Oil platform in North Sea

Four simple reasons to avoid Premier Oil plc

Oil platform in North SeaDisclosure: I have no financial interest in Premier Oil.

Premier Oil’s interim results confirmed my view of this stock: this company has good assets and is operating well, but its debt situation means the stock remains a sell for equity investors.

Here’s are four reasons why I think big losses are likely for Premier Oil shareholders.

1. Covenants would be breached if tested

Net debt rose to $2.6bn during the period and is expected to peak at $2.9bn during Q3. The firm’s net debt/EBITDAX ratio was an eye-watering 5.2x at the end of June, significantly above the firm’s covenant maximum of 4.75x. This is why covenant tests have been suspended while refinancing discussions are ongoing — Premier and its lenders don’t want the firm to fall into default.

However, the significance of this situation is that Premier’s lenders have the firm over a barrel. Premier can’t walk away and find a better deal elsewhere. It has to reach an agreement with its lenders, otherwise it will default on its loans and risk being put into administration.

2. “A full refinancing”

Premier isn’t just tweaking the terms of its loans. In the results webcast yesterday morning, Premier’s FD Richard Rose said that the current debt negotiations are “effectively akin to a full refinancing of the group”.

Mr Rose also explained that the firm has “four or five” lending instruments, each of which has multiple lenders behind it. He estimates Premier is dealing with about 50 lenders in total. So the complexity involved in the negotiations is considerable. Reaching agreement won’t be easy and the lenders have the upper hand.

Premier is hoping to agree revised covenants and longer maturities on some of its loans. In return for this, management expects to accept higher interest rates and to use the firm’s assets to secure its debts.

Management also indicated that during the deleveraging process, Premier is likely to have to get lender approval for any major new investment plans. CEO Tony Durrant indicated that no major new investment spending is likely for the next couple of years.

Details of the refinancing should be finalised during the second half of the year. Shareholders may feel that they are safe, because Premier’s current 78p share price equates to a discount of about 40% to the group’s net asset value.

However, my view is that if Premier’s lenders are having to make compromises and wait longer for their money, then shareholders are also likely to face losses. One possibility is that lenders will get a slice of Premier’s equity, perhaps through the issue of a large number of warrants for new shares.

3. $5 per barrel

One interesting figure from yesterday’s call is that Premier’s interest costs currently amount to about $5 per barrel. This could rise as a result of the refinancing. This figure gives a real taste of the burden the group’s debt pile is placing on its cash flow.

At $50 per barrel, 10% of Premier’s revenue would be absorbed by interest costs alone. Repaying the capital on these loans at sub-$60 oil prices won’t necessarily be easy or quick, especially as the group’s cash flow faces an additional risk in 2017.

4. Hedging risk?

During H2, Premier’s existing hedging positions means that the group will be able to sell oil at an average of $65 per barrel. But in 2017, this coverage tails off. Premier’s figures indicate that current hedging will only provide an average oil price of $45 per barrel in 2017.

If the oil price doesn’t make progress above $50, then this lack of hedging could have a significant impact on Premier’s cash flow.

Only one conclusion

Premier was tight-lipped about the likely terms of its refinancing in yesterday’s call. But it’s clear from management comments that other potential sources of cash — such as pre-pay agreements for oil and gas sales — won’t be viable until the firm’s lenders have agreed a new deal.

I think there’s a reasonable chance the refinancing package will include some kind of dilution for shareholders.

Even if it doesn’t, shareholders should remember that both growth and shareholder returns will effectively be off the cards for the next couple of years. Furthermore, if oil stays low, Premier’s financial difficulties could become even more severe.

I can’t see any reason to own the shares at this point in time.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

An open-cast coal mine

Why I’ve sold South32 Ltd

An open-cast coal mineDisclosure: I own shares of Anglo American and BHP Billiton, but not South32.

I’ve sold my shares in BHP Billiton-spin off South32 Ltd (S32.L). There are three main reasons for this:

  1. My holding was limited to the shares I received as a BHP shareholder. As such, it was a very small part of my portfolio. I’m trying to maintain a more deliberately-constructed portfolio without such oddments.
  2. I already have considerable mining exposure through my holdings of BHP Billiton and Anglo American. Both are sizeable positions (for me). I remain confident about the medium-term outlook for both companies but don’t feel that South32 adds much to the opportunity offered by these much larger firms.

