Petrobras (NYSE:PBR) just released its results with a net loss of $8.6B for 2015, mostly due to the impairment of oil and gas production fields. This is good news because now its balance sheet shows a more realistic image, given the environment of the sector and because impairments are non-cash items, which per se don't indicate the cash flow generation potential of a company.
Petrobras is going through a corporate business adjustment phase with regard to the new oil price environment, which is necessary due to structural changes hitting its business. Shale production in the U.S., other low cost producers like Iran coming into the market, slower growth in China, and development of renewable energies are all strong barriers for oil prices returning to above $60. At the same time, benefits from $30 oil prices are not that evident for oil importing countries, while being penalizing for oil exporters -- thus creating a floor for further price depreciation.
To adjust to this new reality, the company has been selling assets, decreasing its investment plan, and changing its business focus from production to downstream operations. Such actions take time. Many think an indebted company like Petrobras won't have that kind of time, but the recently released 2015 results and accompanying financial information suggest otherwise.
While revenues fell 32% in 2015 mostly because of the oil exploration segment, EBITDA only fell 0.5% and funds from operations only fell 2.7%. With the adjustment of the investment plan to the new environment, funds from operations more than covered capital expenditures. That freed up $2.3B, creating positive free cash flow for the first time since 2007. EBITDA margins improved from 15.9% in 2014 to 23.4% in 2015.
While in 2014 refining, transportation and marketing represented 81% of revenues, leading to a gross loss, in 2015 those items represented nearly half of the gross profit. As only a fraction of oil produced by Petrobras is exported and nearly 90% is incorporated into the downstream business, there is a transfer of value within Petrobras' operational segments -- and that contributes in a positive way to earnings.
This puts concerns about high leverage into perspective. Funds from operations cover total debt by at least 20%, and total debt represents 54% of total assets. Petrobras, with a cash position of $25B and available unused credit lines of $15B, has enough cash and facilities to pay for debt coming due in 2016 and most of 2017 without needing to generate any operational cash flow. These available lines already include the $10B loan from China Development Bank as part of a deal to supply crude to the Asian country. Interest costs are high but manageable, a burden that should decrease overtime as cash flow generation capacity improves.
The impairment of assets was a huge $12.3B, and as reported by the press, one-third of the market cap of the company. However, when comparing the market cap loss from the peak with all the impairments recognized in the same period, the loss in value of assets seems fully priced in by the market.
Petrobras' ADR reached $70.83 on June 1 2008, an all-time high. Today, the ADR is trading at $5.61, a 92% drop or $33.8B market cap loss. Total impairments from 2008 until now (mostly concentrated in the last few years) reached around $30B, which is consistent with the re-pricing the market has made of the assets of the company. This ignores the pile of debt contracted to finance those same assets. Comparing 2015 year-end numbers released by Bloomberg with the pool of analysts estimates, we conclude that with the exception of net income, items like revenue, EBITDA, and free cash flow came out better than expected.
Key concerns about this company are more related to the corruption scandal and contingent liabilities. From the corruption scandal and pending lawsuits side of things, it would be unreasonable to make any judgment. Regarding contingent liabilities, which amount to $41.509M, they are mostly tax related. And in case they materialize, they should be spread out over time.
Petrobras isn't paying any dividends for 2015, and according to management speaking during the earnings conference call: "If the company has dividends they will be paid out; if there are no dividends they won't be paid out." That suggests that in 2016, if net distributable income is positive, dividends should be resumed.
Corporate governance is being reinforced -- you can read about it in the earnings release:
With respect to Corporate Governance, the Company's bylaws were amended to provide for the Advisory Committees, including the Audit Committee and the Compensation and Succession Committee, which is responsible for determining the qualifications for nominations of executive managers, executive officers and Board members. In addition, the Strategic Committee and Finance Committee were both created. Also, under our new corporate governance rules, the Company must be represented by two officers, acting jointly. Additionally, Petrobras scope of authority was reviewed and a shared authority procedure was implemented, in which at least two managers are needed for decision-making.
This means that before the corruption scandal, only one signature was needed to oblige the company -- no wonder there were so many problems.
In all, we can say that results were good as, for the first time since 2007, Petrobras reported positive free cash flow, the company is adjusting its corporate structure in terms of E&P investment plans, it is benefiting from low oil prices in the downstream business, and its leverage is not worrying. Big companies have big debts; the size has to be matched with cash flow generation.
In terms of valuation, I think the stock is cheap and has a 40%-50% upside from current levels. Using a pool of market analysts estimates, EV/EBITDA is around 5x or less for 2016 through 2018. In order to reach a P/B of 1, equity prices in USD would have to increase more than 70%.
In the long term, E&P perspectives are not good, but flagship vertically integrated players like Petrobras should be protected by downstream operations that benefit from cheap oil. Companies operating in large markets, like Brazil, have a particular advantage. Dividends should resume as long as there is positive net distributable income, which could happen as soon as next year.
Risks to this view are contingent liabilities materialization or a deeper depreciation of the currency, two events that I see as unlikely. The first because of the bureaucratic nature of the processes involved, and the second because even with the current political turmoil, the fundamentals remain supportive for the currency as the trade balance is in a surplus and foreign direct investment is entering the country. (For some background on this topic, please see my article "Is The BRL/USD Exchange Rate Reaching A Turning Point?")
Petrobras' bonds with maturities shorter than one year have tightened substantially, but bonds maturing in February 2017 have ask yields of over 5.5%. That appears attractive, given the low-rate environment and could be more adequate for conservative portfolios.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.