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Why Afren Plc Could Surge To 50p

These are hard times for Afren (LSE: AFR) shareholders: they must decide whether to cut their losses or to stick with the management. Hard times also spell opportunities, however. ..

Will Afren Sky-rocket? 

On the face of it, Afren needs a solution within six weeks. The collapse of merger talks with Seplat on Friday means that there’s no easy way out now for investors holding long positions in Afren, but should managers either receive the backing of their lenders and cut a deal both with banks and bondholders, or find a new investor, I believe Afren’s equity value will likely sky-rocket to the levels it last recorded at the end of 2014. 

How likely is such an outcome, though?

It’s hard to say, though if you ask me, I’d add 0.5% of Afren to my diversified portfolio, with the aim to take home a pre-tax return of between 300% and 600% this year. The unaffected stock price of Afren is in the region of 30p to 40p. 

Bye Bye, Seplat 

Strategically, the rejection of Seplat was a very brave move. 

The board has not received any proposal from Seplat that it believes is capable of being implemented on terms satisfactory to all relevant stakeholders in the company, including the indicated value being significantly below the aggregate value of the debt of the company,” Afren said last Friday, adding that the board had concluded that continuing discussions with Seplat was not in the best interests of stakeholders. The announcement was made without Seplat’s consent, Afren added. 

However, can Afren really dictate terms right now? 

Going Under? 

If Afren were on the brink of collapse, there’d be more than one chance that managers would have accepted an offer — *any* offer — from a suitor, even one “significantly below the aggregate value of the debt” of Afren. That’s how deals are done in these circumstances. 

Does Afren management perhaps know something we don’t know?

Very possibly — they have a better understanding of their business model and financials — but key information is out there in the marketplace and helps us assess whether Afren will continue to operate as a going concern or not. 

Fight For Survival 

Many cyclical businesses struggle to run their operations at times, simply because their capital structures are stretched, which means their balance sheets carry too much debt. I believe that that is the case for Afren, whose operating profitability is strong but not strong enough to generate enough cash flow to cover for principal and interest repayments right now. 

At a time when Afren’s 2014 revenues are expected to drop by 40% to about $1bn, too little equity and declining cash flows do not provide reassurance, given that lots of cash must be spent to finance heavy investment, which is key to revenue growth. What’s encouraging, however, is that if the business were properly financed, it would find it much easier to manage its cash flows. This is something that banks, bondholders as well as third parties like distressed debt funds involved in the negotiations will consider. 

All things being equal, Afren needs more than $500m of equity to keep going, while part of its debts (say, 35% or more) must be swapped with equity, in my view. 

One way to engineer a recap deal would be to include some second-lien or mezzanine financing with a one-year grace period in order to preserve cash flows over the short term, hoping that Afren will have found a solution to its problems by the time oil prices have stabilised. Then, Afren may warrant a premium to its unaffected share price…

Of course, as I recently argued, there's a chance that Afren will not be able to cut a deal with its lenders, but any Afren-related losses in your portfolio could be offset by massive gains from a few low-risk stocks that will likely reward you with a 20% pre-tax gain annually.

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended Afren. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.