Stockwatch: Petrofac hits all-time low – should you buy?

Oil and gas firm has been rocked by bribery scandal, but could have good recovery potential.

Shares in £350 million oil and gas industry service provider Petrofac (LSE:PFC) turned up 6% yesterday from an all-time low of around 102p, currently testing 109p.

This followed a plunge from around 170p mid-month after a British ex-employee pleaded guilty to three further counts of bribery.

A Serious Fraud Office (SFO) statement says: “The offences relate to corrupt offers and payments made between 2012 and 2018 to influence the award of contracts to Petrofac in the United Arab Emirates worth approximately $3.3 billion.”

These are in addition to 11 counts admitted in February 2019.

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The total value of Middle East contracts involved was more than $7.5 billion (£5.7 billion), hence theoretically potential for redress from those who lost out. 

A long fall from 900p a share in 2016 

The chart has trended down as Petrofac got embroiled in bribery scandals over the last four years. Some might say this is more a reflection on the way business – especially international contracting – has been conducted over centuries in the Middle East and Asia.  

Investors have feared a repeat of Rolls-Royce (LSE:RR.)’s £671 million bribery settlement with international regulators four years ago.

However, Rolls’ shares did rally from about 215p to 325p during 2017 after uncertainty was removed.  

The dilemma for Petrofac is the extent of time it has been in the spotlight and whether this will damage contract tendering or renewals, despite management insisting not. I think Covid-19’s impact on reducing oil and gas industry activity is probably the more critical factor, although the two could conflate.  

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Fifth most-shorted stock on the London market 

This is by way of issued share capital, with 8.4% out on loan. In due respect to short sellers, the percentage for Petrofac has blipped between 4% and 9% over the last five years in context of losing nearly 90% of market value.  

Yet repeatedly we have also seen short selling on a particular stock become fashionable only for the bear case to evaporate. Indeed, Rye Bay Capital, currently the most vigorous shorter of Petrofac, was doing same to Pets at Home (LSE:PETS) – being over 1% short in autumn 2019 – but the stock started rising sharply from mid-November and by December their short had closed. 

Regulators’ motivation is a significant factor 

Now the SFO has got the bit between its teeth on a major scandal, how far – and justified – is it fair to go with fines that could potentially jeopardise a business? Bribery is a sensitive issue, and regulators – and indeed client firms in contracting arrangements – are tightening up against this.  

Petrofac’s 30 June 2020 balance sheet had $861 million cash, down 16% over six months, versus $1.2 billion financial liabilities. Therefore, if hit with anything like the penalty for Rolls’, it would need a dilutive rights issue at these low levels to cope with fine payments alone. Most likely customers would want to see a material cash buffer as working capital also, to renew or initiate contracts. 

Such is the worst-case negative scenario, but it is possible to argue this is (more than) fully priced in, especially if rising commodity prices feed through into oil and gas as some degree of global economic recovery takes hold. 

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Not even a fifth of Wood Group’s market value 

Petrofac’s circa £350 million market value should be compared to fellow mid-sized company Wood Group (LSE:WG.) at £1.9 billion, yet their fundamentals are not so dissimilar.

Towards the end of last year, Petrofac had a $5.1 billion order book versus $6.2 billion for Wood. Their 2021 projected net profits stand at $65 million and $163 million respectively, also net debt at $422 million versus $1.7 billion.  

Both companies have guided expectations lower as the pandemic reduced energy demand, hence compromised industry activity. But if short sellers’ rationale is for serial downgrades of order books, it is possible this meets with an inflection point in 2021, at least in terms of expectations. A total of 2.6% of Wood’s share capital is out on loan, but given its market cap differential with Petrofac, is actually a greater down-bet (although Wood has greater liquidity).  

Petrofac suspended its dividend last year. But, in the first half, it made £18 million net profit before deducting £95 million exceptional items. So, consensus forecasts for £43 million normalised net profit in 2020 and £66 million in 2021 look fair.

This implies a price-to-earnings (PE) ratio of 6x falling to near 5x based on earnings per share (EPS) of 17p and 20p respectively. If representing ‘trough earnings’, however, this is a very cheap PE. A quality cyclical stock could command over 20x in anticipation of recovery. Wood’s prospective PE is over 15x. 

Moreover, Petrofac’s net tangible assets per share are around 200p, offering comfort to shareholders. Wood’s asset base is grossly distorted by goodwill/intangibles, which represent 145% of net assets. 

So, unless the SFO hands out a crippling fine (hence bringing a dilutive rights issue), Petrofac’s track record shows ample scope to rebuild EPS to well over 20p. Applying a similar PE as Wood’s currently implies a 300p target, say on a two-year view. 

Petrofac - financial summary
Year ended 31 Dec

Source: historic company REFS and company accounts

All three institutions over 0.5% short

Blackrock, Rye Bay and CapeView are involved. Notably, Rye Bay sold another 0.29% on 21 January to be 3.53% short – i.e. a circa £10 million trade for this London-based hedge fund. Its short has consistently expanded from 2.37% on 14 January, as if in response to the SFO’s announcement about a guilty plea from the ex-Petrofac head of global sales. 

That might still represent a small portion of the fund’s overall risk exposure. However, Rye Bay describes itself as taking “high conviction” positions based on rigorous fundamental analysis.  

CapeView has consistently capitalised on Petrofac’s stock price fall since 2016, so you could say is the best overall judge – to date. On 15 January it raised its short 0.18% to 1.08% - i.e. by 20%. 

Possibly they also take the view – at a stretch – that litigation finance firms might opportunistically back suing Petrofac on behalf of companies that lost out in past contracts. I suspect their core bear case, however, is further bad news from the SFO’s investigation conflating with a challenged global economy. 

Petrofac’s last trading update on 16 December raised the 2021 cost-cutting target by 25% to $250 million after a $125 million reduction in 2020 – as subdued energy demand led customers to delay projects and cut their own spending. Preliminary results are due 24 February. 

So, if you are a fund manager running big global equity positions and want a selection of hedge instruments, being short on the likes of oil service groups such as Petrofac or Wood is one way. 

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Recent buying by Petrofac insiders 

This is a concerted, relatively modest gesture rather than showing serious conviction, but is still notable. 

On 6 January, the chairman bought £20,000 worth of shares at 144.5p and six other non-executive directors snapped up £5,000.

This followed a similar buying arrangement last October: the chairman with £20,000 and the six non-executive directors £5,000, all at 110.6p. And, likewise, last July at 181.4p.

Sceptics might say this is effectively programmed trading. Or more sympathetically, that the directors do respect long-term value and that committing to a regular investment plan is a fair practice.  

Make your own mind up!

I have been wrong on Petrofac, with a broadly positive stance in recent years – versus short sellers’ successful negative view from 2017. So, take your own view on my reasoning in this piece, as well as my conclusion that the stock’s risk/reward profile favours: ‘buy’.

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