- If official numbers are true, Gazprom shares are very cheap according to every conceivable valuation metric.
- Current share price indicates most investors are focusing on what might go wrong with Gazprom.
- While it's true that there are huge risks associated with Gazprom, one can't help but notice a well-run company with stable revenues in the big picture.
- If you are willing to take a leap of faith and have strong nerves, Gazprom might have huge upside potential.
GAZPROM: What could POSSIBLY go wrong?
In his excellent (if somewhat overpriced) book Margin of Safety, Seth Klarman nicely sums up the so called "investor sentiment" in a nutshell: In good times, investors no longer worry about what could go wrong, but focus on what might go right. Naturally, the opposite is true in bad times, so the investors focus on what might go wrong.
At the time of the writing of this article, shares of Gazprom, even after their recent rally, are still trading at around 3 P/E and less than 0,4 Book Value per share. These depressed levels indicate that investors are clearly (and perhaps rightly) focusing on what is/might go wrong with the company at the moment.
So, what IS wrong with Gazprom?
Quite a few things. And not just the recent Ukraine crisis or the threat of sanctions. We are talking about a huge, bloated and inefficient company which is controlled by a crony oligarch-state apparatus. The corruption is so widespread that you can find a neatly written article about it in nearly any western media outlet or think-tank institution every other day. Their biggest customer, the EU, basically just hates Gazprom and tries to actively undermine it in every way imaginable. On the top of that, there is always the chance that Russia just decides to royally screw the foreign/minority shareholders should the things go really, really bad in their financial markets and Gazprom investors end up with worthless pieces of paper. Or there might be some sort of inconceivable international sanctions against Russia where investors end up with worthless pieces of paper. The list goes on and on...
In fact, no one is more aware of the problems Gazprom faces than Gazprom itself. In their most recent annual report, through pages 110 to 118, they outline in detail nearly every single risk factor to the company, and their plans to handle those risks. It's actually pretty elaborate and enjoyable, you should go ahead and read it. Even the most incredulous of investors might skip some of the risks mentioned in that official report. Speaking of it...
The "Official" Figures
Normally one looks through the fundamentals, balance sheet, cash flow, etc, and decides whether a company is undervalued or not. In this case, however, by every single conceivable metric, Gazprom looks undervalued IF (and that's a big if) the numbers in official balance sheet are true. Therefore it seems that many investors choose not to believe the official figures in Gazprom's financial statement - which is consistent with the whole "corruption" narrative. Or maybe they think that the revenues/earnings will fall sharply in future. Or a combination of both.
Let's start with the book value in financial statement. The vast majority of Gazprom's reported book value consists of its hard assets, mostly gas infrastructure. The official figures might greatly overstate the real value of some of those. Maybe some pipelines are nothing more than rusty and leaky pieces of junk made in Soviet era needing constant repairs, which are not worth a dime. Maybe that subsidiary media company is just another state owned propaganda TV which will always generate negative cash-flow, and not worth a dime. Perhaps those so called financial investments are loans given to politically connected entities who have no way or intention of paying it back. And perhaps with this Ukraine crisis, a huge chunk of receivables (in form of gas bill) just evaporated and have to be written-off. There are some figures you just can't fake though, like cash and short term investments. In any case, here are Gazprom's assets:
Judging by the share price, Mr. Market does not quite believe the authenticity of these figures and thinks some of the assets in the balance sheet are fictional and have zero real value. That's why Gazprom is trading at a huge discount - the funny part is, before 2008 crisis, Gazprom used to be treated like a blue chip and command a premium compared to its peers - You see, they HAD a stable business, long-term contracts, low debt ratio, the biggest gas infrastructure and the largest gas reserves in the world. So much changed in a few years... Wait, what?
So the billion dollar question (literally) here is, what's the percentage of those imaginary assets? Nobody knows that, except maybe Mr. Putin and Mr. Miller themselves. Let's try to make an educated guess about that number by making a lot of assumptions, paranoidly erring on the side of caution:
- Gazprom's total liabilities are ~3412 bn RR.
