Stockwatch: This stock is fundamentally cheap

At around 460p, the FTSE 250 (MCX) shares of oil & gas engineering and construction services group Petrofac (PFC) remain under a cloud as a Serious Fraud Office (SFO) investigation continues, mainly into the Unaoil bribery scandal. Yet this has not been enough to seriously damage winning/renewing contracts, as was feared when this news broke last May.

A pre-close trading update for the year to end-December 2017 cites trading in line with expectations, with a recovery in new order intake during 2017 securing $5.2 billion (£3.9 billion) of new orders.

“Tendering activity remains high, we continue to maintain our bidding discipline in competitive markets and we have a healthy order backlog,” the company said, adding that former Anglo American (AAL) finance director René Médori will replace longstanding chairman Rijnhard van Tets next year.

I’d drawn attention last May at 650p, making clear a bearish scenario if the chief executive ended up tarnished, yet the stock was worth following lest business was not badly affected.

So, in light of a “business as usual” narrative six months later, it’s worth re-appraising Petrofac. If its boss does subsequently lose public credibility, then the group is exposed as a bid target, especially for dollar-based oil (service) groups able to exploit sterling’s relative weakness.

Downgraded forecasts yet intrinsically cheap

Mind that during September to November analysts did downgrade forecasts significantly, which at first sight looks as if the company has guided down expectations then asserted “in line.”

I’m comparing the consensus forecasts in Company REFS I used last May, with what’s published there now: 2017 pre-tax profit is down by 18.4%, earnings per share (eps) by 12.6% and the dividend by 28.2%. The 2018 outlook was clipped respectively by 7.1%, 9.0% and 42.1%.

In the published information there was a subtle warning in the 30 August interims’ outlook statement: “Group net profit for the full year 2017 is expected to be weighted to the second half of the year” which cynics – or realists – of guidance may interpret as a soft profit warning.

Otherwise the statement cited $2.7 billion of new orders and the narrative was as now: “tendering remains high, healthy order backlog” etc.

There was nothing in public releases to suggest why two brokers downgraded in September and another two in early November, according to REFS.

In both months, ‘buy’ or ‘hold’ stances were involved, with which I concur given a 12-month forward price/earnings (PE) multiple of 7.4 times and a prospective yield 6.4% covered at least twice by earnings – possibly a lot more by cash flow, given the strong record of cash flow relative to earnings (see table).

Admittedly, capex demands have varied, being strong in 2012 to 2014 then only a third of those annual amounts. But if Petrofac only roughly meets recent forecasts, it would still be ahead of 2014 to 2016 annual outcomes.

Net tangible assets per share were 96.1p per share as of last June. I disagree with the REFS’ table figures stating e.g. 63.9p, having subtracted goodwill/intangibles and converted dollar to pound values.

An autumnal lull in contract awards?

On 5 September, Petrofac was awarded a €340 million with global energy group Gazprom for the development of onshore pipelines and a gas receiving terminal in Turkey; then a day later a $700 million contract for engineering, construction and site services on Sakhalin, Russia’s largest island.

The company then did not see fit to disclose further contracts until 12 December: an $800 million contract with BP (BP.) for a gas processing facility in Oman, which followed an initial $1.4 billion contract in early 2014, i.e. operations were underway, hence the relationship being less likely to be broken by the SFO investigation alone. BP’s upstream chief executive said it’s one that has “delivered”. Petrofac has been involved with a large number of projects linked to BP, also in Oman.

Industry context looks supportive

Oil prices have crept up to a mid-$60 area, with better output discipline among OPEC members and a robust outlook for the global economy in 2018; also gas prices have strengthened only partly due to two European supply interruption issues.

Oil & gas services companies’ prosperity tends to lag changes in commodity prices as they affect industry activity, although stockmarket expectations soon factor them in.

The Unaoil scandal has affected other oil services groups such as Wood Group, (WG.) although, at 620p, this Mid 250 stock has recovered 11% from a mid-year low.

