Description

Summary

Petrofac's is a London-listed MENA-focused EPC business serving the energy industry and its shares are a short because of

1. Aggressive profit recognition and slow pace of write-offs in the Integrated Energy Services division (“IES”), which may be worth $1bn at best (if one was to believe management) and next to nothing if one was more critical,

2. Highly irregular working capital movements for the Onshore Engineering division (“OEC”), for which management doesn’t have good explanations or, in fact, contradict representations by management, potentially due to earnings manipulation, and

3. Several red flags raised by the company’s accountants in the 2014 annual report, which haven’t been covered by sell-side analysts.

With the chairman of the company selling ~20% of his holdings aftermarket, we think there are good reasons to believe that the shares will sell off further by another 30-40% over the next few months. Borrow was available and cheap last time we checked, although liquidity in the stock generally is poor with ~2mn shares traded per day, but if anything, this post should warn the investment community of the potential landmines in this business, which is actually well liked by many sell-side analysts.

We will first provide a short description for the business and the activities of the key divisions before laying out the evidence for the short thesis, concluding with an estimate of where this stock could end up going to. We added feedback / commentary from company management / investor relations and also provided sources where appropriate.

Business Description

Petrofac principally consists of an EPC business, the OEC division, that provides fixed price engineering and construction services to the energy industry, and effectively E&P businesses in the IES division. Below is a breakdown of the business in terms of revenue and EBITDA before corporate expenses and eliminations, and before the losses on the Laggan-Tormore contract incurred by the OEC division which we regard as a one-off. These tables show that the OEC and the IES division are the responsible for the bulk of the revenues and EBITDA of Petrofac. For completeness purposes: the Offshore Projects & Operations (“OPO”) division is a low margin business performing mostly cost-plus work on offshore platforms with relatively little contribution to group profitability and similarly, the Engineering & Consulting Services division mostly employs skilled engineers in India in order to do a lot of the engineering work needed by the OEC division, set up this a way to make the business more tax efficient.

Description of Key Divisions

The OEC division bids on construction contracts, e.g. for gas compression plants, and employs the percentage-of-completion method to recognize revenue, which always is a contentious accounting issue. Since 2012, when competition from Korean EPC businesses in MENA increased, the OEC division has exhibited no revenue growth whereas its working capital position went from being very negative (quite customary for EPC businesses to due downpayments received at the beginning of projects), to close to being flat, consuming a lot of cash in the process. The net working capital drag on cash flows may have offset the cash that this business should have generated - unless of course, these “profits”, with which should have come cash flows, were fabricated and never existed in the first place.

The IES division spends money, which mostly gets capitalized, in order to get paid via incentive contracts of various shapes and forms. There are various forms of incentive contracts out there, which range from Production Enhancement Contracts (“PECs”, e.g. the Mexico contracts with PEMEX) on which Petrofac should get ~80% cost cover and then a fixed tariff per barrel of production above specified production thresholds, over Risk Service Contracts (“RSCs”, e.g. the Malaysian Berantai contract) for which Petrofac incurs all the capex itself in exchange for say 50% of incremental production, and lastly Equity Upstream Investments (“EUIs” such as the Greater Stella Area project) which should be straightforward investment stakes in oil fields. Whilst these may sound like three somewhat distinct types of contracts at first, as one digs deeper, the lines get blurry, particularly given the accounting treatment of these contract types.

1. Accounting Recognition of IES Contracts

The accounting recognition of IES contracts is aggressive because the company records them at “fair value” (2014 annual report page 131) and holds them in the “other financial assets” bucket, effectively recognizing all profits upfront, whilst also capitalizing the costs into PPE. Misleadingly, they label these fair valued contracts “receivables”, such as the “Receivable under the Berantai RSC” or the “Receivable in respect of the development of the Greater Stella Area”. Normally, receivables or revenues should only be recognized if they are rather certain, and most certainly if revenues are linked to volatile factors like oil prices, but Petrofac decided it’s they’d rather recognize all that non-cash profit upfront. Arguably, management has classified these “receivables” as “financial assets”, so it’s fair, although certainly confusing.

In today’s environment, the first question that springs to mind is whether the PECs and RSCs have oil price risk (EIUs have undoubtedly oil price risk unless your valuation model are doing funny things), and the answer preferred by management is a resounding “no” at first, but former execs suggested that there definitely is oil price risk: directly in RSCs due to Petrofac taking a share in revenues above certain production thresholds, and indirectly in PECs because fewer wells become profitable at lower oil prices so you produce less volumes and pocket fewer fees in the end of the day. By that logic, today’s lower oil prices should have resulted in significant impairments to financial asset values, which however, isn’t really the case.

