Our companies analyst sees better times ahead for this oil industry services giant, despite the long-term decline of fossil fuels.
What to make of this £565 million oil industry services provider, now it is raising fresh equity capital both to pay a £77 million bribery fine and to cut debt?
Petrofac (LSE:PFC) has re-rated from 109p, where I highlighted it as a “buy” last January, tipping briefly over 180p a month ago in response to a settlement with the Serious Fraud Office that respected a radical overhaul introducing high standards.
Currently it is 135p, following dilution from a circa £200 million share issue negotiated at 115p – probably reflecting a weakened order book that may be due to the bribery hangover, and also to firms holding back from new business despite the rebound in oil and gas prices.
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The stock remains well down on levels around 900p before the Serious Fraud Office first mounted its inquiry in May 2017; it even breached £16 in spring 2012. Yet an element of profit could be deemed artificial if it was obtained by bribery over the 2011 to 2017 period.
Fully valued on a PE basis
At this level the price/earnings (PE) multiple looks to be over 20x, based on expectations for net profit of around £33 million equivalent this year and in 2022. With the share capital enlarged to 520 million, that implies earnings per share (EPS) of around 6.3p. The market is understandably cautious in wanting to see how orders develop.
Yet Petrofac does have an overall strong global reputation for its work, which I think will prevail as industry demand improves. This and a new-broom CEO since last January ought to help net profit recover towards £70 million equivalent in the next three years or so, implying sterling EPS around 13p and enabling the stock to find its way over 200p again.
Upside potential should be greater considering Petrofac’s strong cash flow track record (see table) and dividend-paying capability. Average annual free cash flow per share was over 100 US cents or 74p a share pre-Covid; adjusting for dilution and being cautious, I see scope for recovery to at least 50p. A cash flow multiple below 3x is not going to last: a bidder could even offer a good premium and do well.
Given that a 26p equivalent dividend was paid for 2018 (it’s fair to say that around 45p a share in 2015 and 2016 were exceptional) then a 50% pay-out of 50p a share, free cash flow, implies a prospective yield of 18.5%. I therefore believe the stock has to mean-revert upwards if this scenario becomes realistic.
It is a speculative view, but the potential prize is locking in a substantial annual yield plus scope for the stock to double.
The chief downside risk would appear to be oil price volatility persisting, which checks exploration activity. Yet demand for oil and gas looks set to remain strong, and exploration must respond.
Even if you take the view that oil and gas-related firms will wither in the long run versus green energy sources, Petrofac is already busy helping clients meet emissions targets and other compliance requirements.
24% recent decline in the order book
I expected a stock spike once the SFO inquiry has concluded: past scandals such as Rolls-Royce (LSE:RR.) have shown the market is far more interested in drawing a line under the past than in the scale of any fine, unless particularly onerous.
This enables companies to get back on clients’ approved lists, where new orders have suffered.
When I first looked at Petrofac’s 26 October interims, it was therefore the extent of damage to the “backlog” (order book) which seemed the near-term crux, rather than recent headline figures or a cheery narrative on initiatives.
You have to scroll down a bit to find a 24% like-for-like decrease over six months in the order book, to US$ 3.8 billion (£2.8 billion) as of 30 June. This was explained as low new-order intake in engineering and construction, “as clients continued to defer awards in response to the pandemic and the uncertain historic outlook for oil demand.”
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In reality, an element of the hit must have come from a 15 March update when the United Arab Emirates suspended Petrofac from competing for new awards until further notice. This followed guilty pleas by an ex-employee in relation to the Bribery Act 2010, for contracts awarded in 2013 and 2014.
More positively, the UAE’s national oil company recognised its long-standing relationship with Petrofac and its decision will be reviewed on a periodic basis. In due course, I think UAE will resume full business relations with Petrofac. A crackdown on bribery in various Arab nations was to be expected from the modern ESG culture spreading even there. Petrofac’s being caught red-handed meant genuine damage in these large and attractive markets.
It will be harder to replicate such quality of revenues in emerging markets, given they are often harder to operate in. Yet all countries may come to respect Petrofac’s new “best-in-class” approach - both traditional oil and gas markets and those with an accelerated focus on new energies such as offshore wind, carbon capture/storage, waste-to-fuel/energy or hydrogen.
Petrofac - financial summary
Year ended 31 Dec
|Turnover - $ million||6,844||7,873||6,395||5,829||5,530||4,081|
|Operating margin - %||-3.7||2.4||1.6||2.7||4.0||-3.6|
|Operating profit - $m||-252||186||104||159||220||-148|
|Net profit - $m||-349||1.0||-29||64.0||73.0||-180|
|Return on capital - %||-6.9||5.8||4.0||7.9||10.7||-17.1|
|Reported EPS - cents||-99||0.3||-8.2||17.8||20.5||-51.3|
|Normalised EPS - c||-60.5||81.0||119||123||57.2||-4.0|
|Operating cash flow/share - c||189||182||119||135||66.7||-4.6|
|Capital expenditure/share - c||47.8||46.2||33.1||27.3||28.3||17.1|
|Free cash flow/share - c||141||136||86.2||108||38.4||-21.7|
|Dividend/share - c||63.2||60.5||12.2||35.5||0.0||0.0|
|Earnings cover - x||-1.6||0.0||-0.7||0.5||0.0||0.0|
|Cash - $m||1,559||1,167||967||726||1,025||684|
|Net debt - $m||1,101||1,213||1,159||361||423||429|
|Net assets/share - c||342||305||258||202||176||120|
Source: historic company REFS and company accounts
CEO buys £250,000 shares in the placing
Existing holders were offered shares at 115p on the basis of one for every four held, which limited dilution to about 17% instead of 34% for those not participating. It was therefore frustrating for them to see the CEO, who held no shares, able to buy in via the placing; however, at least he now has skin in the game.
Besides paying the SFO fine, the cash will be used to bring net debt down to $172 million, helping to extend the maturity of other financing arrangements and in due course enabling resumption of dividends.
By way of response, ratings agency Fitch has slightly raised its rating on Petrofac’s debt within overall “B” ratings.
Recent weeks have shown contracts vigour
Current momentum appears to vindicate the new CEO’s approach on quality. In September, a contract worth over $100 million was agreed with the Libyan national oil company for well pads, flow lines and a pipeline.
In October, a strategic partnership with Gazprom was struck across engineering, procurement and construction – the EPC side – both in Russia and abroad. Petrofac “aims to build its credentials as a Russian EPC champion” across the supply chain.
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And in Lithuania, the company has signed a $640 million EPC contract for a refinery, working towards cleaner fuels and improving the plant’s carbon efficiency. With completion due by end-2024, it reflects the potential for “green” demand to bolster, not diminish, oil industry services work.
Then only yesterday (8 November), a $96 million contract was declared with Petronas, the Malaysian state oil company, although it seems like extending a relationship that has existed since 2004. Some such announcements may be part of a current PR agenda to show Petrofac is “back to business”, but do not constitute extra revenue.
Dividend valuation is the key to upside potential
Judge for yourself, but I recognise decent scope currently to lock in a double-digit yield in a few years’ time, as cash flow rebuilds to pay down debt and restore payouts. In which case, the stock will also rise to price such a yield more appropriately for its risks, assuming there is not another plunge in energy prices. If you agree: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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