- Petrobras is currently being valued well below its net assets and stated book value.
- Despite the sharp drop in share price over the last two years, the energy giant continues to remain solidly profitable, thus presenting a potential contrarian opportunity.
- Brazilian governmental intervention may impact the company in the short term due to oil price subsidies which may impact corporate profitability and operating margins.
Screening for strong companies that are experiencing a short-term slump is one my favorite ways for identifying potential investment opportunities. It was utilizing this logic that I first came across my most recent investment prospect. Petrobras (NYSE:PBR) is one of the world's largest oil companies that has entered into an operating slump in recent years due to increased operational costs, production issues at company refineries, and increased capital expenditures. This temporary slump has created a great buying opportunity for long-term oriented value investors.
Founded in 1953 and headquartered in Rio de Janeiro, Petrobras is a Brazilian integrated oil and gas company which divides its operating activities into seven distinct segments and has a presence in over 25 countries. These seven segments include Refining, Exploration and Production, Biofuel, Distribution and International, Transportation and Marketing, and Gas and Power. Additionally, the Brazilian energy company is involved in various research, refining/processing, and extraction of oil, natural gas, and other energy derivatives.
Overview & Analysis
One interesting consideration regarding Petrobras is the fact that the Brazilian government holds a major stake in the oil company. This stake means that the Brazilian government wields a strong influence upon the corporate actions and direction of Petrobras. Since the price of fuel has historically been used as a major instrument of economic policy throughout Brazil, it should come as no surprise that government intervention has repeatedly played a role in the company's operating results and efficiency. In fact, this intervention has led to oil prices in Brazil detracting widely from the corresponding international price of oil (Brazilian government subsidizes the cost of oil in the country as a method to fight inflation) thus affecting corporate profit margins and ultimately destroying shareholder value.
In addition to government intervention, corporate security is also another concern at the energy giant. In September 2013, it was announced that the United States National Security Agency had been allegedly spying on the Brazilian oil company. This spying is rumored to have occurred by the NSA hacking into the firm's corporate network and monitoring phone conversations held by executive management. As a direct countermeasure to this new revelation, Petrobras has reportedly taken measures to invest R$21 billion over the next five years to improve its data security technology.
In response to these announcements alongside a corresponding increase in corporate debt levels and threat of continued government intervention, shares of Petrobras have fallen from a high of almost $24 a share to a low of nearly $10 last month. Since then, shares have rebounded quite a bit to reach a little over $14 a share as of market close April 29th, 2014.
While the many pessimistic and underwhelming news headlines may scare away many investors from the Brazilian energy giant, the current valuation of the company tells a completely different story. With a current 2013 Annual EBIT of $16.96 billion, shares of Petrobras are currently being valued at a Market Cap/EBIT multiple of 5.44 times and an Enterprise Value/ EBITDA multiple of 6.14 times. Both of these multiples fall within the traditional 5-7 times multiple which is typical for companies within the energy sector. At first glance, these metrics would make it seem as if Petrobras is currently priced at a fair price. However, this observation overlooks the reality that earnings for the Brazilian oil company are currently depressed as a direct result of Brazilian intervention and economic policy (subsidized oil prices). In fact, if we were to apply the same valuation utilizing normalized earnings projections, we would come up with an entirely different conclusion.
Looking at the above EBIT historical margin trends for Petrobras, it is easy to see that EBIT margins had consistently remained in the low 20s up until the 2011 fiscal year. Considering this, if we remain conservative and look at the five-year EBIT margin average over the last five years (including TTM), this would yield an average EBIT margin of roughly 17%. To remain conservative, let's discount this average even further and utilize an EBIT margin of 15% for our valuation purposes.
According to average analyst estimates, PBR is expected to generate $143.05 billion in annual revenue during FY 2014, and $146.61 billion during FY 2015. If we apply our conservative 15% EBIT margin to this projected revenue estimates, this would yield EBIT of $21.46 billion and $22.00 billion respectively. Applying a conservative six times EBIT multiple to these EBIT calculations, this would yield a total company valuation of $128.76 billion using the FY 2014 EBIT and $132 billion using the projected FY 2015 EBIT. These valuations represent potential upside in the range of 39.26% to 43.14% from the current market capitalization of $92.22 billion. It also translates into an expected price target of around $19.80 under what I believe to be highly conservative assumptions (I believe an EBIT margin of 17-18% to be a more accurate representation of PBR's earnings under normal operating conditions instead of the 15% which was applied).
Despite the many headwinds currently facing the company, Petrobras continues to remain solidly profitable with over $27.6 billion in operating cash flow over the trailing twelve months. The company also boasts a strong current ratio of 1.50 as of the most recent quarter. This strong current ratio demonstrates the company's strong financial positioning and ability to meet current financial obligations. With a total debt of $131.53 billion, it would take less than five years of EBITDA to completely pay down the outstanding debt, which is a reasonable payback period and indicates that the current debt should be manageable. Trailing return on equity and return on assets also appear to be reasonable at 7.53% and 3.68% respectively (although these metrics are well below the company's historical average).
Adapted from Morningstar.com
Over the last ten years, book value for the company has increased from 5.18 in 2004 to 26.20 as of the most recent quarter. This represents a compounded annual book value growth of 27.59% over the ten-year period. This is an impressive growth rate as it shows that management has been able to consistently grow total shareholder equity at an above-average rate. However, a big negative is that the company has concurrently increased its long-term debt substantially over the same period due to PBR's continued investments to expand crude production.
Despite overall reasonable financial metrics, PBR still appears to currently be trading well below its book value and net assets. With the share price of a little over $14 compared to a book value of $26, it is apparent that the company is currently trading at a 46% discount to its stated book value. Net assets of $134.87 billion (FY 2013 Total Assets of $321.4 billion - FY 2013 Total Liabilities of $172.3 billion - FY 2013 Total Inventory of $14.23 billion) also total well above the current company market capitalization of $92.22 billion and corresponds well with the 6 times projected EBIT multiplier calculated in the valuation section above. This leads me to believe that PBR currently provides a significant margin of safety as the company is currently being valued below its net assets despite maintaining a profitable operation.
While many investors are right to consider continued governmental intervention as a huge potential negative, I believe that the current valuation of the energy giant more than compensates for this drawback. With shares being valued at a near 40% discount to net assets, the downside risk appears to be largely outweighed by the company's future operating potential under a normalized earnings scenario. For this reason, I would recommend shares of Petrobras as a strong buy at current levels.