Gazprom Is Extraordinarily Valued After Beating Expectations With Record Profits

 |  About: PJSC Gazprom ADR (OGZPY)
by: Elliott Auckland

Recently, Gazprom (OTCPK:OGZPY) released its 2011 IFRS results. The numbers, as predicted, were fantastic but still managed to beat the high expectations from analysts. Net profit of $45 billion (+35%) beat analysts expectations of $44 billion and reserves followed suit, reaching record levels that increased by $30 billion to $299 billion. The report also highlights the major achievement of 2011: the completion of Nord Stream (a pipeline into Germany that bypasses politically sensitive Ukraine), which is a major boost for the security of Russian gas to Europe. The effects of this are already beginning to show with Gazprom's market share in Europe increasing from 23% to 27% in 2011.

A recent selloff in share price and this earnings boost places Gazprom among the cheapest companies in the world; it has a P/E of 2.9 times and a 5.1% dividend yield. Understanding why Gazprom is cheap is the most critical stage of analysis, thus I would direct readers to my article regarding its cheap valuation and why I believe it to be wrong.

Russia is currently in a period of reform, in part because of its pledge to join the WTO and also because of its promise to become more efficient. The government has passed laws liberalizing natural gas prices, increasing them 15% per annum. This is a clear positive for the gas producers -- and notably Gazprom, which supplies more than 50% of its volumes to Russia but only achieves about 20% of its profits from there. But as discussed in the "cheap valuation" article mentioned above, these gains will be offset by taxes. From the recent news flow in the Russian press, it appears that 80%-100% of the revenue increases from domestic gas sales will be taxed straight to the Russian government. The Russian press, being generally state-controlled, is fairly useful in understanding the policies being put forth. This, however, simply limits earnings growth rather than destroys it. This is contrary to the belief of some analysts I have spoken to, who believe that taxes will erode Gazprom's earnings even further.

A good summary for investors is the investor presentation, which demonstrates how Gazprom will handle higher taxes: By cutting capex from $50 billion to $35 billion, this will both boost profits and reveal a crucial bargaining card. The Russian government knows it cannot aggressively tax Gazprom because that will cause the effect that was already threatened -- reduced capex and production. There is nothing worse for the government than this scenario; GDP will be hit both from the lack of fixed investment into the fields and the profits from extraction. Simply put, if a field is not economical to develop, Gazprom will not develop it. Thus the tax has to be structured in a way to maximize government revenues, but, critically, also ensure the risk/reward is appropriate for Gazprom. This last point is one that many analysts have missed, and have just jumped on Putin's rhetoric and taken it to the extreme.

Gazprom was a 2% yielding stock in 2010, and this yield will jump to 5.1% for this year's payment of the 2011s dividend. A new policy to pay out 25% of Russian accounting standards net income will create a further surge in dividend payments, which over time will draw in more and more investors. Investors who previously questioned whether the earnings were real and who never looked at Gazprom because the yield was not high enough will now look at the company with interest. With a P/E of 2.9 times and a 5.1% dividend yield, Gazprom is a steal.

Disclosure: I am long OTCPK:OGZPY.