Stockwatch: 50% upside on a two-year view

As oil prices weaken, should you take profits after Cape's 2017 rally from a three-year chart low, or treat better-than-expected 2016 prelims as heralding long-term upside? 

This FTSE Small-cap provides "critical industrial services" for energy and natural resources, which are multi-disciplinary e.g. access systems, insulation, coatings and fireproofing, environmental services and storage tanks.  

At about 220p, the stock is up 25% since I drew attention last January at 177p when an update cited strong trading across Cape's three business regions during the last two months of 2016, particularly Asia Pacific amid high levels of project activity.  

Reasons for low rating are reducing

If forecasts are realistic the forward price/earnings (PE) multiple is only 7 times and the prospective yield about 3.2%. Cape's low rating results from performance volatility after the previous CEO left suddenly at end-March 2012, although his successor appears to have honed a more consistent operation – without contract management upsets.  

A services group like this is inherently exposed to the business cycle, yet Cape's geographic spread involves faster-growing economies.  Above all perhaps, longstanding asbestos liability claims were settled with an insurer just recently on 12 March thereby removing a cloud of uncertainty.  An upfront payment of £18 million will be paid then £34.5 million over 2018 to 2023 which explains a present halving in the annual dividend to 7p per share. However, the board says it will be "progressive" from 2018. The next and final dividend payable 23 June to shareholders registered as of 19 May. 

The market could have been steeled for a worse settlement or the stock's mood became jaundiced (down from about 330p in 2013 and 2014) such that the end-2016 plunge to 141p marked a capitulation that has cleared lingering sellers.  

This last drop was ironic given an 18 November update had indicated 2016 results slightly ahead of expectations, and encouraging prospects overall.  A sting in the tail was Cape increasing its provision against industrial disease claims by £9.7 million, and now the 2016 headline figures are distorted by a £79.2 million provision for the claims (see note 9 to the accounts), but this aspect is becoming history.

Far East and Middle East represent the dynamo

Continuing operations' revenue is up 21.4% to £863.5 million with favourable currency translation contributing 5.3% and a 2015 acquisition 1.6%, hence 14.5% organic growth at constant currency which is respectable.  

It mainly reflects Asia Pacific projects ramping up to more than offset low demand from Australian miners, hence this area's 103% jump in revenue to 35% of group total.  The UK slipped 4.5% to 43% of revenue as oil price weakness undermined North Sea demand also margins, and there was lower demand from coal-fired power generation after plant closures.  

The Middle East region rose 10% to 22% of revenue amid contract wins and increased activity in Saudi Arabia, also a joint venture with the state oil company of Azerbaijan.

The UK side is expected to enjoy substantial margin improvement this year having restructured to better pursue growth, which management contends "should more than offset any margin pressures elsewhere" – why the adjusted operating margin has slipped from 7.4% to 6.4%.  

 Adjusted operating cash flow has jumped 63% to £71.5 million - if mainly due to lower capital expenditure, non-cash items deducted and slightly higher depreciation added back.  A lower tax charge further boosted free cash flow 106% to £57.2 million, which all helped net debt reduce 27% to £80.4 million.

Overall 2016 order intake edged up 0.6% to £846.7 million, but the late-year upturn meant 2016 closed up 6.5% at £917.6 million, the highest ever, with nearly 60% of that due for delivery in 2017.  

While this looks premature to assert a trend, "the board is confident that the business will deliver another strong trading performance in 2017...we continue to invest in our strategy...convinced that it will deliver increased shareholder value over the medium to long term."

What's the real risk from oil prices?

Cape's operational theme in this respect is mixed: weak demand in upstream oil & gas offset by stronger downstream services and power generation.  An average $45 a barrel oil for 2016 meant oil & gas customers had a focus on cost management with widespread deferral of discretionary spending – especially in the North Sea – hence a continued fall in oil prices will re-assert this risk.  

On the downstream side, however, refining and petrochemicals customers seem to have more committed spending plans e.g. on construction projects and maintenance, although margin pressures are evident.  With the Middle East side of the group buoyant, an obvious question is renewed weaker oil prices affecting Saudi Arabia although demand appears robust e.g. with a stable maintenance market and new construction.  The situation looks more challenging in the United Arab Emirates and Qatar although Kuwait and Azerbaijan are stronger.

Should US shale oil supply continue to rise versus OPEC members defying production cuts, then short sellers could take oil prices down a leg – enough to shock the industry into tighter cost control.  So, yes, there is on-going risk for Cape, but not like for a dedicated oilfield services group, and arguably priced into a PE of 7.

Company broker is relatively more bullish

 Within consensus forecasts, company broker Numis Securities has upgraded to anticipate £51.8 million pre-tax profit, rising to £56 million in 2018, for earnings per share (EPS) of 31.3p and 34p respectively. Arden Partners looks for £48.4 million, rising to £48.6 million and EPS of 30.9p and 31p.  

Both anticipate a dividend of 7p, rising towards 8p.  These forecasts were published after the 15 March prelims and, potentially, Numis has an edge having consulted closely with management.  Again the risks of variance seem well-priced into a PE of 7.

Cape's return on invested capital – i.e. operating profit divided by the accounting value of equity plus net debt – has risen from 21.9% to 28.5%, a very good result even if helped by a lower equity value after the asbestos claims-related losses.It augurs well for medium-term financial progress, in support of Numis's optimism.

The stock's risk/reward profile therefore favours continued recovery to re-test 2013/14 highs, on a two-year view, i.e. about 50% further upside potential unless oil prices or the global economy take a dive.

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.