Everyone ends up bagholding a steaming pile of turd in the markets sometimes and for me that time is apparently now (the most recent example, anyway). The company is Saipem (SPM.IT), the Italian energy services company I have owned for nearly a year and written about a couple of times (here and here), currently staring down the barrel of a capital-raise of its own making.

In mid-January, in a drastic turnaround from its October update, Saipem informed the market it would incur a loss equal to more than one-third of its equity, triggering a clause in the Italian civil code requiring it to restore its equity reserves and understandably drawing concern from its creditors.

We are still in a period of extreme uncertainty regarding what any raise/dilution will look like, so I wanted to take the opportunity to pen my thoughts on the matter and why I am holding for now, to keep my future-self honest and hopefully share a few lessons.

What we know

The company blamed rising costs at a number of E&C Onshore and Offshore wind projects for the rout, but we now know it is predominantly due to a Scottish wind project for Electricite de France, which is set to cost the company more than 550m€. Saipem is late in delivering 54 steel casings for wind turbines and looks to be holding up the build.

My investment case for the company was that they were one of the cheapest energy services companies gloabally and looked set to make it to the energy recovery and benefit enormously on the other side. This is obviously fatal to that belief, but what is most disappointing is the company has torched its profitability while reaching far outside its specialty and in what should be a fairly immaterial part of the business (by revenue, renewables only made up 5% of the E&C backlog as of July last year).

This appears to be the ultimate advertisement for sticking to your knitting. The traditional energy side of the business continues to tick along, winning work regularly as commodity prices recover, but that has been over-shadowed by management’s attempts to check the ESG box.

The balance sheet and equity raise

Due to the mostly non-cash nature of the expected losses, Saipem’s net debt surprised positively at year end, coming in at €1.5b, as opposed to the €1.7b predicted. This is a little heart-breaking, as it shows the ability to de-lever on improving results that may otherwise have been playing out, but we have to play the cards we are dealt.

The company still has plenty of liquidity available, as long as its lenders remain supportive. This is possibly a large if, as they already waived covenants last year due to the continuing effects of the pandmenic, but not unreasonable given this disaster looks quite temporary (despite its enormous size) and hasn’t caused net debt to balloon.

The most pressing deadline is a €500m bond maturity in April, that should be covered by this available liquidity or even rolled over in the meantime. By my assessment, there is little credit risk here- the situation has largely been brought upon by the technical breaching of Italian law. We will see if this holds up.

It is well known that the market hates uncertainty and the downgrade announcement certainly provided it, with the shares pummelled 30% on the day and continuing the bleeding, now down nearly 50% since the release. The market has simply shot first and asked questions later, due to being left to its own devices in guessing what the damage will be. This is now a very uncomfortable stock to tell people/clients that you own.

I don’t believe in knee-jerk reactions and try to think of a favourite quote from John Mihaljevic of the Manual of Ideas in times like these (paraphrasing):

“When feeling the temptation to act hastily, ask yourself what would be easier emotionally for the average, herd-following investor to do. You should generally, strongly consider doing the opposite.”

Clearly the base instinct here would be to sell immediately and pretend I’d never heard of the company, but I have done some back-of-the-envelope maths around a worst-case scenario for the raise and I think it has already been more than discounted.

Consider a scenario where the banks want to walk away and the company is forced to raise the capital to clear its debt entirely. As stated above, this would take €1.5b, but the end result would be a debt-free enterprise, hopefully steering well-clear of wind projects and positioned to wait as long as neccessary for energy capex to recover.

Assuming this was done at €1/share (a discount to current pricing, even post crash), Saipem would have an EV and market cap of €2.5b compared to 2019 (pre-pandemic) Adj. EBITDA of €1.27b, for a 2x multiple. I think this scenario is far too pessimistic, considering some of the terrible companies allowed to carry considerable debt in today’s credit environment, but if my assumptions are right and this is as bad as things could get, I can live with that.

The company has reached out to its largest shareholders Eni and CDP Industria for financial assistance, so presumably they will not be keen to dilute themselves and arrange any deal at a fair-ish price and for the minimum amount necessary.

Conclusion

I have left plenty out, but I just intended this to be a short summary of my current thinking. If the company raises successfully and alleviates any near-term stress, I believe it will be a incredibly attractive situation and I also have reason to hope this won’t be too punitive for existing shareholders.

Obvious risks for the outlook would be an unwillingness for Eni or CDP to add capital or being very aggressive about their terms and diluting their own initial investments, to gain an unbelievable deal on their new money.

I believe that successful investing is about showing patience in situations that most find too uncomfortable, so having created one for myself here, we’ll see how it plays out.

I have a 3% position in Saipem.

Guy

*When it rains it pours. As I finish this article, Saipem has released news that an Algerian court has fined it €192m in relation to a 2008 tender. The company has already been cleared by an Italian court in the same matter and intends to appeal the decision.

Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.

Superfluous Value

Mid-debacle thoughts: Saipem