- Cash is taken at face value. That makes ~700 bn RR.
- Most of ~638 bn RR inventories are gas and refined gas products, which may be sold for a good value even in fire sales. Let's just say the inventories are worth ~450 bn RR at worst, it's a nice round number.
- Of ~1339 bn RR accounts receivable, ~313 bn RR are gas bills and advances to Ukraine. We assume these are non-recoverable at worst. ~141 bn are gas sold in Russia and ~118 bn are overpayment of taxes to Russian Federation, these two are slam dunk. Let's assume the rest are worth at 3/4 of its book value. That makes ~835 bn RR in total.
- Of ~1195 bn financial investments, ~136 bn are the investment in Novatek (which now makes ~125 bn RR at today's closing price). ~566 bn are long-term investments in various subsidiaries, which are impossible to evaluate, but let's say they are worth half of its book value. ~105 bn are various short-term loans due within 12 months, let's say these are worth 75%, ~80bn, and the rest of financial investments categorized as "other" are worth one-third of its book value (~130 bn). That makes ~618 bn RR in total.
- ~1740bn assets categorized as "Other" are goodwill, intangibles, exploration assets and deferred tax assets. For the argument's sake, we'll consider the goodwill as worthless, exploration assets are only worth 1/4th of its book value (~46 bn) and that deferred tax assets are worth at face value (~75 bn). That makes ~121 bn RR in total.
So far, excluding hard assets, we have ~688 bn RR or ~20 billion $ negative equity. The company is priced at around 100 billion $ at the time of this article was written, so the hard assets are priced at around 120 bn $ by Mr. Market. According to balance sheet, they paid around 247 bn $ since 2002 to build those (more on that below), on the top of the already existing infrastructure - excluding repairs and maintenance. So we should be talking about some pretty major screw-up if this valuation is fair.
Gazprom spends big on cap-ex (according to official figures, always according to official figures, because what else?), which is normal for an energy company of its size. Indeed, most of its cash generated from operating activities goes to cap-ex. And in any case, cap-ex should be good, because in the long run that's what generates shareholder value. But how much of this cap-ex are new investments, as in new machinery, buildings, wells, pipes, etc. which increases production and efficiency, compared to the money spent just to run those barely working rusty old pipelines?
The "leaky and old pipes" narrative is, in a nutshell, that Gazprom actually spends a most of this cap-ex to botch its barely working condition pipelines - so the actual depreciation is far greater than official figure - which means a portion of "profits" in balance sheet is a fiction, a mirage to lure gullible investors. But why would they do that? Why would they show imaginary profits - thus pay more dividends, as bound by Russian law? If they are cronies who have no respect for minority shareholders, why pay them dividends? Are they planning to issue shares to stay afloat, and trying to drive the share price up just before a major issuance? The answer is no, they are solvent, and no they seem not to care about the daily (or annual, for that matter) fluctuations in share price nor planning to issue shares. If anything, Gazprom pays less dividend than it's supposed to, by basing the portion of dividends on parent company's balance sheet only, not the consolidated balance sheet of whole group. And their debt to equity ratio is minimal (which is confirmed by their BBB credit rating by S&P) and they seem to have a lot of credit line to borrow their way through a major crisis or fund an ambitious project (wink, wink, China deal, wink). So unless they are planning to issue additional shares, this narrative just doesn't hold together. So let's look through the actual numbers:
Since 2002, Gazprom roughly spent 247 bn $ on fixed asset cap-ex. The book value of its fixed assets increased roughly by 258 bn $ during that period (both are not adjusted for inflation). Current book value of its fixed assets are ~280 bn $. Considering adjustments for inflation, revaluation and depreciation, (and assuming there is no foul play) these numbers roughly validates the book value of fixed assets - implying the actual value of Gazprom's fixed assets is greater than market's current valuation.
