Fat Prophets take some profits

As contrarian investors we like to be first to the punch and the identification of an overlooked company with robust fundamentals and terrific prospects ahead of the crowd is central to our success. In the case of support services company Petrofac (LSE, PFC) this week’s bullish statement from investment bank UBS is a clear indication that it no longer remains under the radar and given the impressive, protracted rally we recommend members bank a 65% (excluding dividends) return by reducing exposure by half.

All too often, the investment worlds so called experts are proven wrong. Whilst UBS’s revised £10 target for Petrofac shares is a resounding positive for shareholders such comments can lead to over optimism controlling the share price. Similarly on the downside, a downward revision can herald a wave of negative sentiment and can yield buying opportunities and although we have no hard and fast rule, going against the prevailing investment bank grain has often served us well.

Take for example our recommendation of pub operator JD Wetherspoon which in, less than 3 months, yielded a 57% gain. Members will be aware that at the time of our initial recommendation, Deutsche Bank had placed a sell recommendation on the shares.
 

Whilst it would be folly to disregard the expertise which can found at the desks of the major investment banks, they remain the very same entities which invested so heavily in mortgage backed securities. As investors we pay particular attention to their moves in the market.

Irrespective of events elsewhere, the rise of Petrofac shares over the last 20 months is all the more remarkable given the prevailing wave of asset price deflation. However after such an upward move taking some profits at this stage provides us with comfort on the upside as well as the downside.

Not only have Petrofac shares posted a 65% return since our initial recommendation in November 2007, shares have rallied 21% since our most recent recommendation just 5 weeks ago. It is unlikely that such rapid gains can be maintained.

Today’s forward price earnings ratio of around 14 times is actually lower than the 20 times at the time of our initial recommendation. However back in 2007 earnings estimates were extremely low and, as we noted at the time, did not reflect Petrofac’s ability to secure business and bolster its bottom line.

20 months on and the earnings estimates across the sector as a whole are higher and somewhat perversely, at 14 times earnings, today’s Petrofac’s valuation is stretched compared to certain sector peers such as John Wood Group (11 times).

However, we remain convinced of Petrofac’s out performance over the long run and the awards keep coming.

Last month the company was awarded a major contract worth approximately US$2.1 billion from state-owned Abu Dhabi Gas Industries Ltd (Gasco) which is said to be worth around US$1 billion to Petrofac Emirates, its joint venture with Mubadala Petroleum Services LLC. The award combines the joint venture with Korea’s GS Engineering & Construction and further enhances Petrofac’s position at the forefront of the support services arena.

The four year deal begins this month and is for the construction of the fourth natural-gas liquids train at the Ruwais complex in Abu Dhabi. The award is the first project to be awarded to Petrofac Emirates, which was established in November 2008 and in our view Petrofac’s rising profile in the Middle East will ensure that many more follow.

This was not the only contract won in July. Indeed, the award came only days after Petrofac had signed a new contract with Apache North Sea Limited for onshore engineering and various offshore construction services.

Much like the contracts being offered to players by Middle Eastern owned Manchester City FC these days, Petrofac’s services have been secured for a minimum of 3 years with two optional one-year extensions and is worth approximately £25 million per annum.

Encouragingly, Apache has invested well over US$1.2 billion to renovate a very mature and significant UKCS asset. And with further investment planned, there is scope for Petrofac to broaden its offering to Apache and win additional contracts for further work.

It is evident that Petrofac serves the strong, breezing through 2009 seemingly oblivious to the woes that are forcing businesses everywhere to recapitalise and restructure strategy.

So far this year the company has gained around US$6.5 billion of new business - no mean feat given the excessively taught nature of the credit markets for much of the period. And what’s more the company estimates that the total backlog is currently expected to be approximately US$8 billion which is double the amount at the turn of the year.

Our decision to sell half our holding is a function of prudent portfolio management and is does not reflect a bearish view on the business. Indeed not only do we remain convinced of Petrofac’s long term earnings out performance and astute business strategy, certain macroeconomic dynamics point to a rosy future.

Whilst the company would benefit from a crude oil price in excess of US$100, this is by no means essential. As long as prices remain ‘high’ (evidently current levels are high enough), oil companies will remain active and Petrofac will continue to pick up contract after contract.

Encouragingly, oil currently sits around US$70 per barrel in the absence of any positive data from the globe’s foremost consumer the US. The International Energy Agency recently stated that they expect global energy demand to pick up next year after two years of successive declines and this we believe will set the stage for a dramatic re rating.

In the coming years we expect the price of crude oil to reflect the increasing costs associated with extraction and this provide a springboard for earnings across the entire spectrum from pure play producers to integrated heavyweights. In our view Petrofac will be able to tap into the capital expenditure budgets of these entities all the more easily as the pursue strings loosen.

Since our last review in July, there has been a further improvement to Petrofac’s technical picture. Following a break above the May high of 694p, prices rallied swiftly to the upside, reaching 848p earlier this week. As evident on the daily chart, this is a new all-time high for the stock.

Given the large percentage gains over the last month, we anticipate a period of consolidation in the near term. Nevertheless, previous resistance in the region of 745p to 694p is now likely to provide solid support, limiting downside risks.

From a broader perspective, prices have formed a solid upward trend over the past six months, following a sharp decline throughout the second half of 2008. Although the risk of a pause in the trend has increased in the near-term, with no chart resistance overhead, we believe Petrofac continues to offer solid upside potential over the longer-term.

Given the protracted rally in share price, we recommend Members sell half of their Petrofac shares at 824p.