Putting Gazprom's Tax Worries Into Perspective

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

Over the past two years Gazprom (OTCPK:OGZPY) has been weighed down by tax worries leaving them on an extremely depressed 3x PE ratio. From speaking to analysts and fellow investors the "bearish" view is that Gazprom is under-taxed and that Russia wants to increase taxes. They point to the doubling of the Mineral Extraction Tax as an example of this. However, when adding all parts of the equation together the view that increased taxation will erode earnings is false.

I first became attracted to Gazprom on hearing about the increases in Russian gas prices - 15% price increases have been passed into law for at least the next 5 years. Those analysts that were bearish very quickly responded by saying that these gains would be taxed away, and comments made in the press suggest something along those lines. Ministers are hoping that 80-100% of the revenue gains will go to the government through taxes.

So, to give a "worst case scenario" let us assume that 100% of the increases are taxed away and also that production remains flat over the next 5 years. (Even though Production will likely increase 10% and it is quite possible that not all of the increases are taxed). In 2011 Gazprom had 739bn RUB in domestic gas revenues.

Financial Year Revenue (in bn RUB) Additional Tax* (in bn RUB)
2012 849.85 110.85
2013 977.33 238.33
2014 1,123.93 384.93
2015 1,292.52 553.52
2016 1,486.39 747.39
Click to enlarge

* Additional tax is worked out as Year Revenue - 2011 Domestic Revenue. (I.e. assuming that 100% of gains are taxed away)

Currently Gazprom pays 1,683bn RUB in taxes, so if we assume that tax contributions remain flat elsewhere (which is unlikely - they should rise as profits rise) then the total tax payment for 2016 would be 2.4trillion RUB. To put this figure into some context of the budget; the 2012 revenue forecast for the Russian Government is 12 trillion RUB, or 2016 tax payments will be $80bn. This tax payment will likely be even higher, primarily because Gazprom's production will be 10% higher for oil and gas. (This roughly adds 190bn RUB to their tax payment).

Then there is the fact that this is only one segment of Gazprom, and it is only measuring direct taxes. If we include tax revenue from dividends paid from Gazprom group, and entities that Gazprom have a stake in then the tax income increases further. My estimation is that the government will gain an additional 70bn RUB alone from the 2011 dividend from Gazprom group and Gazprom's stake in Gazprom Neft (OTCQX:GZPFY) - not to mention all the other companies that Gazprom has a stake in.

All of the above is only the summation of current taxation and the bear scenario of taxation for the domestic price increases. Critically, one must understand this simply prevents the Russian gas segment from increasing its profit, its profit will actually remain flat. Thus there is no imminent correction of Earnings through tax worries. In fact, Gazprom can grow earnings healthily while contributing more taxes to the Russian government than ever before. It is important to note that due to Russian gas prices being so low, that revenues only account for 16% of the 4.6 trillion RUB revenues that Gazprom has. Thus, the other 84% can grow, while the domestic profits are flat lined.

Finally I also present a conceptual reason for why Gazprom's Earnings won't be taxed so much so that they become an 8x PE company. The government wants higher GDP and employment more than anything. By having a moderate tax regime, Gazprom will spend the Capex on developing the fields and then sell the gas both contributing to GDP and tax revenues. If an aggressive tax regime is in place then Gazprom will not invest, GDP will increase slower, fewer jobs will be created and government revenues may actually fall. The government's interests are aligned with Gazprom, indirectly through the success of the overall economy and directly through their 50% stake in the state champion.

On a 3x PE Gazprom is mistakenly undervalued and misunderstood. An increased dividend to 5% for FY2011, and continual long term Earnings growth will drive the share price higher and a PE re-evaluation.

Disclosure: I am long OTCPK:OGZPY, OTCQX:GZPFY.