Forte Oil (Bloomberg Ticker – FO:NL) is one of the major downstream petroleum companies listed on the Nigerian Stock Exchange. It recently announced its half year results, which showed growth in all the right metrics. However, this stock has been the magic stock of 2013 – 2014 gaining almost 3000% within a period of 17 months. In this blog I am going analyze the profitability of the firm, examine the quality of earnings and cash flow and then determine if the valuation is worth it after the run up in price.
FO was able to grow its revenues by 33% between June 2013 and June 2014 from N60.0 billion to N79.6 billion while the operating profits grew by a whopping 128% from N2.0 billion to N4.5 billion. The company was able to achieve this by reducing cost of sales, which was able to grow by only 30%, and putting a lid on administrative expenses, which also grew by only 27%. These cost control measures hit the bottom line as the profit after tax jumped by 125% from N1.4 billion to N3.1 billion. As one would expect with a sudden jump in revenues, the quality of earnings deteriorated marginally as account receivables for the six month periods rose by 67.7% from N6.2 billion to N10.4 billion; however, with account receivables accounting for only 13% of total revenues in June 2014, the quality of revenues of FO is not in doubt.
FO also showed very strong cash flow. Inventory turnover rose from 5.8 to 6.4 between June 2013 and June 2014, which means the company has marginally reduced tying down cash on inventories. The number of days of sales outstanding dropped from 60 days to 45 days, which means FO is not keeping cash for too long with customers, but number of days of payables also dropped 136 days to 118 days. Despite the growth in revenues, it is safe to say that FO has not relaxed its credit mechanisms unnecessarily but it needs to watch the growth in its account receivables.
The return on equity dropped from 16.6% to 14.9% between June 2013 and June 2014. This should be  source of concern, and we decided to take a look at what exactly caused the drop in profitability. The net profit margin actually rose from 2.3% to 3.9%, which means that FO does not have any problem with controlling cost. But the asset turnover dropped from 1.23 to 0.70, which means that FO was able to make only 70 kobo for every N1.00 in assets in June 2013 as against the N1.23 it made against every N1.00 in assets in June 2014. We also noticed that the leverage ratio dropped from 5.67 to 2.68, which means that FO deployed N5.67 worth of assets in June 2013 for every N1.00 in equity held against N2.68 worth of assets for every N1.00 held in June 2014. The reduction in return on equity is due to the fact that FO has grown its asset base significantly but it has not been able to deploy it efficiently. While FO has also deleveraged significantly, it has not led to enough gains in interest expense to make the net profit margin make up for the reduction in leverage.
We need to understand what exactly is happening to FO’s profitability. Hence we took a look at the trend of the return on equity. Apparently this metric rose to as high as 20.8% at the end of 2013 but dropped to 10.7% in the first quarter of 2014. This volatility in ROE was caused by the funding in minority interest of N29.0 billion that FO received in 2013. Given the fact that the ROE is now in the uptrend from the first quarter of 2013, it is safe to conclude that FO is in the process of improving efficiency and deploying the funds raised.
FO is a well run company, no doubt. Now we will focus our attention at its valuation. Is the current pricing worth it?
The stock is currently selling at N226 per share, but it is selling at a forward price to earnings (PE) of 40.3x! It has a price to book value of 6.0 and a dividend yield of 2.1%. We also noticed that it has a price to cash flow (from operations) of 68.7. Our conclusion is that FO is grossly overvalued and it should not be selling at more than N141 per share.
Manasseh Egedegbe, CFA