Actually Gazprom spent roughly 120 bn $ on fixed asset cap-ex in the last 3 years alone so unless we're talking about a major incompetence or corruption, common sense dictates that the value of those assets should be worth more than that. But the market valuation implies Gazprom actually spent most of this hard cash on nonsensical projects which are worth billions on paper but actually are worthless. All we know is that those assets sure generate a lot of cash (more below).
Another criticism for Gazprom is that they do a lot of cap-ex for politically motivated projects, like pipelines that circumvent some countries not for profit maximization purposes but due to reservations in Kremlin's political agenda. This criticism sometimes comes with a built-in "corruption" narrative, implying a portion of cap-ex actually goes to politically connected entities instead of generating value for shareholder. There's a grain of truth in all this: For instance, they are building a pipeline (South Stream) to by-pass Ukraine altogether. But if you want to sell Russian gas to Europe and there exists a pipeline infrastructure for that already, then why build another one? It's an unnecessary waste of resources and shareholder money. Unfortunately, a Gazprom investor has to accept the fact that this company, as a part of Russian "national champions" doctrine, will always operate as an extension of Russian foreign policy and will never purely focus on profitability - but it also means they have the power of one of the largest states in the world at their disposal.
Gazprom also generates insane amounts (for its market value, with a Price-To-Cash-Flow ratio of ~2) of cash flow from operating activities. Should the impossible were to happen and Gazprom actually manages to somehow shrink its Cap-ex (by running out of pipelines to build for example, because they already built everywhere!), the earnings will literally skyrocket - assuming flat or slightly declining revenues.
Gazprom's historical growth in top line looks solid. Now, we all know that the historical numbers are meaningless when it comes to evaluate a company: After all, the investor buys its future cash flows, not its past. Also, it might take some time for the post-2008 plunge in Natural Gas prices to affect Gazprom's revenues thanks to its long-term contracts, so maybe the future doesn't look that bright. With that being said, the obvious bottom-left-to-upper-right trend is impossible to ignore:
So... That bloated, inefficient and corrupt management of Gazprom was not THAT incompetent after all, when it came to increasing revenues, even while natural gas prices are at their historic lows (Note that in the same period, the real revenues of S&P500 companies increased by only ~10%). But that too, is largely meaningless, because at the end of the day the only thing that matters is how much money will generate for shareholders in the long run - thus the bottom line.
Herein lies a dilemma. Being a state owned company, Gazprom is unlikely to engage in shareholder friendly activities - they flatly state they won't engage in buyback activity for instance, and spin-offs for their undervalued assets (as recommended by some well-meaning analysts) are probably out of the question when you look at the Gazprom history after 2003 and the effort to put everything together under one roof. That leaves dividends as the only game in town to generate shareholder value, for the foreseeable future. The Russian Federation, Gazprom's largest shareholder, have every incentive to increase its revenues (which they do terrifically) but they have other tools to extract the profits from the company without returning it to shareholders (even though they are the largest one) , should they wish - in effect using it as a piggy bank to fund public spending (just for the record, there is no reason why they should do that, Russian Federation's public debt is so minimal that they may as well borrow).
For instance, they might increase taxes on "gas monopolies" (oops, Gazprom is the only one...). Or they might eliminate dividends indefinitely by reporting minimal profits (Gazprom is bound by Russian law to pay a portion of its profit as dividends), which, without any alternative way to return profits to shareholders, will in effect make Gazprom shares worthless paper. True, that might devastate the investor confidence in Russia, but they survived the 98' and they know it's not the end of the world - in any case, markets are very forgiving nowadays (wink, wink, Greece).
Then again they might play ball, boost dividends, and run the company as they did for so many years - by the rules of the game. Nobody knows (except maybe Mr. Putin) what will happen in future. Note that with buybacks, spin-offs and other tools out of the picture, dividends are the only way to return cash to shareholders, so the abnormally high dividend yield is actually quite normal and investors shouldn't get enticed by that.
