One small-cap turnaround stock I’d buy before Tullow Oil plc

Roland Head explains why Tullow Oil plc (LON:TLW) isn’t on his buy list.

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Today I’m going to look at two stocks. One has just issued a profit warning, the other has been through tough times, but now looks to be on the road to recovery. You might expect the recovery stock to be the better buy, but I don’t think it is.

The profit warning stock is regional airline Flybe Group (LSE: FLYB). Its shares fell by 14% this morning, after management warned that unexpectedly high maintenance costs would hit profits this year.

Adjusted pre-tax profit is now expected to be between £5m and £10m for six months to 30 September, compared to £15.9m last year.

Short-term turbulence

There’s no denying that today’s news is disappointing. The company says that the extra spending is the result of a drive to improve the reliability of its aircraft. Disappointingly, no explanation was provided about those reliability issues being experienced, or the nature of the expected improvements.

However, I don’t think today’s news should have much impact on the wider recovery story here. That’s because the firm’s biggest historic problem – having too many aircraft – is now gradually receding.

Christine Ourmieres-Widener, Flybe’s chief executive, confirmed today that “with the fleet size now reducing… both yield and load factors are increasing.” In my opinion, this could have a transformative effect on its profitability, especially if the group can manage its costs more tightly.

Today’s update indicated H1 net debt should be “broadly in line” with the end of last year, suggesting a figure slightly above £64m. That’s high enough, in my view, but I’m optimistic that the recent arrival of a highly experienced chief financial officer, Ian Milne, will bring a fresh discipline to Flybe’s finances. I expect Mr Milne to complete the changes needed for this long-delayed turnaround to finally deliver.

Flybe isn’t without risk, but I believe the shares deserve a closer look.

Shareholders will need patience

One-time FTSE 100 member Tullow Oil (LSE: TLW) is a shadow of its former self. Revenue has fallen by almost 40% since 2013 and the group has lost money every year since 2014.

The only part of Tullow that hasn’t got smaller is its net debt, which rose from $1.8bn in 2013 to a peak of $4.8bn in 2016. The project spending which triggered this rise is now largely complete and cash flow is improving. A rights issue during the first half also helped and net debt has now receded to $3.8bn.

However, there’s no escaping the fact that the group’s debt burden remains greater than its market cap of £2.5bn ($3.3bn). When this happens to a company, it often means that shareholder returns have to take a back seat to debt repayments.

I believe Tullow shares are likely to lag the wider oil market over the next few years, as management uses much of the firm’s cash flow to reduce debt. The only exception to this might be if we see a major surge in the price of oil, which could lift profits sharply.

Tullow’s debt situation might be acceptable if the shares were cheap enough, but in my view they’re not. At around 185p, the stock trades on a 2018 forecast P/E of 20 and offers no dividend. I believe there are far better buys elsewhere in the oil market.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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