Why I'd dump both Petrofac Limited and Royal Dutch Shell plc

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shell

Over the past three years of depressed oil prices Petrofac (LSE: PFC) has proven the resilience of oil services firms' business model. While its share price has suffered during this time, the company has continued to post solid profits and return very healthy dividends to loyal shareholders.

Yet while this business model is sound, the Serious Fraud Office (SFO) corruption investigation currently under way, combined with persistently low oil prices, are reason enough for me to avoid buying shares of the firm today, despite what is looking like a very attractive valuation.

The problems with the SFO investigation are twofold. First off, there is the very real possibility of a large regulatory fine. Some analysts are mulling over the possibility of fines reaching as high as $800m. A fine of this size, or even a considerably smaller one, could be disastrous for income investors because this is nearly four times last year's total dividend payouts of $224m. Furthermore, although net debt at year-end was $617m, or just 0.8 times EBITDA, a fine this large would not be good for the balance sheet.

So while the company could survive a large fine with more debt and suspended dividend payouts, its share price would likely head further south. And the larger worry with the SFO investigation is that founder and CEO Ayman Asfari may be embroiled in it. We've already seen the longstanding COO suspended by Petrofac and removed by the board, showing that they are taking seriously the possibility of C-suite heads rolling as a result of the inquiry.

Losing Asfari or other long-serving management team members would be a significant hit to the investment thesis of Petrofac, especially since management's ties to Middle Eastern oil companies have long been a key reason to invest in the firm. This isn't to say the share price won't rebound nicely, but with a serious cloud such as this hanging over the company, I wouldn't countenance purchasing shares.

Safe and stable? 

Another problem for Petrofac, and an even bigger one for Royal Dutch Shell (LSE: RDSB) is, of course, the fact that oil prices continue to hover under $50/bbl, despite attempts by oil majors and OPEC alike to engineer a price rise through supply cuts.

The good news is that through slashing operating costs and taking an axe to exploratory capex, Shell has been able to largely balance the books. In Q1 the company recorded $3.8bn in constant cost of supplies earnings as the average price per barrel of oil rose by nearly $4 quarter-on-quarter and capex was cut from $6.9bn to $4.7bn.

Earnings of this level should mean the company's dividend is safe for the time being as they covered the $2.7bn in cash and $1.2bn in scrip paid out during the quarter. But I remain leery of buying the company's shares at this point. There is little sign of oil prices recovering due to either substantial supply cuts or a rapid increase in global demand for petroleum products, not to mention the poor long-term outlook for fossil fuel demand.

This leaves Shell a very nice income stock, but one that is trading at a pricey 15.7 times forward earnings and is still highly indebted with gearing at 27.2%. I reckon there are much better income stocks out there for long-term investors.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK owns shares of Petrofac. The Motley Fool UK has recommended Royal Dutch Shell B. 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.