Interactive Investor

Stockwatch: this share is a buy for its recovery prospects

12th August 2022 09:53

Edmond Jackson from interactive investor

Companies analyst Edmond Jackson examines the investment case for an energy services stock that’s seen its share price yo-yo over the past year.  

Exemplifying how early signs of recession can affect even modestly priced stocks, it is pertinent to review the investment case for Petrofac (LSE:PFC), a £600 million energy services group.  

This stock has been particularly volatile in the last year or so; I believe mainly due to shifting sentiment towards commodities as expectations also change regarding interest rates and inflation.  

Yet its latest interims are a mixed bag, with several elements of wider relevance. 

A stock struggling to break out of its range  

Despite the consensus of industry analysts reckoning on 180p as fair price target, each time Petrofac has made a spirited rally, it has so far slumped back. 

I originally drew attention as a “buy” at 109p last January, with the rationale of a reformed company after historic bribery allegations brought in the Serious Fraud Office. The stock duly reached 180p that October then slumped to 105p – I believe, due to the shock factor in financial markets, how interest rates would need to jack up. 

It then rallied near 150p last May, possibly helped by the Ukraine crisis sending oil and gas prices higher, in turn potentially boosting industry activity. On consideration of the 2021 annual results, I updated at 140p with a near-term “hold” stance, retaining “buy” on a two-year view. 

I concede, the last two years shows a sideways consolidation, and a chartist might say that there is no evidence of breakout to justify “buy”.

Numbers affirm sceptics, bulls can take heart from the narrative 

The first figure I default to, is “backlog”, effectively work-in-progress for a major industrial services group such as this.  

Highlights simply cite $3.7 billion (£3.0 billion), while an 8% drop over the first-half year is buried further down the release.  

Yet management contends that “a significant increase in bidding activity has put us firmly on the path to grow backlog over the full year”. 

Meanwhile, new order intake is cited at $1.1 billion with no comparative supplied; although the 2021 annual results last March cited $1.2 billion.  

Much therefore depends on trusting management’s pitch: how there is an overall strong commodity price environment with increased focus on energy security. In addition, whether work done over the last 18 months puts Petrofac in a strong competitive position. 

As yet, however, no director or senior manager has bought shares at this relatively low level after publication of the results freed the bosses to trade.   

Also creating uncertainty is consensus for a minor net loss this year.

Earnings per share (EPS) near 11 cents or 8.7p in 2023 implies a forward price-to-earnings ratio (PE) just over 13x – arguably fair enough, while group finances are yet to prove strong enough to resume dividends. 

Performance has diverged between two main sides of the group  

While asset solutions and integrated energy services – representing 46% of interim revenue – show good momentum, it has been offset by challenges on the main engineering and construction side. 

These involve “lingering effects of the pandemic including some relatively unfavourable commercial settlements with clients”.  

Might this reflect a new normal generally: where everyone is under the cosh as recession grips; hence business relations get strained and payment delays creep in? 

In which case, a tale of two sides could persist beyond this first-half year. 

A $77 million operating profit achieved by the first two divisions was thus nearly wiped out by a $44 million loss for engineering and construction (which had achieved a $21 million like-for-like profit).  

Modest exceptional items – asset impairments and software costs, offset by fair value gains on asset disposals – have tempered the group net loss to $14 million.   

The firm emphasises the need for contract awards on the engineering and construction side in months ahead, where management proclaims a high level of bidding ahead.  

This could create a modest inflection point for the stock versus uncertain sentiment currently, and hence establish some up-trend. 

I suspect short-sellers reckon on – or are using Petrofac as a hedge against – a scenario where recession plus currently high energy prices hit demand – such that industry projects are thrown into some confusion and delays creep in. Brent oil is down from $128 early last March and $123 last June, to around $97 currently, although gas prices remain massively elevated due to Russia. 

There are two hedge funds short of the stock, over the 0.5% disclosure level: Systematica Investments, which raised its short 0.1% to 0.8% as of 14 July. The other, GLG Partners, trimmed its own 0.03% to 0.79% on 3 August. 

You therefore take a view on the macro scenario, where I think yes, Petrofac currently merits attention – re-iterating “buy” for recovery prospects on its main engineering and construction side. 

I presently think this outweighs downside risks, but such is the state of uncertainty (to borrow a quote from economist Paul Samuelson) that “as the facts change” one may have to change one's mind. 

Petrofac - financial summary
Year end 31 Dec

 2015201620172018201920202021
Turnover - $ million6,8447,8736,3955,8295,5304,0813,057
Operating margin - %-3.72.41.62.74.0-3.9-4.3
Operating profit - $m-252186104159220-160-130
Net profit - $m-3491.0-2964.073.0-192-195
Return on capital - %-6.95.84.07.910.8-19.2-8.0
Reported EPS - cents-990.3-8.217.820.5-54.8-53.9
Normalised EPS - c-60.581.011912357.2-1.7-24.3
Operating cash flow/share - c18918211913566.7-8.6-44.5
Capital expenditure/share - c47.846.233.127.328.313.114.6
Free cash flow/share - c14113686.210838.4-21.7-59.1
Dividend/share - c63.260.512.235.50.00.00.0
Earnings cover - x-1.60.0-0.70.50.00.00.0
Cash - $m1,5591,1679677261,025684620
Net debt - $m1,1011,2131,159361423429395
Net assets/share - c34230525820217111291.4

Source: histroric company REFS and company accounts

Less attractive recent cash flow and debt dynamics 

This probably has also not helped stock buyers prevail in response to interims. 

A $193 million free cash outflow relates to lower profit, a working capital outflow - due to delays in commercial settlements - and a $104 million court penalty. The SFO inquiry into bribery is now history and, for example, the United Arab Emirates has lifted a suspension on bidding. Yet financial delays may be a portent of what is to come. 

Together with a 137% rise in net debt to $341 million at end-June – which is expected to remain similar come the year end – it implies a rise in the financial risk profile, although management expects to remain within banking covenants. 

Perhaps the test here is whether the board feels confident enough by March of next year, to declare some reinstatement of a dividend; although end-June cash had declined 31% to $430 million over six months and Petrofac will need to retain a cash buffer to satisfy contractors. Management proclaims that it has $511 million overall liquidity, if down 28% also. 

I would not bet on that, yet barring a serious recession would target it say in a year’s time. 

Economic uncertainty means Petrofac is chiefly for risk-tolerant investors; but I like how the SFO episode spurred key management changes and a thorough overhaul. It is a leading global energy services group, and transition towards offshore wind and hydrogen is underlined by a medium-term target for at least a quarter of group revenue from green energy. Buy. 

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

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