Stockwatch: Recovery upside available at this mid-cap

by Edmond Jackson from interactive investor |

It's run into trouble, but bad news is already priced in which makes this stock a speculative buy.

Should enterprising investors engage "bribery scandal" stocks, or apply the bargepole?

International contracts in resources, engineering and construction industries have long attracted suspicion that up-front payments may be involved to key officials in developing countries. Indeed, the culture of "baksheesh" is well-established in Asia and the Middle East.

Yet globalisation has driven increasing demand for consistent standards of ethical behaviour.  For example, when Saudi Arabia was exposed by the Khashoggi murder, big business engaged a boycott. The situation as regards bribery still seems mixed and murky, albeit with signs that some countries at least recognise what's internationally acceptable in the 21st century.

Over 50% gain from Rolls-Royce

Past experience has shown it can pay buying into companies caught up in bribery scandals, a company's stock over-reacting negatively to the news. Early in 2017, for example, FTSE 100-listed Rolls-Royce (LSE:RR.) paid £671 million to the Serious Fraud Office (SFO) and US authorities, for bribery cases chiefly in Asia going back nearly 25 years.

Its stock had appeared to fall leading up to this, but after confirmation of the payment it then rose over 50% in six months from 640p to 980p – it had traded a 1,050p to 500p range during 2015.

So, when mid-cap Petrofac (LSE:PFC) oil service shares were hit from 950p to 350p in April 2017, on news of a Serious Fraud Office inquiry into bribery, I favoured the stock as a 'recovery buy' from around 400p (off its temporary low of 350p).  

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

The allegations were not exclusive to Petrofac, they involved plenty more companies using Unaoil, a Monaco-based consultancy, including FTSE 100-listed Wood Group (LSE:WG.) which was investigated for nearly a year in relation to its Unaoil dealings.

Another dilemma is the SFO moving at glacial speed to any conclusion, where investors' mentality de-gears and a majority assumes the issue is past – so the stock "climbs a wall of fear" while a minority wonder if the air is truly cleared.

65% rise also in Petrofac over 2017/2018

Petrofac shares rose 65% from 400p to over 660p by autumn 2018, the award of contracts seemingly unaffected by the SFO inquiry. Then the stock plunged with the wider market to about 500p in late 2018, although it was possibly treated more harshly amid "risk-off" sentiment.

Admittedly, dividends were de-rated from 2017 albeit in response to lower oil prices then, not just the prospect of a lengthy SFO investigation. Demand for oil industry services can be highly sensitive to changes in oil prices, but this year crude oil has rallied as OPEC appeared to maintain better output discipline.

That helped Petrofac rally to 560p, where its prospective yield was still over 5%, covered at least twice by forecast earnings and likely more by cash flow.

Petrofac's strong cash flow profile is why I've also suggested that, if contract wins are not significantly damaged by the bribery affair - but the stock market stubbornly refuses to revalue the group back in a 600p to 1000p range - Petrofac could be acquired by private equity. The idea being to back the current (founder) chief executive with a view eventually to selling it on for a tidy sum, in the medium term.

The CEO certainly believes in value around current levels, having bought 105,750 shares at 470p late March, taking his stake to near 19%.

Petrofac - financial summary             Estimates
year ended 31 Dec 2013 2014 2015 2016 2017 2018 2019
               
Turnover (£ million) 4,065 3,798 5,271 6,063 4,925 4,489  
IFRS3 pre-tax profit (£m) 507 104 -258 77.0 34.7 82.4  
Normalised pre-tax profit (£m) 509 187 15.4 104 431 357 265
Operating margin (%) 12.6 5.9 1.5 6.5 8.8 8.8  
IFRS3 earnings/share (p) 121 21.2 -79.1 0.2 -6.7 14.4  
Normalised earnings/share (p) 122 45.2 2.0 71.9 77.7 78.6 62.2
Price/earnings multiple (x)           6.2 7.8
Cash flow/share (p) -13.3 124 131 149 64.6    
Capex/share (p) 101 105 35.4 35.1 33.1    
Dividend per share (p) 42.5 39.7 43.5 51.7 29.3 29.3 29.2
Dividend yield (%)           6.0 6.0
Covered by earnings (x) 3.0 1.1 0.1 0.2 2.7 2.7 2.1
Net tangible assets per share (p) 264 290 205 213 220 259  
               
Source: Company REFS              

Rationale now tested by Iraq's apparent decision

Last Thursday it was reported in the specialist Iraq Oil Report that Baghdad's oil ministry has ended negotiations with Petrofac over a major gas project on grounds of the bribery scandal.

