Cube Midcap Report (28 Aug 2019) – #PFC #FSJ #SMWH #DPLM

Cube Midcap Report (28 Aug 2019) – #PFC #FSJ #SMWH #DPLM

Good morning, it’s Roland here with today’s Midcap Report.

Companies on my list for today are:

Petrofac (PFC)

  • Share price: 397p (-2%)
  • Market cap: £1.4bn

Half-year results

Oil and gas services provider Petrofac continues to trade under the shadow of an ongoing SFO fraud investigation. The Petrofac share price fell modestly this morning after a downbeat set of half-year results.

The SFO investigation appears to be having an impact on the firm’s ability to win new work in Saudi Arabia and Iraq, two countries cited in the investigation. Historically, these have been important markets for the company.

Revenue is now expected to fall in 2020. Profit margins are expected to weaken during the second half of 2019.

Key points from today’s half-year figures:

  • Revenue +1% to $2,821m
  • EBITDA -8.7% to $305m
  • Underlying net earnings -19.4% to $154m
  • New order intake $2.0bn (H1 2018: $3.3bn)
  • Order backlog -10% to $8.6bn ($9.6bn at 31 Dec 2018)
  • Interim dividend unchanged at 12.7 cents per share

Shares in this firm look very cheap based on consensus forecasts, with P/E of less than six and a dividend yield of about 7.5%. But as I see it, potential investors need to ask two questions before deciding whether to buy:

  1. Does the firm’s underlying performance suggest that this is a good business?
  2. Is the potential impact of the SFO investigation manageable?

I’ll try and deal with these one at a time.

Financial performance

Petrofac has historically generated good levels of free cash flow. Debt has been repaid over the last couple of years and net cash stood at $69m at the end of June, although there is still some debt.

Profitability: Today’s figures show an underlying operating margin of 7.7%. I calculate a return on capital employed of 10% for the half year. To get this figure, I used adjusted operating profit and average capital employed for the half year from the balance sheet.

However, the company reports a more complex adjusted measure which gives a ROCE of 24% for the half year. This appears to be achieved by excluding amortisation from the profit figure (using EBITA instead of EBIT) and by making some complex lease-related adjustments to capital employed.

I have to admit I don’t fully understand the lease adjustments. I’m sure they’re legitimate, but from my point of view it makes more sense to calculate ROCE using a standardised approach that’s more readily comparable with peer firms.

On this basis, I’d have to say that ROCE of 10% looks pretty average. However, it is ahead of some rivals and on an improving trend. This sector has been relatively slow to recover since the 2015/16 oil market crash, as big oil producers have kept a tight lid on spending.

Free cash flow: Cash flow in this type of business can be lumpy over short periods, but my sums show free cash flow of $502m over the last 12 months. This compares to an adjusted operating profit of $485m for the same period, suggesting a high level of cash conversion.

However, cash generation has been boosted by disposals over this period. I’m not sure how sustainable this figure is, given the firm’s guidance for weaker margins in H2 and lower revenue in 2020.

A good company? On balance, I’d say this is a reasonably good business operating in a heavily cyclical sector.

Are SFO risks manageable?

It’s not easy to know how to price the kind of legal and reputational risk posed by the SFO investigation.

One option is to avoid the stock altogether, on the basis that the fraud investigation adds risks that as investors, we can’t quantify:

  1. Petrofac may find it harder to win new work – this already appears to be a problem
  2. The financial burden of any settlement that might result from the investigation could impact on shareholder returns – we have no way of predicting how likely this is

It’s worth noting that so far, neither Petrofac nor any of its current employees have been charged by the SFO.

However, the company’s former head of sales, David Lufkin, pleaded guilty earlier this year to 11 counts of bribery relating to attempts to secure contracts in Saudi Arabia and Iraq.

The SFO investigation into Petrofac has not yet been closed. Closure may not come quickly, either. For context, Rolls-Royce’s was under investigation by the SFO for five years (2012-2017), despite having reported itself to the fraud watchdog.

My view: I don’t think Petrofac is a bad company and I suspect that the shares offer some value at under 400p. But the declining order backlog is a concern. Market conditions are tough enough in this sector, even for operators not facing a SFO probe.

In my view, the risks may not be worth the possible reward. Although the 7%+ dividend yield is tempting, there are other high yield options in the oil and gas sector which carry much less risk.

On balance, I’m minded to avoid Petrofac until trading improves or the SFO investigation is resolved.

James Fisher & Sons (FSJ)

  • Share price: 2,105p (-1%)
  • Market cap: £1.06bn 

Half-year results

This FTSE 250 stock doesn’t seem to have a particularly high profile among the investor community. It’s an offshore service provider that works in a number of specialist sectors including oil and gas, wind, defence and fuel tankers.

Although companies such as Petrofac are subject to the boom and bust cycles of the commodity markets, James Fisher’s mix of work appears to provide some protection from this. Consider the share price chart since the firm’s listing in 1996:

FSJ share chart

Source: Google Finance

Investors lucky (or wise) enough to have held over the last 23 years have enjoyed a 1,849% gain, plus dividends. This is a useful reminder that if you can spot great companies early on, the rewards for doing nothing are truly impressive.

Today’s half-year results suggests the group’s consistent performance is continuing, albeit with a little pressure on margins.

