Interactive Investor

Stockwatch: is the writing on the wall for this small-cap?

After a stock slide, analyst Edmond Jackson reviews a firm under pressure ahead of a key update.

12th December 2023 10:53

Edmond Jackson from interactive investor

Mind how an information vacuum is liable to exist around stocks entering a distress period, despite stock exchange rules supposedly requiring clarity over a drop in market price over 20%. 

Last April, for example, I suggested considering a starter position in small-cap energy services group Petrofac Ltd (LSE:PFC). The stock had jumped from a 46p low to 72p after its partnership with Hitachi Energy was awarded a major wind farm project in the Dutch-German North Sea. Revenue to Petrofac was cited at around $1.2 billion (£955.7 million) annually over six years. A new CEO had taken the reins and net tangible assets per share were equivalent to 54p. John Wood Group (LSE:WG.) – a similar company – had received a private equity takeover offer.  

I thought Petrofac might continue to struggle, but if contracts built, then start to average in. Management is attuned to serving green energy, but quite whether oil and gas production will slow anyway as the fiasco over COP28 continues to show.  

My hunch was affirmed by August’s first-half year results showing a 94% leap in the backlog (work in progress) to $6.6 billion (£5.3 billion) with a strong order intake in both key divisions. After resolving historically low-margin contract issues a free cash outflow of $225 million was expected to reverse in the second half and be broadly neutral for the full year. 

Then on 3 October, a $600 million carbon capture contract was awarded near Abu Dhabi as part of the state oil company’s accelerated decarbonisation. 

If trusting to publicly disclosed information, you might not exactly have reasoned that in two months Petrofac equity would look worth next to nothing. 

Why it can pay to follow short-tracker websites 

The situation shows how price-sensitive information has a tendency to leak – negotiations with banks, for example – and hedge funds act on it. 

From 4 October, Petrofac’s issued share capital on loan has rocketed from 1.4% to 9.2%, making it by far the most-shorted stock on the London market. The real per cent is likely to be higher given a 0.5% disclosure threshold. 

Simultaneously, from 4 October, the stock went into a protracted slide from 70p, you might say derived from such concerted short-selling. 

But only after its price hit 17p on Friday 1 December, did a 4 December update reveal the company as financially on the ropes – with a strategic review under way “to protect the interests of shareholders, creditors and employees”.  

Dilemmas are several-fold, including achieving near-term free cash flow, to stay within debt covenants, consequently secure financing in support of new project work, and also be able to re-pay or re-schedule $252 million debt maturing next October. 

Creditors are first in the pecking order, so if you see them mentioned in the same sentence as shareholders, it usually implies the equity at risk of (near) wipeout.  

“The company is also exploring new financial options across all its classes of capital”. The market’s instinctive reaction is: bondholders taking a haircut, shareholders ending up very well shaven.  

Versus August’s guidance for broadly neutral, annual free cash flow, this will now not be met due to delays in securing advance payment guarantees from banks.  

Quite to what extent it reflects their confidence falling in Petrofac, and/or a general tightening of practice if “macro” is weakening. Probably it weighs formerly, given that the banks will also be aware that a $252 million revolving credit facility needs replacing or repaying in October 2024. 

The net short position has continued to rise, with six hedge funds increasing and only two trimming exposure, most likely because they see little alternative beyond a debt-for-equity swap – possibly down in low single-figures’ pence. 

Petrofac - financial summary
Year end 31 Dec

 20152016201720182019202020212022
Turnover - $ million6,8447,8736,3955,8295,5304,0813,0382,591
Operating margin - %-3.72.41.62.74.0-3.9-7.4-9.1
Operating profit - $m-252186104159220-160-224-235
Net profit - $m-3491.0-2964.073.0-192-245-310
Return on capital - %-6.95.84.07.910.8-19.2-28.4-55.8
Reported EPS - cents-990.3-8.217.820.5-54.8-67.7-60.2
Normalised EPS - c-60.581.011912357.2-1.7-25.4-53.8
Operating cash flow/share - c18918211913566.7-8.6-44.5-28.3
Capital expenditure/share - c47.846.233.127.328.313.114.68.9
Free cash flow/share - c14113686.210838.4-21.7-59.1-37.2
Dividend/share - c63.260.512.235.50.00.00.00.0
Earnings cover - x-1.60.0-0.70.50.00.00.00.0
Cash - $m1,5591,1679677261,025684625450
Net debt - $m1,1011,2131,159361423429390559
Net assets/share - c34230525820217111279.524.8

Source: historic company REFS and company accounts

A classic interim financial manager has been hired  

A new director – apparently “non-executive” – with a strong financial background has been appointed for a limited time to drive a financial solution – in what looks clearly a crisis.  

Petrofac may indeed have just had “its most successful period for new awards for many years”, where you might assume clients would have satisfied themselves as to the group’s financial basis to deliver. But “banking appetite in support of performance guarantees has reduced...” 

One interpretation of this is a macro wake-up call; how despite current optimism, interest rates are set to fall, we have yet to see the full effect on industry of rates being high. 

A swift solution is needed otherwise new contracts will stall. The probability of events is bondholders exercising their prerogative and shareholders left with little.  

The sale of non-core assets is being considered, however, a recent credit analysis podcast - mentioning Petrofac in a weekly review - cited a Malaysian oilfield, which is anyway due decommissioning, hence they were sceptical that enough cash could be raised. 

Mention is also made of “active engagement with financial investors to take a non-controlling position in certain other components of the business portfolio”. Possibly that could limit shareholder losses. If the interim financial manager does pull a rabbit or two out of the hat, the short side is now a very crowded trade and an upward squeeze would follow. Some years ago, Home Retail Group was similarly London’s most-shorted share but hedge funds made losses when it became a takeover target. 

But it is hard to ignore how a 65% slump in the value of Petrofac bonds (traded in Frankfurt) says these holders face losses, hence are likely to exact their pound of flesh from shareholders. 

The inescapable fact is determined selling from early October being well informed otherwise Petrofac equity would have rebounded already. 

A sudden concerted rise in short-selling activity is thus reason to worry about any share. Regulators cannot be relied on; if they ever do act it is usually too late. 

Rating under review offers no grounds for complacency 

With 5-15 million shares traded daily since 4 December, yet the price being overall firm around 20p, there is speculative demand given that the data does not indicate much short-closing. 

But analytically it is hard to avoid a dire conclusion for equity value, considering the likely probability of events, hence a “sell” stance. 

Instead, various analysts have adopted “rating under review”, which protects their firm from embarrassment (or even litigation) if maintaining a “buy” stance on what is now a distress situation. Yet it is a cop-out avoiding embarrassment if management unveils an eleventh-hour rescue for shareholders. 

Take care also, then, if you see “rating under review” on a company declaring bad news.  

Meanwhile, in Frankfurt, Petrofac’s 9.75% bond also reflects distress even for what is the “senior” financial instrument here. Since being issued at $99 in September 2021, it has declined to $35 bid, on a huge $6 spread – its biggest drop happening similarly from early October. 

Arguably, that could be the less risky way to get speculative exposure, if a debt-for-equity swap is likely. However, a minimum investment amount of $200,000 makes it a hefty gamble even for those wealthy enough. 

A 20 December trading update is promised to provide further details in relation to maintaining a key debt covenant. If that remains the case and the update can substantiate progress by the “non-executive” interim director, the equity may rise in the near term. Responsibly, as regards the medium term, I should conclude: Sell.

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

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