Should You Sell Smith & Nephew plc & Buy Petrofac Limited Today?

Smith & Nephew (LSE: SN) is not in bargain territory, but its valuation is moving in the right direction.

Its stock has only risen 6% since mid-2014 and has gone nowhere so far in 2015 — a disappointing trend I’d expect to last until the end of the year, unless more bad news contributes to a meaningful drop in its value.

In fairness, I would feel more comfortable investing in Petrofac (LSE: PFC), an oilfield services group with a market cap of £3.1bn, which could turn out to be a less cyclical play than many expect it to be.  

Smith & Nephew overpriced

Smith & Nephew announced yesterday the voluntary removal from the market of “46mm diameter and smaller femoral heads and corresponding acetabular cup components for the BIRMINGHAM HIP Resurfacing (BHR) System,” which did little to lift spirits in a declining market. 

Make no mistake: Smith & Nephew  is a solid business, with strong fundamentals, but based on its forward valuation for earnings and core cash flows, its shares look overpriced by at least 20%. I am inclined to suggest that S&N could be a good buy at about 900p a share, but it currently trades at a much higher 1,141p.

Its projected dividend is well covered, but at around 1.9%-2.2% in the next couple of years, there are better alternatives in the marketplace, and if pressure builds on operating margins, its dividend policy may come under scrutiny. Smith & Nephew currently trades in line with market consensus estimates, which have risen by 40% since the end of 2013 — the market has been betting on a takeover or a break-up of the company for some time, and even more so in the last 18 months. 

I am happy to sit and wait. 

Petrofac upside

Petrofac is an opportunity that’s almost too good to be true — one that offers a forward yield comfortably double that of Smith & Nephew. 

The dividend is covered — just — by core earnings, recent results showed, but Petrofac announced today the extension and amendment of a revolving credit facility (an undrawn credit, it’s like a credit card!), which gives it more financial flexibility. Of course, this is great news, as its cost of funding would fall in the event that the facility was drawn.

Banking fees are also on their way down, which testifies to a company that boasts a strong pool of relationship banks. 

Moreover, its lowly forward multiples based on earnings and cash flows do not seem to take into account likely expanding margins over the next couple of years, given that Petrofac is committed to efficiency. Its stock price has risen 30% this year. Is that a lot?

I do not think so. Its shares currently trade in line with consensus estimates, but I would not be surprised if analysts became more bullish over time. My personal price target is 1,167p, for an implied upside of 28% into the first quarter of 2016.