Earnings Notes V (Q4 2023)

[Previous earnings notes for Q4 2023: I, II, III, and IV.]

Franco-Nevada Corporation (FNV)
As you may recall from our notes last year on Rise of the Mining Royalty Companies, Franco-Nevada was the original mining royalty company, and is the largest, with a $20 billion market capitalization. Newmont acquired Franco-Nevada in 2002 and spun it back out in 2007.

FNC gets 64% of revenue from gold, 17% from oil and gas, 10% from silver, 5% from "other mining," and 3% from PGM metals. The revenue mix is 32% Canada and U.S., 30% South America, and 26% Central America and Mexico. Unfortunately, their biggest asset, the Cobre Panama mine in Panama which is operated by First Quantum Minerals, is currently on preservation and safe maintenance because of a political dispute.

FNV has net cash on the balance sheet, so the enterprise value is $18.5 billion. For 2023, revenue was $1.2 billion and cash from operations was $985 million. (So the OCF/EV yield is 5.3% and the OCF margin is 82% of revenue.) They spent $520 million on acquisitions of new interests and paid $233 million of dividends. (A 1.2% dividend yield.) General and administrative expense is only 2% of revenue.

Note that FNV's average selling price for gold in the fourth quarter was just under $2,000/oz and it comprised 66% of their revenue, but the price of gold just hit $2,200/oz.

Costco Wholesale Corporation (COST)
Look at a chart of Costco - it's like a meme stock. Even after a post-earnings (fiscal Q2 2024 release) selloff, it is still up 50% (not including dividends) over the past year. The market capitalization is now $324 billion. 

Total revenue was up 5.7% year-over-year, and comp sales in the U.S. (adjusted for gasoline price changes) were up 4.8%. Operating income for the quarter was up 8.4%, to $2.1 billion. (Note that membership fees for the quarter of $1.1 billion are equal to 54% of operating income.) Operating cash flow for the first half of fiscal 2024 has been $5.4 billion. The company spent $2.1 billion on capex (new stores) and paid shareholders $8 billion of dividends.

So the shares are pricey, but growth is good.

OTC Markets Group Inc. (OTCM)
This is an idea for a royalty-like business that is not as expensive as a business of similar quality (e.g. Intercontinental Exchange) because it is smaller. In the fourth quarter, OTCM had an operating income margin of 35% of its revenue less transaction based expenses. The market capitalization is currently $670 million and the enterprise value $638 million.

Free cash flow for 2023 was $31.5 million, a 4.9% yield on the enterprise value. (If you subtract stock based compensation, the FCF is only $25.6 million, a 4% yield on the EV.) Last year, the company returned $26.5 million to shareholders via dividends and $3.4 million via repurchases, which is a shareholder yield of 4.5%.

One concern is that growth has not been great recently for how expensive the stock is. The free cash flow has been lower each of the past two years. However, if you look back five years (to 2018), net revenue then was $56 million (vs $101 million last year), free cash flow (excluding SBC) was $20 million (vs $26 million last year) and shareholder returns were $15 million. So free cash flow was only up 30% in five years, not nearly as good as Enterprise Products Partners (for example).

Petróleo Brasileiro S.A. (PBR)
Our guest writer @pdxsag first wrote about Petrobras for us last June when it was trading for $12.25 per share, an $85 billion market capitalization and an enterprise value of $118 billion. At the time, their recent quarter's free cash flow was $7.9B for a FCF/EV yield of 27%. The market capitalization (at $15 per share) is now $97 billion and the enterprise value is $124 billion. Last year (see results), Petrobras generated cash from operations of $43 billion and had $12 billion of capex, for free cash flow of $31 billion. They paid $19.7 billion in dividends and repaid $10 billion of debt. (A FCF/EV yield of 26% and a shareholder yield of 20%.)

Petrobras shares were down 10% on March 8th after some alarming comments from the company about reducing dividends to invest in an energy transition. Is it worth investing in a country where you would not want to drink the water just to get a bit higher free cash flow yield than you can get on Canadian oil sands?