- "I wouldn't, if I were you, invest in Russian equities right now - unless, you are going short" Jay Carney, White House Spokesman
It's psychologically challenging to go long in a company where red headlines are flashing about every single day: Pipeline explosion, Ukraine crisis, Ukraine won't pay its gas bill, EU to sue Gazprom on its monopolist practices, Ukraine jet/helicopter crashed, Obama-Putin talks collapsed, US warns of sanctions, Gazprom/China talks collapsed (oh wait, never mind...), more Ukraine clashes, etc. In fact, some of the news or articles are clearly biased against Russia. Western government officials are even openly suggesting to short Russian equities. This may be a "blood on the streets" moment for Gazprom if you're willing to go against the crowd.
It might be also reasonable to think that some of the weakness in Gazprom share price is not due to a genuine investor concern about company's fundamentals, but to a form of "politically driven punishment" against Russian financial markets - not that it will matter from an investment decision standpoint, because for all we know this driver might get worse. Just for the record, Russian Federation's financial metrics against external shocks (budget deficit, public debt, foreign reserves, current account, etc) are top-notch, except for its structural weakness to commodity prices.
No matter how hard one tries to make sense of Gazprom's numbers, it all boils down to how much you trust in official figures and how much faith do you have in Russia's stock market, business practices, government, regulations, rule of law and property rights - or said otherwise, its commitment to free market capitalism. So how committed they are?
Before 2008, Gazprom was considered a bastion of emerging markets. It commanded a premium compared to its peers in energy industry. It was going to be the company with largest market capitalization in the entire world, its then CEO said. Russia was going to be a part of global financial system and Gazprom was to be the frontrunner, the national champion, the crown jewel of Russian empire. Such was their vision that they listed its ADR's (certificates that allow a stock to be listed on foreign exchanges) in various western exchanges.
Then came 2008. The Russian market got hit the hardest. Their markets plunged along with Gazprom, and that vision shattered, forgotten in the dusty books of history.
But even during the hardest times (they kind of closed their exchanges for weeks), Russia played hardball capitalism. There were some rumors of course, but no nationalization, debt default, broad capital controls etc. occurred. Meanwhile the US was busy to re-write the entire rulebook of capitalism - once-taboo taxpayer funded bailouts, unprecedented money printing and fiscal stimulus were suddenly desirable and benign policies, all justifiable by "crisis" of course.
I may be speculating but it seems to me that Russia - not just its government or current leadership but as a whole - wants to be a part of global capitalist system. In their terms maybe, but they do nevertheless (Mr. Brzezinski thinks so too). They want to attract foreign capital, to grow, to prosper. That's their vision. They are deeply committed to it. Just think about the recent hoopla about Gerard Depardieu applying for Russian citizenship. In this vision of "capitalist Russia", Gazprom is and will be always the flagship of Russian financial markets. Remember that in that utopian vision of Russian policy makers, Gazprom's market capitalization is 1 trillion $ or just about 900% up from here. As a side note, the officials recently announced they are planning to list Gazprom ADR's in Singapore exchange. Maybe that vision is not dead, it's just hibernating deep down somewhere.
If you are willing to ignore the flashy red headlines and the volatility in the near term and ready to take a leap of faith (on the official numbers, mostly), Gazprom may be an investment with huge upside potential. Its balance sheet is solid, its valuation a real bargain and there is no indication that revenues are on an established down trend. On the contrary, the catalysts which used to drive the price up, like long-term contracts, stable business and large reserves are still there - plus this new Asian expansion. There is no indication that the management is incompetent. Despite all this, the share is trading at nearly generational lows.
The markets believed in Russia's vision once and they may do so again in the future - if they start focusing on what might go right.
Important notice: At the time of the writing of this article, Mr. Putin suggested a "recapitalization" of Gazprom to fund China gas infrastructure deal. Now, since it was denied by Finance Minister a day later, I didn't put it much thought. Such recapitalization may mean Russia has in fact decided to royally screw the minority shareholders and you may put this entire article to trash: A share issuance, depending on details of course, may spell an unprecedented shareholder value destruction. It may also mean that Gazprom's top management doesn't consider these price levels as grossly undervalued - which means the numbers on balance sheet are sketchy and the skeptics were right all along.
Disclosure: The author is long OGZPY.