Interactive Investor

Stockwatch: Petrofac shares are volatile but worth owning

Petrofac breaks with its past and is set to benefit from a possible energy infrastructure boom. Here’s why.  

It is notable how Petrofac Ltd (LSE:PFC) has risen sharply from around 105p a month ago and yesterday tested 150p – retreating with the US sell-off to trade currently at around 142p which capitalises the group around £740 million. 

It’s as if the market is finally pricing in improved prospects for the company after a settlement with the Serious Fraud Office last September – which recognised a radical overhaul and departure of anyone involved in past bribery issues in the Middle East. 

Factors behind a 35% rally since early April 

On 1 April, a major decommissioning contract in Australia’s offshore oil & gas industry was announced. The first phase has potential to be worth up to US$236 million (£188 million) or 9% of the $2,633 million consensus revenue expectation for 2022 – i.e. additional to this, if dependent on timing. 

It was followed yesterday by a $200 million decommissioning contract offshore Gulf of Mexico, addressing nine platforms, 200 wells and 32 pipeline segments. The CEO of Petrofac’s asset solutions business said this affirmed industry-leading experience. 

Such contracts affirm the notion of decommissioning amid a shift to green energies. Petrofac’s 2021 results did cite work in carbon capture/storage, hydrogen, waste-to-value and wind, “increasing markedly”.  

Quite likely there has also been ongoing consideration of a 16 March update regarding the United Arab Emirates – which represented around 10% of 2019 revenue of $5,530 million. This restored Petrofac’s ability to bid for new contracts after suspension a year ago following guilty pleas by a former employee in relation to bribery over contract awards in the UAE in 2013 and 2014.  

There had been speculation that the UAE would restore its relationship with Petrofac which had existed since 2008; the suspension was to show the UAE improving its own act to ensure ethical conduct. 

This update cited “upcoming new tenders” and the stock rose from 136p to 142p last Tuesday after a note from Berenberg, a German investment bank, reinforced this message. 

Whether or not there was any discussion with the company, Berenberg expects Petrofac “to be able to re-enter other markets over the coming months”. Stronger commodity prices are likely to boost project awards across the Middle East and Berenberg endorses Petrofac’s guidance for over $4 billion revenue by 2025.  

Relatively low margin albeit decent underlying profit 

The table of recent years performance shows only low single-digit operating margins, such are the bane of contracting. A median 3% would imply $120 million operating profit, where after deducting possibly $40 million (at the top end) for interest charges and $15 million for corporation tax, circa $65 million net profit would deliver sterling earnings per share (EPS) of around 10p. 

More positively, the 2021 results declared a $35 million “business performance” net profit, so long as you could see past a $195 million net loss after impairments and other charges. This compared with around $70 million net profit in 2018/2019 and oil prices have recently risen by 50% which will boost industry activity. 

In a “risk-off” stock market lately, Petrofac flirted again with a 100p price level i.e. 10x forward earnings, although it is sensitive to changes in sentiment. 

Berenberg has upgraded from “hold” to “buy” reflecting belief that the stock is “now emerging into the light” despite trimming its target from 250p to 210p  I drew attention as a “buy” at 109p in January 2021 and it rose to over 180p last October in response to settling with the SFO.  

    Institutions then drove a hard bargain on price for a £200 million share issue at 115p – making it significantly dilutive - £77 million of which was to pay a fine for bribery over 2012 to 2015, and the rest for re-capitalisation. 

    Existing shareholders were able to participate on a one new share for every four held, limiting dilution to around 17% instead of 34% if not participating.   

    The stock fell to 108p in December then recovered above 150p in January, only to slump to an all-time low sub-100p in early March when Russia invaded Ukraine.  

    But higher oil & gas prices look set to consolidate now that Europe is showing collective grist to cease Russian imports. This should provide a more confident environment for oil & gas operators to commit to projects. 

    Even with any “peace settlement” in Ukraine, Russia is not going to be trusted, hence the sanctions, and this new European/US energy policy will stick.   

