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Will the Petrofac share price reach 800p in 2018?

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One of the largest holdings in my personal portfolio is oil and gas services company Petrofac Limited (LSE: PFC). I bought the stock after the share price crashed last April, when the Serious Fraud Office opened an investigation into the firm for suspected bribery, corruption and money laundering.

My thinking was that the eventual recovery from this setback would coincide with a wider recovery in the oil market. Company profits and market sentiment would gradually improve together, leading to a re-rating of the share price.

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How’s it going so far?

Progress so far has been good. When I last wrote about it at the start of March, the firm’s shares were changing hands for about 430p. They’ve risen by about 30% since then, as the price of crude oil has surged towards $80.

The company has also announced more than $1.1bn of new contracts in India and the Middle East over the last two months, suggesting that its sales pipeline may be improving.

We’re not out of the woods yet

Some challenges remain. We don’t yet know the outcome of the SFO investigation. There’s a risk that the company could face a substantial fine if found guilty.

A second problem is that profits are expected to fall again in 2019. The legendary growth investor Jim Slater always recommended not buying a turnaround stock until forecasts showed a return to profits growth.

Good value

Petrofac’s growth credentials may still be uncertain. But for value investors, I think the firm has a lot to offer. Free cash flow totalled about £215m last year, giving the stock an attractive free cash flow yield of 10% and supporting the dividend.

Profit margins also seem to have stabilised. Last year saw an underlying operating margin of 8%. Forecasts for 2018 suggest to me that a similar result is likely this year.

My target share price of 800p would put the stock on a P/E of about 12.6, based on 2018 forecast earnings. That’s probably a bit punchy at the moment, but it should be achievable once the business returns to growth.

Today, the shares trade on a forecast P/E of 9.5 with a prospective yield of 4.8%. I believe they offer good value at this level.

Another special situation?

Indian mining group Vedanta Resources (LSE: VED) has provided a rich stream of dividends for investors brave enough to take the plunge.

I say brave because this group carries certain extra risks when compared to the other big FTSE mining plays. Its Indian copper business has run into problems recently. And unlike most rivals, it hasn’t yet taken advantage of the mining recovery to reduce debt levels.

Vedanta ended last year with net debt of $9.6bn, up from $8.5bn one year earlier. This borrowing equates to 2.3 times earnings before interest, tax, depreciation and amortisation (EBITDA) and to a whopping 6.4 times last year’s after-tax profit of $1.5bn.

Both of these figures are too high, in my view. But in this case I might make an exception.

Two hidden advantages

There are two reasons for this. The first is that Vedanta’s assets are highly cash generative. The group generated free cash flow of about $560m last year, covering its $164m dividend payment more than three times over.

The second reason relates to the group’s ownership. Chairman Anil Agarwal controls Vedanta through a 67% stake that’s held by his investment vehicle, Volcan Investments. Only 25% of the group’s shares are traded publicly.

This carries risks for minority shareholders, as Volcan can effectively control the group’s future. But Mr Agarwal has kept Vedanta listed on the London market for 15 years. I think it’s unlikely that he’ll turn rogue now. And if the commodity market remains stable, I think he should be able to refinance and repay the group’s borrowings without much difficulty.

In my view, Vedanta stock is priced cheaply enough to reflect the risks I’ve discussed. The shares trade on a forecast P/E of 7.9 for 2018/19, falling to a P/E of just 4.9 for 2019/20. The forward yield of 7% should be covered by earnings and free cash flow. For bold investors, I believe this could be a profitable buy.

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Roland Head owns shares of Petrofac. 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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