Why Gazprom Is Mistakenly Undervalued At 3x Earnings

| About: PJSC Gazprom (OGZPY)

In my article, I presented the bull case scenario for Gazprom (OGZPY.PK). Growing production, domestic prices and a potential deal with China were the main reasons I gave, along with Gazprom's extraordinarily cheap valuation, for my long position. However, in this article I want to demonstrate why the picture is not that rosy and why the shares have been selling off recently.

The major issue centers around the relationship between the Russian Government and Gazprom. The Russian government has several conflicting interests:

  1. The government owns an indirect 50.002% stake, and thus wants the earnings of the company to grow.

  2. The government is elected by the Russian people and thus wants to please its voters in the short-term through lower domestic gas prices and high corporate taxes to generate more spending.

  3. The government wants GDP to grow through higher production and capital expenditure associated with infrastructure development.

  4. The government wants to be more free market by allowing companies and not the government to allocate capital efficiently.

The bearish analysts that I have spoken to, or read their reports, will certainly side with the second point. This is perhaps the most powerful influence on a politician, choosing the short-term. Some have questioned whether Russia will stick to the 15% per annum increases in domestic gas despite it being written into law. The majority of the bears, or sideliners, think that all of the 15% increases will be eaten up by higher taxation. Higher taxes are certainly coming into play as Russia plans to spend an extra 3.5 trillion RUB ($109B) in 2014 than it spent in 2011.

On the subject of Europe, some are worried that threats of a move to alternate sources of gas supply will remove the oil linked pricing mechanism. While they also do not believe China is ready to accept the pricing that Gazprom demands due to two factors: Firstly, Turkmenistan currently supplies pipeline gas into China at a cheaper rate than Gazprom is willing to supply and secondly, the domestic market has subsidized prices, so it is uneconomic to buy at the Russian-demanded price for the Chinese companies.

My response

I do not deny that there will be higher taxes for Gazprom and that most of the 15% increases are at this point in time looking likely to be taxed away. The latest ministry statement was for up to 80% of the increases to go to the government, but that still leaves one fifth or 3% of the increases for Gazprom's top line. The taxation for the increases is coming in the form of a larger Mineral Extraction tax.

The stock as reported by Bloomberg sold off today, on Putin's statement that taxes on gas companies are insufficient. However, I believe this rhetoric to be short-term due to the election year effect. One can already see this through the greater than forecast government spending in the run up to the elections. Russia in the long-term, however, wants to become more economically efficient and it has recognized that the government must play a smaller role going forward. This is why the government is set to announce a new set of privatizations later this year. More importantly for Gazprom, the government is making new offshore production (mainly Arctic based) tax exempt. The government has also announced a plan to increase dividend payouts from state companies to at least 25% over the long-term.

For me, Europe is becoming more attracted to Russian gas than ever before. The deal between Germany and Russia for the NordStream pipeline eradicates the threat of Ukraine taking 'gas hostages'. Meanwhile, the Arab spring in 2011 highlighted the volatile nature of North African and Middle Eastern gas. All of these political points, in conjunction with declining North Sea output and ambitious carbon 2020 agreements mean that Russian Natural Gas production needs to increase 4% each year to keep up with new demand. This is only going to add to the bargaining power that Russia has. At the same time, I question the amount of market share that North American LNG could take from Russia, especially since Gazprom is one of the biggest players in the global LNG market and the company would be far more cost effective in supplying Europe. It is interesting to note that LNG is the most profitable way of supplying gas for Gazprom because of the Russian tax structure.

I think the pipeline China situation is not a story for 2012, but one for 2015 and beyond. At some point, China will liberalize gas prices - much like Russia is doing. The companies that are supplying the gas domestically (in China) are racking up huge state-sponsored losses. This situation is quite simply unsustainable. However, Gazprom currently supplies marginal gas demand to China through its Sakhalin-2 LNG facility and LNG exports are set to increase dramatically to Asia as Vladivostock comes online.

In my eyes no company should trade below 8x Earnings unless you expect its earnings to fall to a level where they are at 8x. If this does not happen, the dividend yield will be a highly attractive return. I believe Gazprom's earnings over the long run are set to increase. I think 2012 will likely be a tough year due to weather conditions (the largest driver of gas demand). However, beyond that, European volumes and prices will trend higher, domestic profits will become a greater and greater share (albeit at a slightly slower pace than I originally thought) and the large profits from new LNG facilities* will boost earning further. Meanwhile, a 5% 2011 dividend, which is set to increase, will be an attractive yield to wait on for higher profits and P/E rationalization.

*Another piece of news out today is a deal between Gazprom and Novatek to develop the 16Bcm of gas reserves for LNG in the Yamal region. (This is twice the size of current U.S. reserves.)

Disclosure: I am long OTCPK:OGZPY.

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