Why UK Oil & Gas Investments plc isn’t the only stock I’m avoiding

G A Chester discusses why UK Oil & Gas Investments plc (LON:UKOG) and another small-cap are on his list of stocks to avoid.

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Shares of UK Oil & Gas (LSE: UKOG) closed yesterday at 4.9p, valuing the Weald Basin play — home to the so-called ‘Gatwick Gusher’ — at £173m. With projections of 100bn barrels of oil potentially in the area, the bull case for UKOG has been well rehearsed. As my Foolish colleague Rupert Hargreaves discussed recently, if only a fraction of the estimated barrels are recoverable, the rewards could be enormous.

Set against this is a current absence of evidence of large-scale commercial viability and the fact that the price of the most recent trading of interests between companies operating in the Weald would seem to give an implied value to UKOG’s acreage of a fraction of its £173m market cap.

Operating and financing update

The company’s shares were volatile in early trading this morning, after it released an operating and financing update. The news wasn’t good from flow testing the lowest depths of its Broadford Bridge well, the company concluding that “sustained commercial flow rates … could likely only be obtained via reservoir stimulation beyond the scope of its existing regulatory permissions.”

In the other part to the update, UKOG said it has secured a £10m financing package. It said it’s “now fully funded to deliver planned drilling and testing programme through 2018.” The funding deal might sound good to people who are unfamiliar with the kind of financing announced. However, mentions of 0% interest, a share price of 8p and a prohibition on the provider of the loan holding a net short position in UKOG are red herrings.

The terms of the deal put it in the class of what is colloquially called ‘death spiral financing’. The lender is in a position to make a high and almost risk-free return, without holding a net short position, but the mechanics of which lead to a slowly collapsing share price and accelerating dilution of existing shareholders. I previously had UKOG marked as a stock to avoid for various reasons. But adding to those reasons the type of financing announced today, I can only rate it a ‘sell’.

Big brands but big debt

With business partners and institutional investors having substantial shareholdings and debt in the form of conventional loan notes and bank facilities, Premier Foods (LSE: PFD) has the kind of backing that’s signally absent at UKOG. Its shares are trading up around 7% today at 39p after it released encouraging half-year results.

This owner of a strong portfolio of brands, including Batchelors, Homepride and Mr Kipling, is valued at £327m. The big issue with the company, which is trading at just 4.9 times forecast earnings, is the high level of debt still weighing on it after historically over-extending itself with acquisitions. It today reported a £21m reduction in net debt but at £535m it remains an onerous burden. For example, first-half operating profit of £22m was entirely wiped out by net financing costs of £24m.

I see Premier as a stock to avoid purely because of this high level of debt. However, the business and brands are attractive and a takeover by a bigger company with deeper pockets is possible. Premier received an indicative offer at 65p a share in March  last year, although I wouldn’t want to invest simply on the basis that a new bid might come in at some point.

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.

G A Chester 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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