Stockwatch: Steely patience and steady accumulation required here

Did I make a colossal error, drawing attention to mid-cap oil & gas engineering services group Petrofac (PFC) at 650p on 23 May? Or does a further substantive drop below 350p, currently testing 450p after a latest trading update, indicate the situation stabilising to offer value?

Using published information, I said that a buying case assumed Petrofac's chief executive did not end up tarred by a Serious Fraud Office (SFO) investigation into historic dealings with Unaoil; secondly, that a strong balance sheet with "reducing debt" supported an 8% dividend yield, even if the business slipped amid low oil prices and the investigation.

I also cautioned that with the stock being actively shorted it meant the likelihood of further volatility.

Chief executive arrested, questioned and cautioned

Twists in the story then jolted the market. Having declared on 12 May that an SFO investigation was underway, Petrofac co-operating and both its chief executive and chief operating officer had been questioned, franker detail then emerged.

It appeared the chairman had asserted control, such that a 25 May update clarified both men had been arrested in the process, albeit released without charge. I would still not discard my argument how virtually all examples of regulatory action like this - e.g. Rolls-Royce - see stocks rebound after the initial shock, and while the SFO seems determined to justify its existence nowadays, it has also dropped cases that looked ominous.

Yet the 25 May disclosure made Petrofac's situation more serious: the independent investigation (I had referred to) that found no wrong-doing, had been rejected by the SFO which does not consider the company to have co-operated with it.

This raises the liability of any fine although reports of $800 million (£625 million) are speculative. Suspending the chief operating officer shows the seriousness of it all; that chief executive Ayman Asfari continues in his role underlines my point. He is essential to the business as its founder, holding key client relations. The board has fudged a way forward to maintain Petrofac's very existence.

Trend to higher debt, differs from guidance

One of the details in a latest 27 June update, knocks a prop from my buying case. "Net debt is forecast to be around $1.1 billion at end-June in line with expectations." That doesn't accord with previous information unless Petrofac has given preferred analysts a steer.

The 2016 results, as declared on 22 February, highlighted "net debt down 10% to $617 million reflecting strong cash generation and capex rephrasing." This change undermines the case I made for a "robust" 8% yield at 650p, even though Company REFS show broker projections up to 2 June looking for an annual dividend over 50p per share - excepting SG Securities which has cut to 25.8p in respect both of 2017 and 2018, still implying a supportive yield of about 6% at current share prices.

At 650p, however, I based my view on the end-2016 balance sheet which included £900 million cash and a 52p dividend per share requiring £180 million - i.e. do-able given Petrofac's strong cash flow profile, despite £1,375 million debt at end-2016, 80% of which was long-term.

Implied changes within the net debt profile indeed beg the question whether (say) halving the dividend would be prudent: a substantial cash buffer is needed to tender effectively for contracts, which potential clients may expect to rise given the risk of a substantive SFO fine.

Soft profit warning: 2017 to be "second-half weighted"

A positive aspect of this latest update is new order intake of $1.7 billion during 2017 to date, up from $0.8 million according to last June's update. News earlier this month, of a long-term framework agreement in Oman and a Kuwait training contact, likely prompted short-closing thus helping the stock rebound from about 350p.

Yet, with the SFO bombshell dropping only as of 25 May, it would not have destroyed progress towards such deals: the future is what counts, hence analysts cautiously trimming 2018 forecasts (see table).

Management cites underlying first-half net profit of about £110 million equivalent, versus consensus for £400 million normalised pre-tax profit in 2017, thus a "second half weighted" message.

Mind a risk how talk of being "second half weighted" can seed a genuine profits warning. Given that a falling oil price (as it affects demand for energy services) is the likely culprit, it may persist as confidence in OPEC slips and US shale producers cope with lower prices. On a forward price/earnings (PE) ratio of about 6 times though (unless Petrofac warns formally), the stock prices in plenty of disappointment.

Institutions take long and short exposure

It reflects scope for contrasting views: over the 3% disclosure level, Deutsche Bank has risen over 7% (possibly as custodian for various funds) and Toscafund has 5.2%. Tosca is an established risk-lover, having bought into AIM-listed Quindell during its 2015 crisis. Hopefully, it has learned lessons since it raised exposure to UK housebuilders in 2007.

Meanwhile, AQR Capital Management steadily increases its short position to 3.8% as of 26 June; and also has a 3.9% short in Wood Group which is similarly affected by the Unaoil allegations. AQR runs short positions in 30 other UK-listed stocks, in context of £146 billion assets under management, so may desire short exposure to hedge risk against equities/oil generally, the Unaoil scandal being of additional interest.

Analysts include no outright sellers and most who advocated "buy" at higher prices, re-iterating this. Jeffries, which has been sceptical of Petrofac converting enough of its backlog into genuine revenues before the SFO issue arose, now argues "buy" after the price drop, while Numis has upgraded to "buy" having asserted "underperform" on 2 June, according to Company REFS.

What stance is justified now?

Warren Buffett claims a simple approach to stocks: "be greedy when others are fearful" and vice-versa, on which basis you'd currently be a seller of high-priced growth plays to focus on special situations like Petrofac, and retain a cash cushion.

Yet Buffett restricts his universe to what he can dependably value, which doesn't apply here: market price is certainly low, but the underlying risk/reward profile is mercurial.

This management has bowled at least two googlies, as if things have not been disclosed as they should, thus an amber light. What stance to take significantly involves how much risk you are ready to engage: market price likely discounts a dividend cut, though omitting an interim dividend at the late-August results, deferring what payout decision to the 2017 prelims, would be another jolt.

There's a challenged scenario which involves low oil prices, hence a reduced pay-out, the market pricing for at least a 6% yield given hefty ongoing debt. More positively, if Petrofac can capitalise on "a very good pipeline of bidding opportunities" then the shock of the SFO revelation should continue to abate.

So, I don't think I've blundered on a long view, albeit a hard lesson alighting on a high-yielding stock at the low end of a chart range. With hindsight, I might have waited for it to turn up.

Mind there's no guarantee current support will hold if oil prices continue their drift, a profit warning materialises and the interim dividend is omitted. My long-term stance remains that, unless Petrofac's chief executive is badly compromised by the SFO, the stock is in buying territory. Steely patience and steady accumulation are required.