Rolls-Royce (LSE: RR) and IGAS Energy (LSE: IGAS) are two stocks I’m steering clear of for 2016. Let me explain why.
Shares of Rolls-Royce fell 32% in 2014, followed by 34% in 2015. The FTSE 100 aerospace giant issued no fewer than five profit warnings over the period. City analysts expect the company to post an earnings drop of 20% when it releases its 2015 results next month; and have pencilled in an accelerating decline of 43% for 2016.
As the series of profit warnings unfolded, it seemed at first that Rolls-Royce’s troubles were relatively limited, with the impact of the falling oil price on the Marine division being particularly prominent. However, the fifth profit warning in November, and the release of the initial findings of new chief executive Warren East’s strategic review the same month, showed the company’s problems to be deeper and more wide-ranging than previously indicated.
Rolls-Royce continues to have a number of attractive qualities, including a £76.5bn order book and an embedded culture of engineering excellence, while Mr East — the former boss of British tech champion ARM Holdings — knows what it takes to run a world-class business.
I just feel a turnaround and the rebuilding of investor confidence could take some considerable time. With the shares trading on a pricey 19 times forecast 2016 earnings and the dividend increasingly being seen as under threat by City analysts, I see little reason to rush to invest at this stage.
AIM-listed IGas Energy has been more directly and severely hit by the low oil price than Rolls-Royce. Shares of this onshore UK oil & gas explorer and producer fell 67% in 2014, followed by 52% in 2015.
I wasn’t keen on IGas this time last year, suggesting it was highly likely it would need to raise cash. Despite the company avoiding having to do a rescue fundraising from shareholders by selling off £30m of assets, and despite the share price now being considerably lower than a year ago, I’m still not keen.
Debt and cash flow are huge problems for IGas, whose market cap is currently £53m. At the last balance sheet date of 30 September, the company had gross borrowings of over £100m and net debt of £64m. In the six months to 30 September, cash generated from continuing operations was just £0.24m.
The vast majority of IGas’s borrowings is in the shape of secured bonds (with a 10% per annum coupon) which mature in March 2018. The prospects for IGAS repaying the debt — or refinancing it on reasonable terms — don’t look good. The bonds have recently been changing hands at a 40% discount to par, giving a 17% yield. What that tells you is that hard-nosed bondholders at the top of the pecking order for recovering their investment are pretty pessimistic, which means that equity holders — who rank bottom — should be seriously worried. The risk of a hugely dilutive debt-for-equity swap — or a total wipeout for shareholders, à la Afren last year — is a very real possibility.
For this reason, I’m avoiding IGas. In fact, I see the downside risk as substantial enough that I would sell the shares if I happened to own them.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.