The European Sovereign Debt Crisis has been giving headaches to investors for more than two years now, and like all financial crisis it has claimed its casualties, especially in the financial sector where companies such as National Bank of Greece (NBG) and Allied Irish Banks PLC (AIB) have seen their markets capitalizations shrink by more than 90% since January 2010. The Eurozone has been on the brink of collapse since last winter, when the sovereign bonds of Italy and Spain have topped yields that appear to be unsustainable in the long term and, unlike Greece, Ireland or Portugal, their debt burdens are simply too large to be bailed out. Although the end of the crisis is still not in sight, we are beginning to see some light at the end of the tunnel after Mario Draghi, the President of the European Central Bank, has sparked a two day market rally when during a speech at the Global Investment Conference that took place in London on July 26, he declared that
the ECB is ready to do whatever it takes to preserve the euro and, believe me, it will be enough.
The rally has lifted European stock indexes by more than 5% in just two days but the shares of many long-battered companies are still trading near their 52-week lows, and in some cases, near their record lows.
The two companies I am about to discuss are both in the energy sector which, unlike consumer goods (such as apparel or the latest tech fad) or the entertainment industry, is of paramount importance because it sells a product that developed and emerging economies alike can't do without. I have already written about them six months ago, so I am going to reassess their valuations in light of the recent developments and market action.
The company I will present in this first part is ENI (E) which has been a core component of my personal portfolio since 2007. The former Italian NOC (National Oil Company) has been a public company since the mid 90s, although the Italian government still owns a 30% golden share. I have published a detailed sum-of-the-parts analysis last February, concluding that the company was worth at least $55 per ADR; it was trading at $44 back then and has touched a high of $49.50 in March and a low of $37.90 on May the 30th. After the recent rally it has risen back to a price of $41.20 per share and Q2 earnings will be announced next Wednesday. (Aug 1)
Let's review the most important developments since last February:
- Mozambique Gas Finds: the company in March and May announced new giant natural gas discoveries off the coast of Mozambique with a mineral potential estimated to range between 47 and 52 tcf of gas in place, a quantity enough to satisfy all U.S. gas needs for more than two years.
- Gas prices reduction: Eni and Gazprom (OTC:OGZPY) officials met in March and reached an agreement, securing a reduction in gas prices from Gazprom. This of course will increase Eni's profit margins.
- Strategic agreement with Rosneft: In April, Eni's CEO and the President of Rosneft (OTC:RNFTF) signed an agreement which provides for the joint development of the licenses in the Black Sea and the Barents Sea on the Russian shelf and Rosneft's acquisition of a participating interest in Eni's international projects. Eni will be holding a 33.33% stake in each JV, in an area where deposits are estimated to hold total recoverable resources of 36 billion barrels of oil equivalent.
- Sale of stake in SNAM: Eni owns a 52% stake in Italian pipeline company SNAM (OTC:SNMRY), with a market value of about Eur 6.4 Bil ($7.7 Bil). A 30% stake will be sold to state-owned financing group Cassa Depositi e Prestiti in three tranches (last in may 2013), while the remainder will be sold to institutional investors; a 5% stake has already been transferred and Eur 612.5 Mil ($750 Mil) have been paid to Eni on July 23. The Abu Dhabi Investment Authority and other Mideast sovereign-wealth funds have shown interest in the remaining 22% stake. The cash will be used to increase E&P activities, which offer higher returns on capital, and to cut down debt.
- Share buyback: On July 16, shareholders have approved the commencement in 2013 of a share buyback plan, up to an amount of Eur $6 Bil. ($7.2 Bil) and up to a maximum of 363 million shares, representing approximately 10% of the share capital in circulation.