    So, it is rational how this stock now enjoys positive speculation, even if it is at an early stage to make firm projections.   

    A 20% fall in backlog depressed reaction to 2021 results 

    Annual results on 23 March saw the stock fall from 118p below 112p – subsequently down to 103p – although equities were unsettled at this time given the Ukraine crisis. 

    I recall scrolling through the results to see the “backlog” (equivalent to work-in-progress) down 20% to $4.0 billion at end-2021, “reflecting progress delivered on the existing project portfolio and low new order intake on the engineering and construction side, with contracts delayed in response to Covid”. 

    More positively, new order intake was $1.2 billion, up from $0.7 billion at end-2020, with over 90% of order intake secured in the second half of the year as demand recovered.  

    It could be said that a turning point was therefore established, making the fall in backlog a misnomer, although perception of contractors does tend to hinge on backlog.  

    Petrofac - financial summary
    year end 31 Dec 2015 2016 2017 2018 2019 2020 2021
    Turnover - $ million 6,844 7,873 6,395 5,829 5,530 4,081 3,057
    Operating margin - % -3.7 2.4 1.6 2.7 4.0 -3.9 -4.3
    Operating profit - $m -252 186 104 159 220 -160 -130
    Net profit - $m -349 1.0 -29 64.0 73.0 -192 -195
    Return on capital - % -6.9 5.8 4.0 7.9 10.8 -19.2 -8.0
    Reported EPS - cents -99 0.3 -8.2 17.8 20.5 -54.8 -53.9
    Normalised EPS - c -60.5 81.0 119 123 57.2 -1.7 -24.3
    Operating cash flow/share - c 189 182 119 135 66.7 -8.6 -44.5
    Capital expenditure/share - c 47.8 46.2 33.1 27.3 28.3 13.1 14.6
    Free cash flow/share - c 141 136 86.2 108 38.4 -21.7 -59.1
    Dividend/share - c 63.2 60.5 12.2 35.5 0.0 0.0 0.0
    Earnings cover - x -1.6 0.0 -0.7 0.5 0.0 0.0 0.0
    Cash - $m 1,559 1,167 967 726 1,025 684 620
    Net debt - $m 1,101 1,213 1,159 361 423 429 395
    Net assets/share - c 342 305 258 202 171 112 91.4
    Source: Historic Company REFS and company accounts

    Petrofac’s Russian exposure was just 0.6% of the end-2021 backlog. 

    I would not say the balance sheet is particularly strong, but equally should not compromise recovery. End-2021 net assets were down 18% to $485 million with a 9% decrease in cash to $620 million, although the ratio of current assets to current liabilities was a satisfactory 1.4x.  

    Some $750 million of short-term debt was rescheduled longer-term, although a decrease in other financial liabilities helped an 8% reduction in net debt (see table). Goodwill and intangibles constituted 30% of net assets; and yes, reputation counts in this industry. 

    High PE as the market cottons on to recovery prospects 

    Assuming Petrofac meets consensus for sterling equivalent EPS of 4.4p this year rising to 10.5p next, the forward price/earnings (PE) ratio is 32x, easing to 13.3x – a classic example that when confidence grows, recovery stocks do trade on high PE’s. 

    This makes Berenberg’s point about how “the market may want to see awards before pricing in a recovery”, seem overtaken. 

    I think a near-40% advance in a month also reflects the universe of attractive stocks narrowing as economic prospects put most industrial and consumer plays in question.   

    Petrofac offers exposure to high oil & gas prices, a likely turnaround and probably operational gearing too – hence its appeal to speculators. 

    The see-saw chart also means that on 27 April, GLG Partners reported a 0.51% short position, trying to bet on downside, although the stock has since risen from 131p.  

    A market slump in months ahead would see this volatile stock go lower, but I think it may be establishing a medium-term uptrend and for good reasons. 

    A “hold” rating seems appropriate in the short run but, in the context of a two-year investment view, I retain: Buy.   

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

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