Monday, June 5, 2023

Guest Post: @pdxsag on Petróleo Brasileiro S.A. (PBR)

[From our CBS correspondent @PdxSag. Previously on CBS regarding Petróleo Brasileiro S.A. (PBR).]  

Petróleo Brasileiro S.A. (better known by the portmanteau "Petrobras") is the partially state-owned Brazilian integrated oil company. Petrobras was created in 1953 under the government of Brazilian president Getúlio Vargas with the slogan "The Oil is Ours" (Portuguese: "O petróleo é nosso"). The company explores, produces, distributes, refines, transports and markets petroleum and its products. They operate worldwide, however Brazil represents more than 90% of production and almost all of its reserves, thanks to the large amount of proved undeveloped reserves offshore of Brazil.

The current market capitalization of PBR (at a $12.25 share price) is $45.5 billion, and the enterprise value is $118 billion. (For comparison, Canadian Natural Resources' market cap is $62B and its EV is $72B.) Petrobras reported earnings of $7.3 billion for Q1, which means that shares are trading for 1.5 times annualized earnings. (Again for comparison, CNQ's Q1 earnings were  $1.4B, for an annualized forward PE of 11.) For Petrobras, the adjusted funds from operations for the first quarter were $14 billion, which is an annualized AFFO/EV yield of 47%, Their free cash flow was $7.9B for a FCF/EV yield of 27%.

At present there is no stock buyback program, though the CEO has suggested they should start share repurchases. Dividends are statutorily mandated and the current dividend policy is to payout 60% of FCF when net debt is below $60B, which it is now. The first quarter dividend is $0.76/share paid in two installments, in August and September, which is a yield of 24%, if it were annualized. (Q4-2022 dividend was  $1.15/share, and an incredible $3.80/share for the entire year.)

Petrobras' stated goal is to be the last oil producing company in the world. They are offshore experts and over 90% of their crude and NGL production of more than 2.6 million BOE/d comes from offshore wells. Their first quarter earnings report lists 3 projects coming online this year with an incremental 275k BOE per day, and 9 projects through the end of 2027 with an estimated 1.35 million BOE/d attributable to Petrobras.

Their average cost of production plus royalties and taxes is approximately $21 per barrel. With Brent at $75 per barrel, another 275k barrels (equivalent) per day would be an incremental $1.3B per quarter (assuming they were all oil anyway). Call it perhaps $1 billion to account for current well depletion and that not all of the crude production will be exported. Still, that's a potential 12% increase in free cash flow by Q4 2023. Will that push the dividend back to $1 per quarter on a $11-12 stock?

Compared to domestic producers, these results are stupefying. (See the shale treadmill in the U.S.) Most people stop there and mumble something about too good to be true. Maybe they roll their eyes at Latin America and think that every country is one bad election away from Venezuela.

Consider, however, that these national oil companies are already majority owned by their governments. Over half the dividend payout goes to the government and funds their budget. The national governments need the huge dividends for their social programs. As far as expropriating the not-quite-half of the company they don't own to not-quite-double that part of their budget is obviously penny-wise and pound-foolish as they would not be able to access the much larger debt markets, put a stain on all their domestic corporations, and make hiring foreign expertise significantly more expensive. My assessment is an expropriation by Brazil is by no means zero risk, but it may be lower than what the market is pricing in at a 24% dividend yield.

My take is that you are getting a gigantic running yield for taking oil price risk (which everyone shuns) and Brazil risk. Let's stop for a moment and quote Lyall Taylor's essay about "fishing where the cod is":

I instead try to look at as many stocks as I can, spanning across all sorts of different countries and industries, and all up and down the quality spectrum, and I try to value them. Instead of looking at 1% of the world's investment universe, I try to look at as close to 100% of it as I practically can (of course this is a vastly unmet aspiration on account of time constraints).

Now, I am looking for exactly the same attributes in a good business as anyone else - I don't take issue with any of the Buffett criteria, or dispute they are not highly desirable. And I also do not deny that quantitatively cheap multiples don't, in and of themselves, indicate somethings is genuinely cheap, because factors such as capital allocation and competitive advantage genuinely matter. However, what I do when a company falls short of the perfect ideal, is I put a price on that shortfall. I say, ok, the governance is ok but not great; I'll take 30% off what I'm prepared to pay for it. Or the business' competitive position is ok, but not great, so I'll take another 30% off for that. Or there is some long term disruption risk, so maybe I'll take 50% off for that, etc. So I don't automatically disqualify stocks because they aren't pristine, regardless of price. I instead try to price risk and value companies.

Basically what I'm doing is not insisting on only buying companies that are 10s (out of 10), for 8, which is what most value investors are trying to do these days. I am happy to own an 8 and 5, or a 5 and 2. or even a 3 at 1. I don't care that the business is not a 10. I care that it's undervalued. And generally, the only time you get a chance to buy a 10 at 5, is when the 5s are priced at 1 (i.e. a recession), and so even then, they are often not the best investments on offer. And what you learn over time is that there is a tonne of money to be made owning 7s, 5s, and even 3s, as long as you can buy them cheap enough.

Don't like the corporate governance? Apply a discount. How much do you think is enough? 10%? 50%? 80%? 99%? 99.999%? Gazprom has probably a 90% discount for corporate governance at present, and trades at 2-3x earnings. And yet the vast majority of the global value investing community won't buy it. A 90% discount isn't enough? How much is enough then? 99%? What happens if current efforts in Russia to improve SOE corporate governance bear fruit? Most value investors would prefer to wait until after corporate governance reforms have happened and the price is 5 times as high

It should be noted here that this piece was written in 2019 and Lyall got obliterated in Russian stocks when they invaded Ukraine. Yet Lyall is right, as CBS has noted, it is just that Lyall did not size his Russia trade properly.

