These are hard times for Afren (LSE: AFR) shareholders: they must decide whether to cut their lossesor to stick with the management.Hard times also spell opportunities, however. ..
Will Afren Sky-rocket?
On the face of it, Afren needs a solutionwithinsix weeks.The collapse of merger talks with Seplaton Friday means that theres no easy way out now for investors holding long positions in Afren, but should managers either receive thebacking of their lenders and cut a deal both with banks and bondholders, or find a new investor, I believe Afrens equity value will likely sky-rocket to the levels it last recorded at the end of 2014.
How likely is such an outcome, though?
Its hard to say, though if you ask me, Idadd 0.5% of Afren to my diversified portfolio, with the aim to take home a pre-tax return of between 300% and 600% this year.The unaffected stock price of Afren is in the region of 30p to 40p.
Bye Bye, Seplat
Strategically, the rejection of Seplat was a very brave move.
The board has not received any proposal from Seplat that it believes is capable of being implemented on terms satisfactory to all relevant stakeholders in the company, including the indicated value being significantly below the aggregate value of the debt of the company, Afren said last Friday, adding that the board had concluded that continuing discussions with Seplat was not in the best interests of stakeholders. The announcement was made without Seplats consent, Afren added.
However,can Afren really dictate terms right now?
Going Under?
If Afren were on the brink of collapse, thered be more than one chance that managers would have accepted an offer *any* offer from a suitor, even one significantly below the aggregate value of the debt of Afren. Thats how deals are done in these circumstances.
Does Afren management perhaps know something we dont know?
Very possibly they have a better understanding of their business model and financials but key information is out there in the marketplace and helps us assess whether Afren will continue to operate as a going concern or not.
Fight For Survival
Many cyclical businesses struggle to run their operations at times, simply because their capital structures are stretched, which means their balance sheets carry too much debt. I believe that that is the case for Afren, whose operating profitability is strong but not strong enough to generate enough cash flow to cover forprincipal and interest repayments right now.
At a time when Afrens 2014 revenues are expected to drop by 40% to about $1bn,too little equity and declining cash flows do not providereassurance, given that lots ofcash must be spent to finance heavy investment, whichis key to revenue growth.Whats encouraging, however, is that if the business were properly financed, it would find it much easier to manageits cash flows.This is something that banks, bondholders as well as third parties like distressed debt funds involved in the negotiations will consider.
All things being equal, Afren needs more than $500m of equity to keep going, while part of itsdebts (say, 35% or more) must be swapped with equity, in my view.
One way to engineer a recap deal would be to include some second-line or mezzanine financing with a one-year grace period in order to preserve cash flows over the short term, hoping thatAfren will have found a solution to its problems by the time oil prices have stabilised. Then, Afren may warrant a premium to its unaffected share price
Of course, as I recently argued, there’s a chance that Afren will not be able to cut a deal with its lenders, but any Afren-related losses in your portfolio could be offset by massive gains froma few low-riskstocks that will likely reward you with a 20% pre-tax gainannually.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended Afren. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.