As it happens, I think South32 is a fairly decent company. The balance sheet appears strong and cash generation also seems reasonable. Had I invested in size in South32 when the shares were lower, I might have made this a core position.

However, South32 looks fairly valued to me for now. I’m not tempted to buy more. So I decided to swallow the dealing cost and sell, in order to boost my cash position ahead of my next buy.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Lonmin underground mine (copyright Lonmin)

Lonmin plc Q3 update: does this valuation still make sense?

Lonmin underground mine (copyright Lonmin)

Lonmin underground mine (copyright Lonmin)

Disclosure: At the time of publication, I own shares in Lonmin.

Lonmin shares have tripled in value in just seven months.

I’ve become increasingly aware that unlike the other big miners, Lonmin’s share price recovery is not backed by rising profits and substantial balance sheet improvements.

After such rapid gains, I thought it was worth taking a fresh look at the stock following yesterday’s Q3 update. I’m concerned that Lonmin’s financial progress may be slowing.

The company warned that full-year costs are now likely to be between R10,400 and R10,700 per PGM ounce, up from guidance of R10,400 per ounce previously. The rand also appears to be gaining strength relative to the US dollar.

In this article I’ll ask whether Lonmin’s market cap still makes sense. Is the risk/reward balance still favourable for equity investors?

How to value Lonmin?

Profits? Lonmin’s lack of profits makes valuation more difficult. Looking back at the group’s historical performance isn’t hugely helpful either. Between 2010 and 2014, Lonmin generated an average post-tax profit of -$9.4m. During this period, platinum prices were mostly higher than they are today.

The picture that emerges is one of unpredictable profitability driven by platinum prices, the USD/ZAR exchange rate and poor cost control and labour relations.

Book value? How about the value investor’s favourite metric, book value? Lonmin’s last reported book value was about 510p per share. The stock currently trades at a discount of more than 50% to this valuation.

However, as with the UK’s banks, a distinct lack of profits could mean that Lonmin trades below book value for a long time yet. A P/E of 20 — not unreasonable for a recovering cyclical business — would imply a net profit of $95m.

On the same basis, the current share price of about 230p implies a net profit of about $43m. Yet consensus forecasts suggest a loss of $17.9m this year and a profit of just $1.4m next year.

I fear that there’s a big gap between the performance implied by Lonmin’s current valuation and the reality.

PGM prices vs. exchange rates

Lonmin’s profits could rise sharply if the price of platinum continues to recover. This could well happen, as the white metal remains well below levels seen in the past:

IG Index 5yr platinum chart

Platinum prices over the last five years (source: IG)

However, recent gains in platinum — which has risen from $1,009/oz to $1166/oz since the start of July — have not resulted in rising forecasts. In fact, the consensus view has edged slightly lower, with the Reuters consensus forecast loss per share dropping from $0.15 to $0.19 at the start of August.

One reason for this may be the USD/ZAR exchange rate, which now appears to be moving against Lonmin:

IG USD/ZAR price chart

1yr USD/ZAR price chart (source: IG)

Exchange rates are at least as important as PGM prices for Lonmin. Yesterday’s update confirmed this view. Consider these figures, which represents 2016 and 2015:

Average prices $ basket incl. by-product revenue $/oz 796 907
R basket incl. by-product revenue ZAR/oz 11,864 10,861
Exchange rate Average rate for period ZAR/$ 14.99 12.08
Unit costs Cost of production per PGM ounce ZAR/oz 10,596 10,839

Data from Lonmin Q3 2016 Production Report

The USD PGM basket price has fallen by 12% over the last year, while the same basket priced in rand has risen by 9%.

This kind of swing is one of the reasons Lonmin’s historical profits have been so volatile. As a matter of policy, Lonmin’s doesn’t hedge commodity price exposure. Nor does the group have businesses in other countries which act as natural hedges.

Thus long-term survival is dependent on having low cost assets and building up a big cash pile when times are good. I’m not sure Lonmin’s track record of three rights issues since 2009 supports such a confident outlook for equity investors.

