One turnaround stock I'd sell to buy Tullow Oil plc
Today I'm looking at two turnaround stocks at different stages of their recovery.
I've recently turned positive on oil group Tullow Oil (LSE: TLW), as I'll explain later in this piece. But I'm not sure if today's second stock -- information management software group Idox (LSE: IDOX) -- has reached the end of the troubles which caused its shares to crash last year.
The market likes it
The market has given a warm reception to today's delayed full-year figures from Idox. At the time of writing, the shares are up 10% to 37p.
Today's gains have come despite news that the firm's adjusted profits for the year missed the revised guidance provided in December's profit warning. Adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) fell by 14% to £18.3m last year, below December's revised forecast of £20m.
The group originally expected to report EBITDA of £27.2m last year. A cocktail of problems prevented this, including delayed contracts, incorrect revenue recognition and complications arising from last year's acquisition of healthcare software firm 6PM.
Look forward, not back
Investors appear to be comfortable that interim chief executive (and former CEO) Richard Kellett-Clarke has resolved these issues. To some extent I agree. But I'm not completely convinced.
Although the group announced several contract wins today, Mr Kellett-Clarke warned that plans for "a change in product pricing" and "a focus on cash conversion" will initially depress revenue. He plans £7m of cost-cutting to help rebuild margins, but it's not clear to me how quickly these benefits will come through.
I'm also concerned that the 6PM acquisition could cause further problems. The group's auditors issued what's known as a qualified opinion on today's results. Their view appears to be that 6PM's record-keeping prior to the Idox acquisition was so poor, they couldn't be sure that some of its figures were correct.
Although Idox looks cheap on about 7 times 2018 forecast earnings, I think these forecasts are likely to be revised following today's results. I also think the 6PM acquisition could cause further headaches. I will be staying clear for now.
I was impressed by these figures
As a contrast, the recent 2017 results from Tullow Oil were strong enough to persuade me to take a positive view on this stock.
The group's net debt fell from $4.8bn to $3.5bn, thanks to $721m of proceeds from a rights issue, lower spending and improved cash flow. The group also managed to refinance much of its debt, providing security about future repayment schedules.
All of these factors were largely predictable, but I wanted to see concrete evidence of progress before considering an investment. Luckily the stock is now on sale at a price that's 22% lower than one year ago, when the risks were considerably higher in my view.
Why I'd buy
Although Tullow's remaining net debt of $3.5bn is still equivalent to a chunky 2.6 times EBITDA, last year's free cash flow of $543m gives me confidence that this figure should continue to fall in 2018.
This free cash flow gives the stock a trailing price/free cash flow ratio of 6.5, which is very cheap. Although spending will be higher this year, reducing surplus cash, I still expect the firm to be strongly cash generative.
As net debt continues to fall and profits gradually recover, I'd believe Tullow shares could deliver attractive gains.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.