Why Petrofac Limited could trade 40% higher by 2018

Oil services firm Petrofac(LSE: PFC) is performing well operationally and the outlook is positive, yet the firm languishes on a low-looking valuation.

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A return to modest profit

Lower oil prices and challenges relating to a big loss-making contract have affected the company's business over the last of couple years. But February's full-year results for 2016 revealed that revenue was up 15% and there was a return to a positive net profit of $1m, compared with a loss of $617m during 2015.

In an indication of how cash continues to flow into Petrofac's coffers, net debt plunged 10%, which can only be a good sign, in my opinion. The directors showed their cautious optimism by maintaining the dividend at 2015's level and said that the payout is "well covered" by free cash flow.

The statement outlined Petrofac's plan for recovery, which is to focus on core strengths and reduce capital intensity. By focusing on costs and generating cash from operations, the directors believe Petrofac can maintain a strong balance sheet, and the news that debt is reducing lends weight to assertions that the recovery plan is working.

Chief executive Ayman Asfari reckons that the firm's markets are competitive, but bidding activity has increased in recent months. He says Petrofac has a decent pipeline of opportunities across its core markets and has enjoyed recent success tendering for contracts. The firm's backlog of work commitments, he says, provides "excellent" revenue visibility for 2017.

The elephant in the room

Petrofac's business seems to have stabilised and, in my view, looks poised to recover and gain more ground operationally from here on, even if the price of oil stays where it is. Today's slimmed down Petrofac looks fit for the current operational environment. The oil industry can't put off maintenance and development work forever and that's why Petrofac is seeing a stream of new contracts coming through now.

The elephant in the room is the possibility that the price of oil could plunge to half its value again and stay there, pulling the rug from under the entire industry and rendering many operations economically unviable. If that happens, Petrofac will see its workload plummet, along with its profits and its share price. However, reading the tea leaves, I think that outcome seems unlikely and it's just a risk we must take to hold shares in Petrofac today.

A valuation anomaly?

Perhaps the fear of a future plunge in the price of oil keeps Petrofac's valuation modest. Today's 915p share price puts the firm on a forward price-to-earnings ratio around 10 for 2018 and the forward dividend yield runs near 5.9%. City analysts following the firm expect earnings to cover the payout just over 1.7 times.

This valuation compares well to the median forecast of all stocks on the London stock market that have estimates, which shows an average P/E ratio of 14.1 or so, and an average dividend yield of around 3.2%.

Assuming investor confidence grows that the oil price will not plunge, and that Petrofac can continue its operational progress, I reckon the firm's valuation could re-rate closer to this median forecast level, perhaps before the end of 2017, suggesting around 40% upside potential for the share price on top of gains due to potentially higher profits.

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Kevin Godbold owns shares in Petrofac. The Motley Fool UK owns shares of and has recommended Petrofac. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.