Natural Resource Partners L.P. (NRP)
Let's start with the highlights from NRP's Q4 2023 conference call:

*Years of hard work and persistence are paying off. The business is generating robust levels of free cash flow, the capital structure is solid and our financial outlook is much improved. As of today, our total remaining obligations, which include debt, preferred equity and warrants, stand at approximately $270 million, a 40% decrease from just 1 year ago. I would like to express my sincere thanks for the support of our employees, external stakeholders and Board of Directors, without which none of these results would have been possible. We retired $178 million of preferred equity at par in 2023 and settled 1.5 million warrants, both with cash. And early this year, we settled an additional 1.2 million warrants utilizing cash and common units. There are two factors we consider when deciding whether to settle warrants with cash or common units: First, do we have ample liquidity, which we define quite conservatively, I might add; and second, is the market value of the common units less than our estimate of intrinsic value? If the answer to both of those questions is yes, we settle with cash. While we will not comment specifically directly on our view of intrinsic value, I will say that it was our inability to answer yes to the liquidity question that caused us to issue units to settle a portion of the warrant exercises early this year. We continue to add additional bank revolver capacity that will provide financial flexibility to settle warrants with cash and accelerate redemptions of preferreds.

*We received $81 million in cash distributions from Sisecam Wyoming in 2023, which is the highest annual amount of regular distributions we've ever received. This result was driven by record high sales prices, both domestic and export during the first half of the year. Unfortunately, global soda ash export prices fell significantly in the back half of the year as new low-cost soda ash supply came online in China, Turkey and the United States. We expect 2024 to be a challenging year as global soda ash markets absorb significant new production volumes, a process that we believe will take several years to complete. Cash distributions to NRP will adjust accordingly as profit margins compress due to the combination of lower sales prices and inflation-driven cost increases. Despite the current headwinds facing the soda ash industry, our long-term view of our investment in Sisecam Wyoming has not changed. We are one of the world's lowest-cost producers of a product that has favorable long-term fundamentals, driven by urbanization, the megatrends for renewable energy and the electrification of the global auto free fleet.

*You are right in what you summarized initially that at our current run rate that it's not too long before we get to the point where we're obligation free. But I don't want to speculate now on what we would do in 1.5 years, 2 years from now if we had excess cash. I can tell you at this point in time, we don't see opportunities in the market. If we were in that theoretical situation where we had excess cash today, they are not on the horizon overly attractive opportunities to deploy capital. That being said, I will point out that we are focused on the task at hand right now, and we're not out beating the bushes for places to deploy capital. I think you can rest assured that we are going to be quite thoughtful about anything we do with respect to deploying capital in any manner other than distributing it out to unit holders. 

At the current unit price of $92, the market capitalization is $1.2 billion (using the February 2024 unit count and not the year-end). They have spent $55.7 million repurchasing warrants in Q1 2024 and have hopefully earned about the same amount from two months of cash flow. If that is the case, the enterprise value is currently around $1.4 billion. Last year's free cash flow of $313 million represents a 22% yield on the enterprise value.

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!)

The "BRICs" Are Uninvestable

We were talking about China this week and about how "China and Russia have the same problems - pervasive corruption, an aging population, higher birthrates among separatist minority groups". I think we have thoroughly established that China is an immense fraud and misallocator of capital.

I have never talked about it on the blog before, but I have business experience in Brazil, and their economy is total chaos. As corrupt as China but more disorganized: siesta culture. As an outsider or public company, you automatically have a higher cost of capital and less profitable business model than local, private competitors because you have not paid the right bribes to avoid taxes and regulation.

I rarely hear anyone seriously propose to invest in India. But many people are also unaware that India is a country that has considered toilets and rejected them, even at great cost to their own health!

Russia is a sad case that I am ambivalent about. Russia has aspects of anti-fragility because it already collapsed to a low order of complexity, and because it is net long and benefits from higher energy and commodity prices. It is just dumb luck that Russia has so much natural gas. If the communists could have sold it all in one slug to the west at any point, they would have. But they couldn't and these resources have now conferred an anti-fragility on Russia.

Unfortunately from an investment perspective, Russia does not have a tradition of harmonious minority ownership of corporations. We will watch and see whether ownership in Russian public companies eventually translates into meaningful economic interest, but right now it doesn't.

I propose a long-term short of the BRICs. Only a very ebullient social mood - and overpriced U.S. securities to match - has caused investors to be interested in abstract (imaginary) claims on BRIC businesses.

The BRIC ETF BKF has a dividend yield of less than two percent. One of the funny things about buy and hold investors is that they choose to ignore some very unpleasant discontinuities in stock index time series. For example, once during the past century you would have lost all of your investment in Chinese companies in a confiscation. How do you account for that? Are you getting paid for that risk with a two percent yield?

Brazil Sucks

• Brazil Government “Milks the Cow” (Petrobras), Again
• Petrobras sells African asset for peanuts to Brazil’s “vampire squid” BTG Pactual, who gets free-lunch from Brazilian taxpayers (again)

Brazil sucks and the U.S. is becoming more like Brazil.