Controversial Gazprom Still Cheap, Still Risky

| About: PJSC Gazprom (OGZPY)
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Summary

Geopolitical wrangling and a warm European winter have weighed on both results and sentiment at Gazprom.

A recently-completed agreement with China is likely just the first step in a wider focus on gas-hungry Asian markets.

Gazprom trades at a steep discount to its European peers. Even granting that some discount is appropriate given the risks, these shares look about 20% undervalued and offer good yield.

Recommending Russia's giant natural gas company Gazprom (OTCPK:OGZPY) to readers last year was a controversial pick and one that has not worked out as well as I might have hoped. I went into it well aware of the attendant risks of owning a company that is virtually an arm of the Russian government and that has a reputation for not working and playing well with others. While the roughly 3% gain since then isn't horrible, it has lagged other turnaround energy stories like Statoil (NYSE:STO) as well as its home index (though only by a couple of percentage points).

Given the Russian government's combative attitude toward Europe and the West, I'm less bullish that Gazprom's valuation discount is going to improve in the near future. I continue to believe that only modest growth can support a fair value well above today's price and that Gazprom has significant restructuring opportunities, but it takes a strong contrarian streak to invest here. I continue to see opportunities here for aggressive investors with a long-term orientation, but I can't fault investors who will argue that there are easier ways to generate alpha in the market over the next 12-24 months.

Finally Dotting The I's With China

Gazprom and the Russian government have been negotiating with China and CNPC (PetroChina's (NYSE:PTR) parent company) over a long-term gas supply agreement for the better part of a decade, but the entities recently hashed out the remaining issues and now have an agreement in place that is expected to result in Gazprom selling an average of 38Bcm (or 1.33Tcf) a year in natural gas to China starting in about four years. That volume is less than what Gazprom sells to Europe in a quarter, but it will nevertheless allow the company to leverage its eastern resources and it is likely just the first step in a greater focus on Asian markets.

Although the final negotiated price for the contract will reportedly not be revealed it seems to be an open secret with various sources claiming prices of $350/mcm up to around $385/mcm. That is better than initial expectations when China was reportedly pushing for discounts to European prices of over 20%.

While the market was pleased to see the agreement finalized, there has been quailing over the capex needs to fulfill this agreement. Spending to develop the eastern fields and build the Power of Siberia pipeline will reach around $55b, with an additional $6B or so going to a new gas processing plant, petrochemical plant, and helium plant. The deal with China also includes a prepayment/advance mechanism that could allow Gazprom to get about $25B ahead of deliveries.

It's not unusual for the market to react to events like these with "buy the rumor, sell the news," but I frankly find the consternation over the capex to be a little odd. Did analysts think that Gazprom was going to give its employees leaf blowers and fans and just blow the gas over the border into China? It was always obvious that there were going to be significant capex needs tied to any deal, and the $55b estimate is in line with most expectations and within the company's ability to fund.

Fighting Your Customers Is Seldom Good Business

Gazprom and its customers in Europe have a love-hate relationship; nobody likes dealing with Gazprom, but it is generally accepted as a necessary evil given that Europe can only supply about half of its needs from internal production.

While Eni (NYSE:E), E.ON (OTCQX:EONGY), and GDF Suez (OTCPK:GDFZY) have been working relatively constructively with Gazprom on new contracts, the situation with Naftogaz (Ukraine's national oil and gas company) has been much more contentious. Gazprom and Naftogaz have a long history of disagreements, threats, and last-minute resolutions, but Gazprom stopped deliveries to Ukraine (while continuing deliveries to Europe through Ukraine) back in June after Gazprom implemented a shift to a prepayment basis citing unpaid debts. Both companies have resorted to arbitration in Sweden, but that will likely take years to resolve. Gazprom is claiming an outstanding bill of over $4 billion and is offering a $100/mcm price cut, while Naftogaz wants an even bigger cut (closer to $160/mcm) and the elimination of take-or-pay contracts.

At the risk of sounding overly cynical, this is just the way it's going to be for the foreseeable future. Gas storage levels in Europe are high after a warm winter, but bargaining leverage will swing back to Gazprom if/when economic activity picks up in Europe and/or when a rough winter arrives. Deliveries from new sources like Noble's (NYSE:NBL) offshore Israeli gas fields are still a little ways off and even then companies like Noble and Statoil cannot completely replace imports from Gazprom.

Restructuring Potential Is There, But Is The Will?

Gazprom's returns on capital aren't all that bad, with the company's low double-digit returns on par with other European operators like BP (NYSE:BP), Total (NYSE:TOT), and Statoil even with a domestic business mostly operated at/for breakeven results. These returns are likely to drop significantly in the coming years, though, as the company deploys capital to develop its eastern fields and build those pipelines to China well ahead of earning returns on those assets. This is a "takes money to make money" situation, but also a risk that business in Asia never develops as expected.

In the meantime, there appears to be a lot of "leakage" across Gazprom - operating expenses appear higher than they need to be (relative to other European operators) and capital is not always deployed in the most effective manner. Bears will argue that this is another "ah ha moment" underlying the problem of Gazprom's close relationship with the government and the Russian government's willingness to run Gazprom as a de facto welfare/crony reward program.

While that is probably true to some extent, I don't believe the Russian government is completely stupid; a better-run Gazprom will generate more dividends for the government and I believe there is more willingness on the part of the government to allow Gazprom to operate more efficiently than the market currently believes. With the Ministry of Finance recently lowering its expectations of 2016 dividends from Gazprom (though still well above present levels), this may mark a move toward a more realistic, returns-focused approach to how Gazprom operates.

Estimating The Value

There is always a lot of "may," "could," and "believe" where Russian companies are concerned. As I said earlier, I don't fault any investor for deciding to give a wide berth to Russian companies, particularly resource companies, as they sometimes make companies like Eni or Petrobras (NYSE:PBR) appear to be run in a hands-off manner by comparison.

I still see value here. In a long-term FCF model that only looks for long-term revenue growth of 2% (only a bit higher than other European operators like Total) and low-to-mid single-digit free cash flow growth, I come up with a fair value of $10.50 and that includes a 200bp risk premium on the discount rate. EV/EBITDA is likewise suggesting undervaluation - even if I cut back my multiple to 3.0x (from 3.5x previously), the implied fair value is $10.70.

The Bottom Line

All told Gazprom looks about 20% undervalued (excluding the 4.5%-plus dividend yield) with what I think are conservative assumptions. Clearly there are risks that Putin's bombast and ambition serves to alienate the West even further and/or that economic mismanagement reduces domestic demand, as well as the risk that customers in the West will find alternatives to Gazprom's gas. There aren't that many energy companies offering this combination of capital appreciation potential and dividend yield, though, so it is a question of how much risk investors want to take on for that extra potential.

Disclosure: The author is long STO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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