This hasn't yet been clarified by a Regulatory News Service announcement from Petrofac, though if "fake news" the company would likely have been quick to dismiss it. The stock fell 5% over the day, recovering towards the end, possibly with day trading "shorts" closing, and opened this week after Easter – up 4% around 485p.

For what intelligence, institutional holdings may reflect, the last RNS was 5 April with Blackrock increasing its stake over 5%. 

The potential game-changer for equity risk is whether this apparent decision spreads in the Middle East, i.e. the market’s initial caution in 2017 was correct and it has just taken longer to manifest with regard to fundamentals.  

Petrofac's involvement in Iraq constitutes about $500 million (£385 million) in context of a $9.7 billion "backlog" meaning work in progress. Analysts at the broker Jefferies estimate the group has been awarded $24 billion worth of contracts in the Middle East over 2010 to 2018: principally Kuwait ($8.5 billion) and Oman (£6.8 billion) followed by UAE and Saudi Arabia each with just over $3.0 billion. 

Iraq is small in context at $1.7 billion contracts awarded during this eight-year period, but its apparent decision to shun Petrofac begs the question if others might follow.

If the market was truly worried about Iraq's apparent decision spreading, the stock would likely be priced (lower) for more than a 6% yield like presently, though with no official company news, a majority of shareholders may not be aware of Iraq.

Stock will likely be sensitive to the backlog trend

Prelims to end-2018 had cited new order intake of $5 billion in context of a $9.6 billion backlog at end-2018 – if down 7.8% on the end-2017 backlog of £10.2 billion. Backlog can vary for reasons such as contracts timing, but the market is likely to watch its trend more intently – also new order intake, obviously – lest Iraq's decision is a harbinger.

In fairness, on 13 March a $1 billion contract in Algeria was announced "where we have been operating successfully for more than 20 years, with a strong record for project execution and the development of local capability."

Thus my 'speculative buy' stances on Petrofac are being tested – also at 465p last December, on a 6%-plus yield, on the basis an OPEC output deal would beget more contract awards.

Overall, I think a tactic of buying drops still applies, but I should acknowledge risk has leapt in the short term given this is a group chiefly focused on the Middle East. Petrofac can’t afford for others to follow Iraq's apparent example.

Otherwise corporate financials have looked strong

End-2017 net debt of $612 million had become $90 million net cash at end-2018, principally due to $506 million net divestment proceeds but also improved working capital inflows and lower capital expenditure.

I've extensively modified the Company REFS table partly because some key figures don't tally with my reading of the financial statements, especially the group's underlying operating margin which REFS quotes as around 2% - as if the typical contractor vulnerable to revenue changes – but in terms of business performance profits is in high single digits.

You can question exceptional items bringing down IFRS3 reported profits, but private equity and other potential acquirers are likely to see through to a normalised margin. 

Will clients see the issues as historic?

Admittedly, some revelations haven't been good. Last February, Petrofac's co-founder (who died two years ago) was posthumously accused by the SFO of taking part in a scheme to pay multi-million-dollar bribes to secure contracts, when charges were laid before a court against another former Petrofac boss.  

In a 7 February "board update" RNS, Petrofac said a former employee had admitted bribery but that no charges have been brought against any group company or any other officers or employees.

March also saw strikes involving North Sea workers, both for Petrofac and Aker Solutions, after a move from two weeks off, three weeks on pattern, to 3:3 and 3:4, generated protests but appeared to result in capitulation.

'Speculative buy' stance remains

Despite a wobble over Iraq and the ever-present risk that Middle Eastern countries – specifically government agencies – may be adopting a cleaner line, I wouldn't lose sight of how Petrofac remains priced broadly to take a big SFO fine on the chin.

That implies recovery upside over the longer term. A more pertinent medium-term risk perhaps, is the global economic cycle rolling over.  Speculative buy.

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

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