- Sale of 5% stake in Galp: Last week Eni announced that it had concluded with Amorim Energia BV the sale of 41.5 million shares, at the price of 14.25 euro per share, of a 5% stake in Galp Energia (OTC:GLPEY), Portugal's largest Oil & Gas company. Following the transaction Eni still holds 23.84% of the share capital of Galp Energia. The stake has been sold at a profit and the proceeds ($725 million) will be reinvested in E&P operations.
- Entry into Kenya: On July 2, the company announced the signing of three product sharing contracts, awarded by the government of Kenya, for the acquisition of exploration blocks. Eni's entry into Kenya reinforces its presence in the exploration of the frontier basins of East Africa, which has recently led to the discovery of significant volumes of natural gas in the deep waters of Mozambique, and further strengthens its leadership in Sub-Saharan region.
- Other significant events are the restructuring of the petrochemical division with a new strategy, the rebranding to Versalis and a plan to list it in 2016; the acquisition of exploration blocks in Vietnam, gas investments in Ukraine and Egypt and an agreement with China National Offshore Oil Corporation (CEO) for the exploration of a block situated 400km off the coast of Hong Kong.
What about the negative events? None that I know of, except some pirate attacks to production sites in Nigeria.
Oh, I forgot about Moody's (MCO). They keep on lowering Eni's ratings. In October 2011 they reduced Eni's long-term credit rating from Aa3 to A1. Last February they lowered it to A2 and on July 17 they lowered it to A3. It is evident they are not fans of this company. I usually ignore these overrated agencies' opinions, considered that these are the same guys that failed to warn investors about the Asian financial crisis, Enron and the subprime crisis, giving positive, investment-grade ratings to AIG (AIG) and Lehman Brothers up until their collapse; also note that a Moody's report from December 2009 is titled "Investor fears over Greek government liquidity misplaced". Less than six months later Athens received a $150 Bil. rescue package.
Let's see how Eni compares to its peer group
|ENI||Peer Group Average|
|5yr avg Net Profit Margin||8.4||10.7|
|5yr avg Return on Equity||16%||19%|
This brief appraisal shows us that Eni is attractively priced compared to its peers, although its efficiency ratios and its leverage are slightly worse than the industry average. Note though that the debt/equity ratio comprises Snam's debt. Once Snam sale goes through in 2013, the debt/equity ratio will be 40%.
A very simple DCF Valuation
I ran a simple discounted cash flow valuation, using the following parameters:
Annual EPS growth: 4% next 10 years, leveling off at 3% thereafter
Discount factor : 12%
Using these conservative parameters, the calculator reports a valuation of $61.3 per ADR. If I make the calculations in Euros, given the recent currency weakness versus the dollar we get to a valuation of about $57.1 per ADR using the latest EUR/USD ratio of 1.23; if I use the average EUR/USD ratio in the past ten years (1.31) we get a value of $60.7 per ADR.
In these past six months there have been positive developments for the company, especially the huge gas finds in East Africa and the ongoing corporate restructuring with the sale of SNAM and other minority stakes, which will provide the business with fresh funds to invest in more profitable exploration and production assets.
A key drawback for Eni is that most of its reserves and operations are in politically unstable countries leaving the company open to risks such as threats to its employees and damage to its production facilities; political instability also implies disputes with governments and a constant risk of nationalization of assets. This hindrance though may also turn out to be a key strength, since Africa is a promising continent for oil & gas explorers and Eni has a strong geopolitical advantage in the region, having already established a solid presence there. Let's not forget the firm ties with Gazprom (cooperation began in 1969) and Rosneft: Russia holds the largest gas reserves and the 8th largest oil reserves in the world.
The company has an aggressive growth strategy, planning €60 billion of expenditures over the 2012-2015 period, with most of them related to upstream activities.
A last point worthy of mention is that Eni has a substantial utility business that helps it diversify against the fluctuation of oil prices.
In light of all the aforementioned developments, I consider Eni at these prices a very good long term investment. I give the ADRs a fair value of $60.
Note: last week I have increased my investment in the company and now it makes up more than 20% of my stock portfolio.