The current president of Brazil, Lula, is a left-wing populist. He has been the target of what I consider FUD tactics from former president Bolsonaro aligned politicians. Their two biggest charges are that he is a closet communist and that he will expropriate the company. They doesn't stand-up to scrutiny as Lula was previously president of Brazil from 2003 to 2010. That term overlapped with the prior oil commodity cycle during which time Petrobras stock appreciated 20X peak to trough, on top of paying-out generous dividends.

The other common charge from the Bolsonaro side is that Lula cronies will embezzle funds from Petrobras and shareholders won't see any benefit. Using the rule of thumb that politicians always blame the other guy for that which they are guilty of, I suspect Bolsonaro-ists were making serious kick-back bank under his presidency as Petrobras divested itself of many refining and midstream assets. I strongly suspect their motivation for the FUD campaign is they are salty that their gravy-train has ended. They are doing everything they can to ruin his administration to get themselves back in power. One of Lula's campaign planks was that Petrobras divestments were going to come to an end. I'm no expert on Brazilian politics, but comparing the rhetoric from both sides, I think I see what was going on there.

As far as too good to be true, it is because everyone says that, that the stock is so cheap. David Einhorn suggests that no one wants to do the work or step-up and take a chance. This is passive investing mindset. ("Passive" is the perfect name for it, in the sense of low-agency.) It is out-sourcing your thinking to a faceless committee that will pick the “market” for the S&P500, Dow, QQQ, etc. If your company is not in the “chosen” market ETF's, it is basically ignored by over 80% of the investing public. The 401K retirement funds, which are the marginal stock buyer, will completely ignore the company, while plowing 25% of every dollar into just 7 tech darlings. That is no problem to me. I don't care personally because I'm reinvesting the dividends to buy more under-valued shares. I'm stacking barrels in the ground and compounding my investment. 

A final point on the ADR's: there are two shares per ADR, so be mindful of that when reading press releases from the company. You have to double the stated dividends per share because an ADR gets two of them.

Also, and more importantly, are the two classes of shares and ADR's. The common shares get voting rights, however the Brazilian government owns over half the shares so their vote is the only one that counts. The preferred shares have no voting rights, but receive the same dividend, plus a nominal guaranteed dividend if there is not sufficient profit to fund a dividend for the year. The preferred shares trade at a 10% discount, but since they receive the same dividend, they are actually a much better value. I personally prefer the PBR/A over PBR. (Of course Twitter has a meme for it!)


CP said...

Another good point from Lyall's essay:

A really great example of this was the airline industry 5 years ago (I totally missed this trade as well). Buffett taught a generation of value investors to never buy airlines, period (myself included). So we didn't even either bother to look. We just declared airlines, always and everywhere, uninvestable, regardless of price. However, for those that did look, they would have discovered that the industry had consolidated down to a small number of players, and management incentives had also changed to ones focused on returns on capital, rather than growth. The global aircraft fleet was also hitting record high levels of utilisation and seat density, while Boeing and Airbus' order backlogs were 10 years long, so global capacity could not be added quickly (particularly given P&W's engine issues, which were delaying deliveries). This was a very real and important change vis-a-vis the past. Returns on capital were likely to structurally improve.

The companies started to make good money. But they still sat there at 4-5x earnings, and started buying back stock. In 2016, US airline stocks screened at the very top of Joel Greenblatt's 'magic formula' list, with a combination of high returns on capital and very low multiples. I saw them, and thought to myself, "you know what; I bet they probably are a buy, because everyone hates airlines, but it might also be distorted by the recent drop in oil prices; everyone knows airlines are terrible businesses, so perhaps the formula is a bit skewed in this instance." So I quickly passed and didn't look any deeper, just like everyone else, even though I already knew the magic formula to be a great way to cut through my own biases. And I'm usually pretty good at recognising this bias when I see/feel it, and forcing myself to take a closer look. But even my biases in this case were too strong.

Allan Folz said...

Excellent point about airlines. It's not hard to imagine a large number of PM's out there think to themselves never buy LatAm. How many don't even bother to look?

Also, consider it from PM's career risk: no one gets fired for missing a trade, but if something goes wrong and you're long... imagine the phone calls from your Boomer LP's when a LatAm trade goes against you.

Anonymous said...

The last time Lula was President he just looted Petrobras, but now different world, he is on Team Global Tyrant, do not underestimate this guy selling out the Brazilians to please his masters, that do not live in Brazil.

AllanF said...

You sound like a Bolsanero-ist. Hilarious. Did you even read the article? You are literally doing what I said they always do.

Anonymous said...

I think anybody that comments on any social media, see Allen F, has to state whether they are vaxxed or not.

Would be a great filter.

CP said...

It looks like the market cap is wrong in this post - should be $85 billion (now) - but the EV was correct.

CP said...

Market cap is now $90 billion.

The company put out a "Production & Sales" report for Q2:

In 2Q23, average production of oil, NGL and natural gas reached 2.64 MMboed, 1.5% lower compared to 1Q23, mainly due to higher volume of losses from stoppages and maintenance, the natural decline of mature fields and divestments. Those effects were partially offset by the ramp-up of P-71, in Itapu field, and the startup of FPSOs Almirante Barroso, in Búzios field, in pre-salt Santos Basin and Anna Nery, in Marlim field, in addition to new wells of complementary projects, in Campos Basin. Pre-salt production set a new quarterly record of 2.06 MMboed, equivalent to 78% of Petrobras total production, surpassing the previous record of 2.05 MMboed in 1Q23.