remains wary of Wood's "progressive" dividend policy, even if the board's sense for this was to raise the interim payout by only 1% at last August's results, and the table shows consolidation around this level in the last three years. It's obviously a useful return to lock into, hence adding to share price upside if other risks reduce.

John Wood Group - financial summary            
year end 31 Dec 2013 2014 2015 2016 2017 2018
             
Turnover ($ million) 5,753 6,574 5,001 4,121 5,394 10,014
Operating margin (%) 6.3 7.6 3.2 2.2 0.5 1.7
Operating profit ($m) 365 497 159 89.4 27.9 165
Net profit ($m) 296 322 79.0 27.8 -32.4 -8.9
IFRS earnings/share ($) 0.70 0.93 0.17 -0.07 -0.01 0.09
Normalised earnings/share ($) 0.77 0.74 0.68 0.51 0.39 0.29
Operating cashflow/share ($) 1.03 1.23 1.23 0.49 0.34 0.81
Capital expenditure/share ($) 0.36 0.29 0.22 0.23 0.18 0.14
Free cashflow/share ($) 0.67 0.93 1.01 0.27 0.16 0.67
Dividend/share ($) 0.22 0.28 0.30 0.11 0.34 0.34
Covered by earnings (x) 3.1 3.3 0.6 0.7 -0.2 0.9
Net debt ($m) 325 327 320 349 1,641 1,559
Net assets per share ($) 6.5 6.8 6.3 5.8 7.3 6.7
             
Source: historic Company REFS and company accounts            

Actions on margin improvement

The table shows miniscule operating margins in recent years versus a ramp-up in debt, i.e. high financial risk for a scenario of global slowdown and falling oil prices. First-half 2019 results did however show the operating margin (before exceptionals) rising from 2.5% to 3.3%, potentially climbing out a three-year trough.

Yesterday's regulatory news service (RNS) announcement also cited "strategic plans to create a higher margin project management, operations and consulting business" and you can hear this capital markets presentation via Wood's website.

Acquiring Amec was promoted by Wood's CEO as "transformational", offering potential for £110 million cost and incremental revenue synergies towards a "less cyclical business with light assets and balanced risk".

But the 2018 outcome was such that, while revenue nearly doubled, extra debt meant the net interest charge rose from 23% to 31% of operating profit, hence the rise in pre-tax profit was tempered to 30%. Net debt had edged down 6% albeit was a hefty $1.55 billion.

Last August's interims then saw revenue slip 2.6%, and the order book a similar 2.3%, while cost-cutting helped saw operating profit (before exceptionals) advance 28%. Interest costs, tax and exceptional charges restricted any bottom line turnaround from a $51.8 million loss to $13.1 million profit; but, in a challenged environment, Wood is standing its ground.

Those results also showed energy markets led international progress in the eastern hemisphere, and environment/infrastructure operations in North America. So, if oil prices are stabilising, the macro context is broadly supportive.

Acquirer's balance sheet albeit a cash buffer

Last June, Wood had $4,349 million net assets supported by $6,365 million goodwill/intangibles, i.e. typical premium to tangible net assets paid making acquisitions.  The debt profile showed near-term debt down 27% to $892 million versus $2,068 million longer-term, although, significantly, there was $1,157 million cash.

The circa $300 million disposal of a nuclear-related business due in the first quarter of 2020 should aid debt reduction, and the CEO says this brings Wood "close to target leverage". My eyebrows are raised if similarly by Tory and Labour promises to ramp up public spending back to 1970's levels – so call me conservative about debt.

Less attractive for medium-term debt reduction and dividend support was an 82% slump in first-half net cash generated from operations to $55.1 million. While investment needs were only $7.8 million net, financing requirements cut cash reserves by $195 million, and the dividend was effectively paid with debt – its cost of $159 aligned with a $148.5 million increase in long-term borrowings. At least the cash buffer supports dividend payments in the near term, even if the macro environment deteriorates.

Whatever the CEO's words, I think investors are likely to see debt reduction as an important yardstick, hence the cashflow statement is also vital to watch. The last wasn't what you want to see but may be a snapshot in time.

For those risk tolerant: buy a test holding

I conclude there's scope for the macroeconomic and industry context to improve if Trump sees necessity to cut a deal with China before the 2020 presidential election heats up.  Financial expectations will at least rise if his Administration does so. This, and continuing "steady eddy" updates from Wood Group, should be enough to prompt an element of buying, especially now this stock is a crowded short trade.

If you accept this analysis, a strategy might be to dip a toe in with a "tester" position and see if the market/events affirm it. Then buy more, or cut if trade talks collapse. It's impossible to assert a conviction view here as the probabilities are a moving feast, but I sense potential to tip positively. Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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