Stockwatch: A 7.4% yield worth the risk?

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Stockwatch: A 7.4% yield worth the risk?

What do latest interim results imply for fallen mid-cap oil play Petrofac (PFC), where consensus forecasts apparently suggest a forward price/earnings (PE) ratio of about 6 times?

That the interim dividend has been cut 42% to about 9.84p a share equivalent (the oil services industry reports in US dollars) - consensus expectation was for a 16% drop to a 39.3p total dividend - shows the market having anticipated this better than brokers' analysts.

Within the consensus, SG Securities projected a 25.9p payout for both 2017 and 2018, implying a 6% yield with earnings cover of 2.5 times this year, reducing to 2.4 times in 2018 given an expected 7% earnings slip. But these numbers were end-June, the situation is quite fluid and it appears possible to entertain a 7%-plus yield at a current share price of just over 400p.

Impact of lower oil prices is evident

Aside from a Serious Fraud Office (SFO) investigation into bribery allegations that slashed Petrofac's market value from about 900p to as low as 350p last May, subdued demand for engineering services is the crux factor that originally prompted short-selling and needs focusing on.

Group revenue is down 19.6% and pre-exceptionals' net profit is down 4% or 41% on a reported basis. Significantly for medium-term prospects, the backlog (effectively, work-in-progress) is down 12.6% in six months to $12.5 billion (£9.7 billion), a main reason why the analysts' consensus is cautious for 2018.

In terms of divisions, the main engineering & construction side (E&C, about 75% of 2016 revenue/profit) shows revenue down 20% to $2.4 billion, "reflecting project scheduling" albeit with new order intake of $2.4 billion and net profit slipping just 1% at $161 million.

If the revenue fall genuinely reflects timing rather than challenges, that's a sound performance by Petrofac's principal division. Engineering & production services (EPS, about 23% of 2016 revenue/profit) looks flat in challenging conditions: $300 million new contracts/extensions mainly in the UK, Iraq and Kuwait, albeit revenue down 17% to $700 million amid lower activity and order intake, yet net profit has still edged up 2% to $51 million.

The Integrated Energy Services (IES) side has had issues and remains loss-making – $19 million in the red, on revenue down 37% to $97 million, or 14% excluding asset sales. It would have helped to clarify if IES restructuring means there is ongoing liability for exceptional charges: their significance shown by interim earnings per share of 36p sterling equivalent pre-exceptionals, or 16p after, these down nearly 90% due to impairment on the Greater Stella Area development on the IES side.

With exceptionals declared ultimately related to lower oil prices and reduced production forecasts, that leaves it open for further charges if oil prices slump, but such is the industry at any time.

Scope for a medium-term bullish upshot

A mixed operational review is quite to be expected as Petrofac's clients react to lower oil prices. But if, as I explained in my last macro review, central banks continue to explore means of economic stimulus, this should be supportive of oil prices unless disunity in the OPEC cartel and a resurgence of US shale oil supply tip the oil price equilibrium to downside.

Thus, with added jaundice surrounding the SFO inquiry, there's potential for Petrofac shares to rise if this industry leader continues to deal with its challenges and the commercial context doesn't worsen.

It's tricky to have conviction here, the situation remains potentially fluid, but the extent of fear towards this stock can drive upside alone if it steadily abates. I should note, such a rationale is not shared by AQR Capital Management which continues steadily to raise its short position to a substantial 4.82% of the issued share capital as of 18 August. Within 8.77% of equity on loan, three traders are increasing their shorts and two reducing.

I'd prioritise oil industry fundamentals than worry about this or the SFO - where Rolls Royce (RR.) has shown it is possible to move on from this kind of inquiry despite worries it creates at the time. Sections of the media have whipped up fear with the prospect of contracts not being renewed or possible to win, but there is no real evidence beyond caution resulting from lower oil prices.

Reducing $1 billion net debt compromises dividends

As I've previously noted, management's guiding for $1.1 billion net debt at end-June "in line with expectations" was cute. It's turned out at $1 billion, and the leap from $600 million in six months is a priority for free cash flow to reduce, than pay out to shareholders.

It's explained by way of "working capital movements" albeit the company having "good liquidity of $1.3 billion at end-June" with a $1.2 billion credit facility extended to June 2021 and $300 million term loans refinanced.

Meanwhile, capital expenditure reduced 44% to $110 million in the first half, if related to just two matters. Thus net cash outflow of $149 million for the period would otherwise have been higher, and compares with a like-for-like $17 million net cash inflow.

The situation is manageable due to ample credit facilities but, altogether, it means the interim dividend is de-based by 42%, with the board targeting underlying earnings cover of 2 times to 3 times and interim payouts representing 33% of the prior year total dividend. On such a basis, the 2017 total payout would be 29.5p, representing a prospective yield of 7.4% with the stock at around 400p.

So long as management can avoid further upsets, 400p may therefore be seen as an intrinsic support level. With some three-quarters of group revenue Middle East-derived – a part of the world where "baksheesh" payments are part of culture to expedite service – it seems less likely oil industry clients would drop Petrofac even if the SFO does prove aspects of bribery.

When the news first broke in May, one quite felt "tell us something new about the international oil business". Clients are more likely to prioritise quality of service, where Petrofac is an industry leader.

What if the price slides under 400p again?

Chartists cite a current range of 411p to 488p since mid-June, with 500p the upper limit due to so much negative sentiment; while under 411p support at 345p comes into play. On such a rationale the stock is currently at a tipping point.

I would set this aside and focus on fundamentals. Other things being equal, another drop would offer scope to buy, albeit less so if driven by renewed weakness in oil markets.

Petrofac is a more challenging recovery play than most, due to oil's inherent uncertainty and the SFO inquiry to boot. But unless oil slumps and/or the chief executive ends up seriously damaged by the investigation as to require replacing - in the eyes of the London market - then at current prices the stock's risk/reward profile is already long-term attractive.

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 -143 104 365 340
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 80.4 66.6
Earnings per share growth (%) 14.3 9.1 -63.0     786 -17.2
Price/earnings multiple (x)         46.7 5.3 6.4
Historic annual average P/E (x)   12.8 9.9 18.4   78.7  
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 39.3 50.3
Dividend yield (%)         11.1 9.3 11.9
Covered by earnings (x) 3.1 3.0 1.1   0.2 2.1 1.3
Net tangible assets per share (p) 199 264 290 205 217    
Source: Company REFS

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.