Wood has not seen fit to declare any suspension/resignation like Petrofac did in May when its chief operating officer stood down. This was interpreted as a compromise measure to address Petrofac’s public credibility without also losing the chief executive, who is the group’s founder (also with an 18.5% shareholding) and seen as vital to top-level client relations.

Ongoing strength in key operations

Looking for clues in the update’s operations review, as to what may have contributed to broker downgrades, it’s possible to deduce it from all three divisions. Manifestly, the smaller Integrated Energy Services side appears responsible, with operating profit guided to the bottom end of a $80-100 million range, while the main Engineering & Construction side (about three-quarters of group revenue/profit) has seen $4.1 billion new orders this year amid a high level of tendering, and the Services side (just under a quarter of revenue/profit) has seen $1.1 billion “awards and extensions”.

To be picky, such numbers don’t inform as to what client attrition may also be involved, to determine net revenues, although the backlog – work in progress – was $10.3 billion at end-November, “reflecting a recovery in new order intake, offset by progress on our existing range of projects”. At the end of 2016 it was $11.7 billion.

This leaves whatever amount of fine, as the explicit financial risk, although the real issue is whether and what extent Petrofac’s founder-chief executive Ayman Asfari ends up tainted by SFO conclusions.

In early September, Asfari was fined €300,000 for allegedly acting on inside information in 2012 by Consob, the Italian financial regulator.

This regulator claimed a previous chief executive of the Saipem oil company had informed Asfari of his resignation before it was announced, and Asfari had bought put options in Saipem shares, proceeding to make a five-fold gain.

He is also banned from any managerial or supervisory roles in Italian listed companies for 12 months; however, this sanction was administered without Asfari being notified of the charges hence able to defend himself, and he denies the allegations.

Petrofac – financial summary           Consensus estimates year ended 31 Dec 2012 2013 2014 2015 2016 2017 2018                 Turnover (£ million) 3,938 4,065 3,798 4,480 5,832     IFRS3 pre-tax profit (£m) 483 507 104 -219 74.1     Normalised pre-tax profit (£m) 469 509 187 -143 104 298 316 Operating margin (%) 11.9 12.6 5.9 -1.9 2.8     IFRS3 earnings/share (p) 116 121 21.2 -67.2 0.2     Normalised earnings/share (p) 112 122 45.2 -44.9 9.1 73.7 60.8 Earnings per share growth (%) 14.3 9.1 -63.0     712 -17.5 Price/earnings multiple (x)         50.5 6.2 7.6 Historic annual average P/E (x)   12.8 9.9 18.4   70.9   Cash flow/share (p) -57.5 -13.3 124 131 149     Capex/share (p) 105 101 105 35.4 35.1     Dividend per share (p) 36.8 42.5 39.7 43.5 46.9 28.2 29.1 Dividend yield (%)         10.2 6.1 6.3 Covered by earnings (x) 3.1 3.0 1.1   0.2 2.6 2.1 Net tangible assets per share (p) 199 264 290 205 217                     Source: Company REFS               Short positions are mixed, but largest is reducing

Those short positions disclosed total 8.04% of the issued share capital; material enough to have depressed the price. Three of six positions have increased, but trading firms with the three largest positions are reducing them.

The behaviour of AQR Capital Management, 3.69% short as of 6 December, is frankly bizarre: they ran this position up to 4.2%, implying a circa £65 million down-bet on Petrofac, now reversing it, on little change in published information throughout. So I would not be distracted by any sense these big traders have better insight.

On fundamentals, risk/reward favours upside

Despite my concerns as to how guidance may have been imparted, when brokers downgraded last autumn, I’d agree this stock is fundamentally cheap.

The Unaoil story loses its impact, the longer Petrofac can assert “business as usual” and oil prices are also helping lift sentiment. Market price is still at least half what it was in May. Buy.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.