Does news of setbacks mean that energy service stocks are no longer a buy? Analyst Edmond Jackson assesses the circumstances and a battle between acquisitive directors and short-sellers.
Despite stabilising after a Serious Fraud Office investigation, with top management replaced, the chart for Petrofac (LSE:PFC), a circa £350 million oil and (increasingly) green energy services stock, has plunged as low as 65p from 125p only a month or so ago.
Recalling the context
Until last Tuesday, there had not been a trading update since the August interims showed near break-even at the operating level on underlying revenue down 23% to $1,228 million (£1,008 million). A $14 million overall net loss was struck, and the backlog (or work-in-progress) had eased from $4.0 billion to $3.7 billion over the six months to end-June.
A $193 million free cash outflow (hence no interim dividend payout) meant net debt had soared from $144 million to $341 million over the period. But Petrofac was in compliance with its banking covenants at end-June and had $511 million liquidity to give clients confidence on project delivery.
Management blamed Covid-related industry challenges for the numbers, with things looking up. It said: “The market outlook for Engineering and Construction continues to improve and we are optimistic that the opportunities we are bidding on will start to be awarded in the second half of the year. E&C has a $45 billion, 18-month pipeline of opportunities...”
Petrofac - financial summary
Year end 31 Dec
|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
Sudden news of CEO departure prompted short-selling
On 22 November, it was announced the CEO of just two years will leave at the end of March 2023 “to pursue other interests”. His successor, who joins from McDermott International, a global provider of engineering and construction solutions to the energy industry, said he looks forward to “building on the excellent progress,” and the departing CEO added: “After an intense period, Petrofac is today in a stronger position.”
In terms of validity of watching short-seller data, four institutional traders proceeded to raise their disclosed short positions (over 0.5% of Petrofac’s issued share capital) The total disclosed extent rose from 1.7% on 22 November to 4.5% as of 19 December.
On 25 November, Schroders also reduced its stake from 14.7% to 9.5% but this involved a sale chiefly to Azvalor Asset Management of Spain, which doubled its holding to 10.0%.
Update reveals $100 million group loss for 2022
In last Tuesday’s trading update, a circa $190 million operating loss on the E&C side was said to be mitigated to around $100 million at the group level: “reflecting adverse commercial settlements, further unrecovered cost over-runs in the legacy portfolio and cost increases on the Thai Oil Clean Fuel joint venture project.”
It compares with prior market consensus for a $7 million net loss.
Management maintains: “a positive outlook for the recovery in E&C and continued growth in Asset Solutions, with $68 billion scheduled for award in the next 18 months.”
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Net debt was $396 million at 15 December, with cash management partly offsetting delays in E&C contract awards and unrecovered cost over-runs in the E&C legacy portfolio during the second half.
The stock swiftly fell 10% to 65p as interpretations weighed negatively, yet maintained that level. Petrofac carries substantial debt for its size and will need to refinance it next October at what must be higher interest rates. In a worse-case scenario, bankers could insist on a capital restructure – i.e. a dilutive equity-raising while the stock is at record lows. There are already over 521 million shares issued.
Three insiders buy nearly £900,000 worth of stock at the low
Later Tuesday afternoon, it was disclosed how Petrofac’s founder, chairman and even the out-going CEO had bought a total 1,370,000 shares at around the market lows, helping the price sustain a recovery to about 70p.
My respecting much earlier purchases by insiders admittedly did not result in a secure medium-term investment. I rated Petrofac “buy” at 109p in June 2021, which worked well given a rally over 170p that October, but volatile-sideways trading persisted until the drop from 125p a month or so ago.
It is unclear quite whether company-specific factors are to blame or the real problem is inherent risk of cyclical industries at the early stage of economic downturn.
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Yet energy markets appeared to be recovering from Covid disruption, war in Ukraine propped prices, and demand for green energy services had appeared a firm industry context.
The sector is not immune to current industrial unrest: what was not in Tuesday’s update was a two-day strike a month ago, led by the Unite union, which argued Petrofac has not delivered on reviewing a 10% pay cut for staff in 2020.
Prospects appear to hinge on whether a global recession ensues, making it harder even for a capable new CEO. Aggressive insider buying versus a determined posse of short-sellers shows the scope for radically diverging views. I retain a “buy” stance around 70p currently, but know your risk appetite here.
A read-across to John Wood Group
Shares in John Wood Group (LSE:WG.), a circa £870 million servicer, initially fell in sympathy from 126p to 122p, but recovered through Tuesday to close at 128p and have risen further to 132p. It still continues a downturn from 160p in late November.
I have similarly advocated Wood equity, where last October I noted five directors had bought £315,355 worth of shares since August’s interim results – in particular, a relatively new CEO snapping up £234,600 worth at 138p.
I thought that at 115p Wood merited a “buy” stance, as one to consider averaging into.
The consensus has been more bullish than for Petrofac: Wood expected to make $118 million net profit in 2022 hence a rebound in earnings per share (EPS) to 9.6p equivalent and 13.3p in 2023 – for a price/earnings (PE) multiple of 12.9x, easing to 9.3x. If a 5.2p equivalent dividend per share is paid in respect of 2023, the yield would be 4.2%.
John Wood Group - financial summary
Year end 31 Dec
|Turnover - $ million||5,001||4,121||5,394||10,014||9,890||7,564||6,426|
|Operating margin - %||3.2||2.2||0.5||1.7||3.1||-0.4||0.5|
|Operating profit - $m||159||89.4||27.9||165||303||-32.9||32.3|
|Net profit - $m||79.0||27.8||-32.4||-8.9||72.0||-229||-139|
|Return on capital - %||5.0||3.0||0.3||2.1||4.1||0.5||-0.1|
|Reported EPS - cents||17.3||7.3||-7.4||-1.3||10.5||-34.1||-20.6|
|Normalised EPS - c||67.5||51.3||38.7||28.7||22.2||-0.3||1.1|
|Operating cash flow/share - c||123||49.5||34.2||80.9||96.4||45.1||-8.8|
|Capital expenditure/share - c||21.8||22.7||18.0||13.8||21.3||13.1||17.0|
|Free cash flow/share - c||101||26.8||16.2||67.1||75.0||31.9||-25.8|
|Ordinary dividend/share - c||30.3||10.8||34.0||34.5||0.0||0.0||0.0|
|Covered by earnings - x||0.6||0.7||-0.2||0.0||0.0||0.0||0.0|
|Cash - $m||851||580||1,257||1,353||1,857||585||491|
|Net debt - $m||320||349||1,641||1,559||2,052||1,568||1,855|
|Net assets/share - c||633||576||732||674||645||606||590|
Source: historic company REFS and company accounts
On 29 November, management held a capital markets day to explain its refreshed strategy, taking “a more focused approach to growth, targeting specific priority markets across energy and materials that best match our competitive strengths. This tighter focus will help ensure we can grow both profitably and sustainably.”
You could say management should be doing that anyway.
They proclaim the group is “transformed...well-positioned for growth” – serving oil & gas and chemicals, also hydrogen and carbon capture, minerals and life sciences.
Yet not unlike Petrofac, operating margins will be flat in the near term due to investment to secure growth.
“In the medium term, we see opportunity for some margin improvement” leading to single-digit operating profit growth. Mind, Wood’s specific reference is to “adjusted EBITDA” which is near operating profit – but at low single-digit percent growth, could mean (near) flat profit or worse.
Combined with reducing legacy liabilities, a return to positive free cash flow is entertained from 2024 onwards.
It seems wise to take such projections with a pinch of salt, given rising risks of a global recession.
At some risk of being tactically premature with an industrial cyclical, I maintain: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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