What about cash flow?

Ultimately, a business is only viable if it can generate positive cash flow.

Last year’s $407m rights issue left Lonmin with net cash of $69m. At the end of Q3, that figure had risen to $91m, suggesting positive cash flow of $22m so far this year. This figure may have been distorted by working capital and forex movements, so I’ve done my own sums.

Using Lonmin’s published figures from H1 and Q3, I estimate that the firm has generated operating cash flow of around $40m so far this year. After three quarters, Lonmin appears to be some way short of covering this year’s planned capex of $105m — which is the bare minimum necessary to maintain and improve current operations only.

Lonmin expects the fourth quarter to be the strongest, but warned in yesterday’s updates of a number of factors which “have the potential to interfere with production” during this period. These include local government elections and wage negotiations.

My verdict

Lonmin has clearly made a lot of progress since its rights issue. Chief executive Ben Magara appears to be doing a good job of transforming and maximising the potential of the business.

I believe Lonmin does have the potential to become free cash flow positive and profitable. But I can’t avoid the conclusion that this outcome is heavily dependent on unpredictable PGM prices and the USD/ZAR exchange rate. There’s also the risk that costs will creep up again. Lonmin appears to be at the mercy of factors it cannot control to a greater extent than some other miners.

A second concern is that Lonmin’s valuation appears to price in a return to levels of profit that are an order of magnitude above current forecasts. I suspect further share price gains will be as much down to good fortune as good management execution.

On that basis, I’m going to sell my shares in Lonmin.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.


A share tip circled in a newspaper share listing

Barclays plc H1 results: mixed news, but I’m holding

A share tip circled in a newspaper share listingDisclosure: I own shares of Barclays.

Today’s interim results from value portfolio stock Barclays plc (LON:BARC) came in ahead of analysts’ expectations, hence the 6% rally in the bank’s stock.

Notwithstanding this, group pre-tax profit was down 20.7% to £2,063m. Group return on average tangible equity fell from 6.9% to 4.8%.

One bright spot was that Barclays’ CET1 ratio has risen from 11.4% to 11.6% so far this year.

For value investors, a further highlight was that tangible net assets per share increased to 289p during the first half, up from 275p at the end of 2015. Barclays’ continued actions to dispose of non-core assets, including the initial 12% placing of Barclays Africa, seem to be having a positive effect on the balance sheet. Even after today’s gains, the stock trades at a 45% discount to NTAV.

The problem — or at least the risk — is that Barclays still appears to have a mountain to climb. This is best expressed by the contrast between the profits from the bank’s core divisions and the losses from its non-core division:

  • Core pre-tax profit 1H16: £3,967m (1H15: £3,347m)
  • Non-core pre-tax loss 1H16: £1,904m (1H15: £745m)

There appears to be a profitable bank waiting to escape from a whole load of loss-making dross. The question is whether Barclays can dispose of its non-core assets quickly and cheaply enough.

A second question is whether the bank’s profit margins can survive further cuts to interest rates, as now seem possible in the UK. CEO Jes Staley said today that while a base rate cut to 0.25% would have little impact on margins, a drop to 0% could be more “significant”.

What next?

Banks have already taken longer than expected to recover. Today’s results suggest progress is being made but make it clear that there’s still much further to go. From my relatively non-expert viewpoint, the macroeconomic context doesn’t seem likely to accelerate Barclays’ recovery.

However, the bank’s balance sheet is improving and a capital raise appears unlikely. Mr Staley has already cut the dividend in half. My view is that the stock’s discount to net asset value should provide some downside protection, as long as the profitability of Barclays’ flagship UK banking and Barclaycard operations isn’t called into question.

One final thought is that on a two-year view, the chart below suggests to me that Barclays shares might be due a rebound — note the improving RSI and Momentum readings:

Barclays share price chart

Barclays share price chart July 2016 (courtesy of Stockopedia)

For now, I continue to hold.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Onshore oil installation

What does the DNO bid mean for Gulf Keystone Petroleum Limited shareholders?

Onshore oil installationDisclosure: I have no financial interest in any company mentioned.