Looking at the accounting methodologies, one can see that management doesn’t pay much regard to prevailing oil price levels or the dismal cash flows their IES investments are generating, because of their opaque ways of valuing these financial assets. If you dig in the notes, you can see that they use level 3 fair value measurement to value their Berantai asset, although oil prices clearly should be an observable input for the valuation. Even more strangely, the Greater Stella Area receivable was moved from level 2 to level 3 (2014 annual report page 131) during 2014. Now, the Greater Stella Area receivable is extraordinarily strange because it also captures a loan made to the struggling subsidiary instead of neatly separating it out, but one can’t ask for too much transparency from this management team. As we asked management about why they moved the accounting levels for the Greater Stella Area receivable, the feeble response was “because our auditors told us so, we did this that we are able to impair the Greater Stella Area receivable”, which is not very satisfying, also because they appear to be happy to clash with their auditors on OEC revenue recognition, as we will see later. Overall, their accounting methodology appears to be very arbitrary and not very consistent throughout time and their asset portfolio.

If one fully believed management, one would generously attribute $1bn in valuation to this particular division because of a $500mn receivable from PEMEX and apparently, there is an option in the Berantai contract by which Petrofac could get the book value of $360mn back. Management struggled very hard to explain to us how the Berantai put worked, supposedly Petronas guaranteed Petrofac a minimum 11% IRR on the capex and could “invoke” a payment to get Petrofac to that minimum IRR, but please don’t ask why Petronas would ever pull the trigger themselves or whether the minimum IRR payment can be triggered by Petrofac because management couldn’t provide an answer to this seemingly straightforward question. Also the PEMEX contract is currently being renegotiated with PEMEX so management has excused itself to give any guidance to what the contract was in the past or will be in the future. Right now, the Berantai and PEMEX contracts apparently generate “single digit million $” net profit per year, yet together make up more than 50% of the net book value of IES as per company so absent any real minimum payment by Petronas or significantly more favorable contract from PEMEX, it is unlikely that the IES division is worth the $1.7bn book value as per their 2015 results presentation.

2. Highly irregular working capital movements

The OEC division employs percentage-of-completion method of accounting for revenues and costs, and by extension profits, and it is not so much the receivables and payables that are concerning, but the “work-in-progress” and “accrued contract expenses” lines. These lines are not concerning because they are, by nature of what they are, revenues / costs recognized in your income statement but not yet billed to a client because the relevant milestone hasn’t been met yet or the invoice has not yet received, as it is quite customary for companies using percentage-of-completion accounting. However, the movements in working capital elude any explanation we’ve heard so far from either analysts or management. This area has attracted a lot of scrutiny and questioning from other buy-side analysts and here is our take on it.

In the 2015 results call, management explained that the cash flow drag in NWC has been due to extraordinarily high cash advances received by OEC between 2009 - 2011 (Bloomberg transcript page 6), but this is wrong as the cash drag is due to a much higher work-in-progress balance. As one breaks out the payables line in its components, one can see that advances from customers has never been as negative, i.e. as cash releasing, as it has been in 2015. Whilst the 2011 number was indeed relatively high compared to the years before and after it, today’s much more positive NWC balance is not driven by customer advances but by a much larger work-in-progress figure which means that management has accrued for a bunch of revenues that haven’t been billed yet.

The thing to point out is that a larger work-in-progress number doesn’t have to be illegitimate in itself for a growing business as the company is clocking more revenues and racking up more costs as it is taking on more projects. However, the OEC division has not really grown between 2011 and 2015, even when one includes the fixed price construction business that used to be part of OPO, which did admittedly grew a fair bit between 2013-2015, one wonders whether this could really justify an increase in WIP of $1bn since 2010. Furthermore, even if you bought the argument of a growing business, note that in the “accrued contract expenses” line has (a) moved more in line with revenues, and (b) again exhibited nowhere near the same growth profile as work-in-progress. Management brushed off these movements in work-in-progress etc. as being tied to contract level accounting that they don’t want to provide detail on.

3. Accounting red flags

Last but not least, we want to highlight worrisome language that we found in the notes of the 2014 annual report concerning auditors’ clashes with management over accounting policies, some instances of fraud that prompted management calling in 3 of the Big 4 accounting firms to conduct fraud risk assessment, and instances of weak internal controls.

