Stockwatch: A robust 8% yield

Is it time to buck the downtrend in this £2.2 billion oil and gas engineering services group? Since a 12 May update flagging a Serious Fraud Office (SFO) investigation into Petrofac, this mid-cap stock has fallen from over 800p to 650p - edging below a two-year volatile trading range from 1,070p.

In a five-year context, however, Petrofac has been in a bear phase from 1,740p, falling by more than a quarter in November 2014 when profits were guided substantially lower due to falling oil prices, project timing issues, a union dispute and bad weather.

Yet broker consensus estimates look for normalised pre-tax profit recovering towards £400 million this year. Among such forecasts, the latest on 1 March forecast targeted £434 million, rising to £522 million in respect of 2018, for earnings per share (EPS) of 102p up to 123p.

That implies a price/earnings (PE) in the region of 6 times and over 2 times dividend cover for the 8% prospective yield. With 7.2% of the equity out on loan, short sellers may, therefore, be accentuating downside given Petrofac's fundamentals are overall robust.

What's wrong?

The investigation relates originally to Unaoil, a Monaco-based company providing "consultancy services" in Kazakhstan between 2002 and 2009 - the SFO alleges potential bribery, corruption and money laundering.

Six months ago, Petrofac insisted there was no evidence any director was aware of alleged misconduct at Unaoil, having appointed auditors/lawyers to delve into allegations a former executive was paid £1.5 million equivalent to clinch a Kuwaiti oil deal.

An Australian newspaper claims to have seen emails in which this executive requested Unaoil to make confidential offshore payments. He later became a Unaoil director. To cynical followers of the international oil industry, it all sounds nothing new.

Furthermore, seasoned readers of Private Eye will not raise expectations regarding "Serious Farce Office" investigations, although its civil servants must necessarily justify their existence.

Bull case

It's possible to conceive a situation where, even if Petrofac is issued a sizeable fine, its shares will bounce as uncertainty is removed and the market refocuses on fundamentals. Due to a circa 53p per share dividend, well-covered by projected earnings and supported anyway by balance sheet cash, the market won't ignore this.

Remember an adage: "In the short term the market is a voting machine, longer-term a weighing machine." The underlying context is promising: while there wasn't a trading update at the 11 May AGM, the 22 February prelims cited "increased bidding activity in recent months...a good pipeline of opportunities across our core markets..." An £11 billion order book was said to give "excellent visibility for 2017."

Similarly, the macro context is supportive for services demand: oil prices are being managed reasonably well by producer nations' co-operating, also healthy demand from industry and consumers. This defies bearish claims about how producers would cheat and revived US supply from shale would depress oil prices and related shares. So, unless Petrofac has guided analysts recklessly, a profits recovery looks fair.

Short-term technical bias due to shorting

Admittedly, not all the 7.2% equity on loan relates to the SFO investigation: Petrofac has been targeted before, possibly in the same way Tullow attracts short-sellers as a means of exploiting, or hedging against, oil price weakness.

I wouldn't necessarily be deterred: there have been plenty of examples where hedge funds follow each other on short-selling ideas, then end up having to buy back at higher levels, i.e. they are behind the curve.

This introduces an element of pent-up demand to be resolved in future, enhancing recovery prospects so long as Petrofac's dividend prospects are intact. Mind it also involves near-term market uncertainty as the price can drop simply if more hedge funds borrow stock and sell.

Bear case

Even if Petrofac ends up facing a substantial fine, the market will move on. The principal risk - albeit a long shot, given an internal inquiry already - would be chief executive Ayman Asfari being implicated in the claims, thus creating a difficult ongoing issue.

Both he and Marwan Chedid, chief operating officer, have been interviewed under caution by the SFO. Asfari family interests own 18.5% of Petrofac and he is effectively the founder of the listed group, having joined in 1991 then led a buyout in 2001 and floated it in 2005.

So it's a very different situation from a professional hired CEO which the board can more easily replace. Such a scenario would also be a test of how "independent" the non-executive directors really are.

Be aware that on 18 May one of them opted to resign immediately after just seven months' service. That does raise the risk profile because non-execs sometimes flag their disapproval of a company by walking away; yet they may seek above all to preserve their own reputations than work through a difficult patch in the company's best interests.

Robust balance sheet supports dividend policy

Petrofac can appear to have excess debt, being 159% geared in gross terms, although netting off £900 million equivalent cash reserves means net debt of £475 million, or 55% gearing, in context of £863 million net assets - of which a modest 15% constitute goodwill/intangibles.

The debt profile is 80% long-term, which together with short-term debt reduced by 10% last year, helped by strong cash generation. Admittedly, the income statement shows the net finance charge clipping 20% of operating profit. So aspects of the balance sheet aren't ideal to buttress Petrofac in an industry downturn, but it can fairly be described as robust.

In particular, the cash position effectively underwrites dividends for the short to medium term, the projected 52p per share dividend costing about £180 million. See from the table how Petrofac's downturn from 2013 saw an earnings slump, yet dividends were only briefly trimmed.

So, although the market pricing the stock for an 8% yield may look as if it's flagging a risk this payout won't happen, it would need a colossal fine from the SFO not to do so.

In conclusion: Petrofac hasn't the best five-year record on fundamentals, its chart implies a share for traders, and the SFO investigation has enhanced volatility due to shorting.

But the yield is now attractive for enterprising investors and aids re-rating potential, so long as Petrofac's boss is not compromised by the SFO's conclusions.