Key facts:

  • H1 revenue +10% to £286.9m
  • Operating profit +1% to £24.5m
  • Cash flow from operating activities +2% to £26.3m
  • Pre-tax profit -3% to £20.9m
  • Earnings per share -3% to 33.6p
  • Interim dividend +10% to 11.3p

Unlike Petrofac, Fisher’s profits are almost free of adjustments, allowing us to use the statutory figures without having to try and decipher the adjusting items. Good.

However, profits remained fairly flat despite strong sales growth. Looking at the income statement, cost of sales rose by almost 11% and administrative expenses were 12% higher. This suggests to me either that the company has not yet passed on cost increases to its customers, or that it is investing for new growth.

My feeling is that both factors may be relevant. Investment was certainly high during the period. The group made an acquisition in Brazil and purchased two dive support vessels during the period, spending a total of £52.2m. For this reason, the group’s strong cash conversion didn’t convert to free cash flow.

This spending lifted net debt to £159m, or £190m when operating leases were included under new accounting rules. This is equivalent to 1.7x EBITDA, or 2.3x EBITDA, respectively. Given the group’s track record of c.10% operating margins and 13% ROCE, I would be comfortable with this level of borrowing if I was a shareholder.

Outlook: Performance is expected to improve during the second half, due to various seasonal and timing-related factors. Earnings are expected to rise by about 8% this year, according to Reuters consensus forecasts.

My view: James Fisher seems like a business I’d be happy to own. But I’m less comfortable with the share price, which values the stock at 22 times 2019 forecast earnings and gives a dividend yield of just 1.6%.

Given the group’s long-term performance, this could be a reasonable price for a good business.

However, my feeling is that the valuation is quite full, given the group’s middling profitability and debt burden. I’d probably choose to wait for a cheaper buying opportunity.

WH Smith (SMWH)

  • Share price: 1,985p (unch)
  • Market cap: £2.1bn

Pre-close trading update

WH Smith’s travel-led growth story continues to roll on. The firm appears to be expanding its definition of travel and notes that hospitals are now the second-largest channel in its Travel business.

Overseas growth is another area of strength and WH Smith now operates 428 stores outside the UK.

The secret to the success of the Travel business seems to be that the firm finds locations where it can sell to a captive market in localised, semi-monopoly conditions. As you’d expect, this is good for profit margins. However, costs are high in these locations — in airports and I believe railway stations, it’s normal for retailers to be charged rental as a share of revenue. This limits the amount of operating leverage that can be achieved on rising sales.

Perhaps for this reason, the group’s half-year results in April showed that the high street is still more profitable, with a trading margin of 14.5% versus 12.1% for the travel business.

Results for the full year are expected to be in line with expectations. Last year saw the firm generate a 56% return on capital employed. Strong cash flow is deployed to a twice-covered dividend and used for buybacks, which have reduced the share count by about 14% since 2013.

My view: Good strategy and consistent execution have made this business more profitable for far longer than some investors might have expected. I suspect this will continue.

Trading on 17 times forecast earnings with a 2.9% yield, WH Smith stock looks fairly priced to me at the moment, but still attractive to hold.

Diploma (DPLM)

  • Share price: 1,986p (unch)
  • Market cap: £1.8bn

Trading update

This FTSE 250 manufacturing group operates in the life sciences and industrial seals markets. It’s another stealth multibagger — the Diploma share price has trebled over the last six years.

However, profits have only risen by about 50% over the same period. So we can see that the shares have become considerably more expensive.

Is the price still worth paying? Today’s trading update confirms that performance for the year ending 30 September 2019 remains in line with expectations.

Since 2013 (at least), the company has generated a return on capital employed between 20% and 25% and an operating margin of about 15% in most years. Diploma appears to convert the majority of its earnings to free cash flow and has reported a net cash balance at each year-end date during this period.

At first glance, this looks like a high quality business to me.

Analysts’ forecasts tell us that earnings are expected to rise by about 11% this year, to 62.7p per share. This puts the stock on a forecast P/E of 25, with a dividend yield of 1.8%.

My view: As with James Fisher and WH Smith, this business looks like a good long-term hold to me. But I’d rather wait for a cheaper opportunity to buy, as the current share price doesn’t seem to offer much room for error.

That’s all for today. Thanks for reading this far. I’ll be back tomorrow with another Midcap Report.



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    Hello Roland, Thank you for your reports. Like your analytical approach. Can you please explain a bit more on how do you calculate the ROCE. I use SharePad and take ROCE as a given figer from the ratio table. Your article inspired me to recalculate and look into the ROCE figures in more depth. Would you be kind enough to explain in a bit more detail which figures are taken to calculate ROCE. I use a SharePad so if you could pinpoint if you use EBIDTA,EBIT or PAT and where do you find an avg capital employed figure.
    Many thanks for your help.

    • comment-avatar

      Hello Jan, thanks for your comment.

      The calculation I use for ROCE is:

      operating profit (EBIT) / average capital employed

      Sometimes I may use adjusted operating profit, depending on my view of the adjustments.

      I calculate capital employed as:

      total assets – current liabilities

      This is a slight simplification, but works well.

      To get the average capital employed for a period, I calculate capital employed at the start and end of the period, add them together and divide by two.

      I hope this is of some help. This is fairly generic. Most companies prefer to use an adjusted measure of profit when they calculate ROCE. Some companies will also use more complex calculations to reflect the actual capital employed during a period. Both measures tend to improve ROCE, oddly enough.

      Although I take note of these figures, I like to use a generic approach that’s comparable between companies.


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