Disagreement over accounting:

“The [Audit] Committee reviewed the reasonableness of judgements made regarding the cost to complete estimates, the timing of recognition of variation orders and the adequacy of contingency provisions to mitigate contract specific risks for projects significantly behind schedule. Consideration was also given to the assessments made in relation to the recognition of liquidated damage provisions and to the impact of certain larger contracts being entered into as part of consortiums. The Committee held discussions with Executive Directors and received regular internal audit reports into the operating effectiveness of internal controls relevant to these judgements. The external auditors challenged management on the revenue recognition amounts and reported their findings to the Committee.

The Committee concluded that the timing of recognition continues to be in line with IFRS requirements although ongoing monitoring of the judgements was requested as part of the Group’s regular management reporting.” (page 90)

Emphasis is ours. In the 2013 annual report, there was no “external auditors challenged management” and the committee concluded that they “were comfortable with the judgements made in respect of these items” instead of requesting ongoing monitoring. In all fairness to Petrofac, Amec Foster Wheeler also has their auditors saying that they “challenged” management over revenue and margin recognition, however, Amec has just taken over Foster Wheeler which had a larger fixed price construction division, so it is somewhat more acceptable for the auditors to challenge management over the revenue recognition policies. Petrofac didn’t do any major acquisitions or changed their business in any major way, therefore it is more suspicious to see auditors suddenly inserting this type of language.

Potential fraud:

“Following on from the work started in 2013, KPMG-Forensics completed their independent fraud risk assessment (FRA) within the OEC business. Further FRA exercises by PwC and Deloitte have now commenced within OPO and the IES Mexico business respectively, which aim to understand the major fraud risks which may affect each business and to identify any weaknesses in our current processes. This work will continue throughout 2015. We believe that these exercises are very timely, as during 2014, a small number of cases of potential fraud were identified in different parts of the business. Each of these issues, whilst not material in the context of the Group’s results, was brought to the attention of the Committee with full investigations conducted and ongoing.” (page 88)

Apparently, it is good practice to conduct an FRA from time to time, but given the costs of these accountants, it is very usual to call in forensic accountants from the other big accountancies unless management worry that the ones already hired are incapable of handling the investigations or are also compromised. One would think any one of the Big 4 would be able to handle these affairs and one can only speculate that there is something bigger going on.

Weak internal controls:

“During the year, a small number of incidents involving the override of major internal controls were identified including non-compliance with the Code of Conduct and these were duly reported to the [Audit] Committee. Discussions were held to outline the investigation and actions taken, including preventative activities required to avoid recurrence.” (page 91)

As per management, this related to the fact that they guided for 2015 profits at the beginning of the year but then had to issue a profit warning as losses on Laggan-Tormore rose. We are sceptical that this is the whole story as the language reads “a small number of incidents”, but one would need to ask the audit committee itself. Interestingly, management kept the practice of recognizing losses on Laggan-Tormore as time went on instead of making a provision for the total loss to be unwound over time, but we appreciate that Laggan-Tormore was special project where the project team was way out of their comfort zone.

Conclusion

Applying 5x multiple of analysts consensus EBITDA of $850mn, which is appropriate for a mediocre EPC businesses given the risk of project cost overruns, you end up with a target share price of GBp 650 vs. the GBp 900+ right now. If one were to attribute no value to IES and valued the remaining businesses at a 5x EBITDA based on the company’s firm backlog for 2016 and EBITDA margins of ~10%, one arrives at a share price below GBp 500, ~40% lower if the company opens in the 800s tomorrow, which it is likely to given the share placement. Needless to say, seeing insider selling is never a good sign despite the CFO recently stating that he never felt as comfortable with regards to the company’s financial standing, but quite frankly, his historical record of providing guidance around financials has been patchy at best.

We’ve spent a lot of time trying to get comfortable with a company where management owns a lot of the equity and has had a good track record in the Middle East, which is the only area in the world where the energy industry is booming today, but we have always been disappointed. Could be equity be worth nothing? Maybe, but the company should have $1.1bn in cash on balance sheet so it is not immediately obvious whether there is any hard catalysts such as a capital raise or bankruptcy.

Catalyst

No hard catalysts as company appears to have a lot of cash on its balance sheets. May re-rate due to insider selling and sustained competition in core EPC business in MENA even if suspicions of fraud don't harden.