I’ll update this post when Gulf’s board issues a statement or any further news emerges.

Update 29/07/16 @ 1945: Gulf Keystone issued a response to the DNO proposal after the market closed today.

The firm says that as the DNO proposal is for a post-restructuring takeover, the firm’s focus remains firmly on executing the restructuring successfully. Significantly Gulf emphasises that:

“we will not engage in any additional process that causes the Company to be distracted from that objective” [the restructuring]

In my view this implies support for the DNO proposal. But even if I’m wrong, this story can only end one way. Gulf Keystone shares remain dramatically overvalued, in my opinion.

Update 29/07/16 @ 1010: Gulf Keystone has issued a holding statement saying it is reviewing DNO’s proposal.

Update 29/07/16 @ 0945: Gulf Keystone shares continue to trade up on the day at about 4.2p versus the restructuring share issue price of c.0.83p and the DNO offer price of 1p.

This is crazy in my opinion. Although the DNO bid arguably undervalues the long-term upside from Shaikan, it certainly doesn’t undervalue it by a factor of 300 per cent or more. I remain confident that Gulf Keystone shares have much further to fall.

DNO makes $300m offer for GKP

Norwegian operator DNO ASA has launched a $300m takeover bid for Gulf Keystone Petroleum Limited (LON:GKP).

The cash and shares deal is intended to be implemented after Gulf’s proposed refinancing has been completed.

DNO’s offer is priced at a 20% premium to the equity value of USD 0.0109 at which Gulf Keystone plans to issue new shares under its refinancing plan.

DNO appears to have designed the offer to attract Gulf’s bondholders. This makes sense, as with Gulf in default on its bonds, the firm’s bondholders are in de facto control of Gulf Keystone.

According to this morning’s release from DNO, here’s what’s on offer:

  • For the Gulf Keystone guaranteed noteholders, the DNO terms reflect 111 percent of par value compared to 99 percent under the contemplated restructuring;
  • For the convertible bondholders the DNO terms reflect 18 percent of par value compared to 15 percent under the contemplated restructuring;
  • For ordinary shareholders, the offer represents a 20 per cent premium to the share price of USD 0.0109 at which Gulf Keystone is planning to issue new shares as part of the planned restructuring.
  • $120m of the offer will be in cash, with the remainder in shares. This will provide bondholders who don’t want to hold equity to make an immediate exit in cash (rather than having to try and dump their equity into a soft market).

There’s no response yet from Gulf Keystone’s board. I’d imagine that this is because they need to consult with their bondholders before issuing a statement.

My view is that this offer is likely to be attractive to Gulf Keystone’s bondholders.

Will anyone outbid DNO?

DNO is the largest of the Kurdistan producers in terms of both production and reserves. This morning’s statement made it clear that DNO is top dog in Kurdistan, and points out that Gulf Keystone is already dependent on its pipeline connection facilities.

I particularly liked the way that DNO emphasised that its oil is better quality (higher API number = lighter oil) than that of GKP. Here’s an extract from DNO’s proposal:

DNO has been active in the Kurdistan region of Iraq since 2004 and ranks number one among the international oil companies in oil production (50 percent), oil exports (60 percent) and proven oil reserves (50 percent).

DNO holds a 55 percent stake in and operates the Tawke oil field at a current production level of around 120,000 barrels of oil per day (bopd) of 27 degree API crude. Gulf Keystone holds a 58 percent stake in and operates the Shaikan oil field at a current level of around 40,000 bopd of 17 degree API crude.

Production from Shaikan is transported daily by road tanker to DNO’s unloading and storage hub at Fish Khabur for onward pipeline transport to export markets.

In my view, this is an opportunistic but pragmatic and fair offer from DNO. The reality is that companies in financial distress — like Gulf Keystone — can’t pick and choose. Gulf may not have the luxury of waiting until the market improves before selling up.

Gulf Keystone bulls will presumably believe that today’s offer from DNO is the opening salvo in a bidding war. Personally, I doubt this. My view is that other Kurdistan firms are unlikely to make a competing offer. DNO’s deep connections in the region give it an advantage. I can’t see an outsider wanting to get involved given the complexities and risks of operating in Kurdistan.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.