Gazprom - An Excellent Dividend Opportunity

Summary

• Gazprom shares currently offer investors the potential for a very high return, both in the form of dividends and share price appreciation.
• However, there are numerous political risks that investors should consider and weigh against the potential returns.
• Whilst these risks are a drawback, I believe the potential future returns provide ample compensation for this higher level of risk and thus Gazprom shares are undervalued.

Introduction

Throughout the year I’ve been focused on analysing large companies that tend to ‘fly under the radar’, with the objective of finding undervalued companies sporting an attractive risk-return trade off. My theory being that the lower competition will translate to lower market efficiency and hence a higher risk adjusted return.

Upon completing my research on Gazprom (OTCPK:OGZPY) I was surprised how significantly undervalued this company appears and correspondingly, how high the potential returns appear. Whilst the potential return is very high, there are various unique political risks associated with this investment and thus it’s better suited to investors with a moderately high risk tolerance. This article will provide an analysis of the reasons I believe Gazprom shares present an excellent opportunity for risk tolerant investors.

Image Source: Wikipedia.

Company Overview

Gazprom’s primary business is the production, transportation and sale of natural gas throughout Russia, Europe and soon, China. This natural gas business is the largest in the world, with their proven reserves accounting for an impressive 17% of global total and their gas transmission system being the world’s largest. Whilst this alone is already massive, their operations don’t stop there, as they also operate a large vertically integrated oil company through their majority owned subsidiary, Gazprom Neft.

Since Gazprom is a relatively unknown company I will compare several of their metrics to one of their better known peers to help readers understand the scale of their business. Whilst I cannot quantify the exact extent to which Gazprom is followed, considering their shares have only 10,653 followers on Seeking Alpha versus Exxon’s (XOM) 302,397 followers it indicates they’re underfollowed.

Two observations are easily apparent when comparing their upstream production and downstream refinery throughput, the massive scale of Gazprom operations and their greater exposure to upstream activities, see the chart below. Their gas transmission system primarily consists of 172,100km of pipelines in Russia, which is 25% more than Kinder Morgan’s (KMI) pipeline network and could reach around the Earth’s circumference more than four times.

Graph Source: My own work.

Date Source: Exxon 2018 Q1 Results, Chevron 2018 Q1 Results, Gazprom 2017 Presentation & Gazprom Neft 2017 Annual Report.

When presenting their 2018 investor day presentation, Gazprom provided the graphic below that compares their proven reserves to their peers, with the aggregated total of the super majors’ reserves falling materially lower than Gazprom. Obviously the larger a company’s proven reserves the better, since they simply cannot produce oil and gas without first having economically viable reserves. Based upon my calculations their reserve life is approximately 37 years, which is substantially higher than the 8 to 12 years that is common for the super majors. Therefore, even though reserve replacement is a constant concern for the super majors, Gazprom can afford to operate for an extended time with few new discoveries.

Image Source: Gazprom Investor Day Presentation (previously linked).

Unique Political Risks

Whilst the scale of Gazprom’s operations is simply astounding, there is considerable controversy surrounding the company and various unique political risks. These mostly stem from the Russian government’s controlling ownership and the various destabilizing activities they’re accused of undertaking throughout the world. In response to these actions the United States government has imposed various sanctions against Russia, which has in turn weighed down the valuations of Russian companies. Whilst this situation is undesirable, as I will outline, I believe it’s manageable and the potential returns are substantially high enough to more than compensate investors.

US Sanctions

The first main risk and uncertainty is whether the United States government will impose further sanctions against Russian companies and if so, the severity of these new sanctions. Gazprom’s controversial Nord Steam 2 project is often considered as a potential target, with the United States government threatening sanctions against the other European companies involved, such as Shell (RDS.A) (RDS.B).

Whilst I’m normally hesitant to tempt fate by making predictions on political matters, I’m of the belief that any new sanctions will ultimately pose nothing more than a headline risk to Gazprom and have minimal long-term effect. In the particular case of Nord Steam 2, considering the project is supported by the regional countries and should obtain funding regardless of sanctions, I believe the project will be completed.

I believe that if the United States government were to impose crippling economic sanctions against Russia, such as those levied on Iran, they would have already done so following the annexation of Crimea, the downing of MH17, the 2016 election interference and the Skripal poisoning. Even though the United States government may desire to cripple Russia, to their dismay they would ultimately recognize the significant economic importance that Russia and Gazprom play to Europe, including their local military bases.

Furthermore, during the previous few weeks the United States government has talked of removing the Rusal sanctions, with Treasury Secretary Steven Mnuchin stating their objective was “not to put Rusal out of business”. In my view, if the United States government isn’t willing to put Rusal out of business, they’re unlikely to be willing to cripple a considerably more important company such as Gazprom.

Therefore, I believe that any future sanctions will merely continue to figuratively ‘nibble’ around the edges because Gazprom is simply too big and too important. I believe that whilst risk tolerant investors should closely monitor any new developments, they shouldn’t be deterred from investing.

Corruption

A frequent criticism of Gazprom is the perceived high corruption levels within Russia, with commentators alleging that the company isn’t run for the benefit of the non-government shareholders. Considering Russia’s corruption index score by Transparency International, see below, on the surface this seems to be quite a justifiable conclusion. However, I believe the extent to which this corruption is effecting Gazprom’s financial performance is being over emphasized.

Image Source: Transparency International.

If there is extensive corruption within Gazprom with insiders pilfering the company’s profits whilst having no regard for external shareholders, it should be reflected in their return on equity, capital and assets. After comparing these metrics to Exxon, see below, it’s apparent that Gazprom’s results are very close to those of Exxon with the difference being immaterial. Therefore, is there corruption within Gazprom? Quite possibility, however judging by their financial performance the effects seem to be minimal and manageable, thus I feel these allegations shouldn’t deter risk tolerant investors.

Table and Calculation Source: My own work.

Date Source: Gazprom 2017 Results and Exxon 2017 10-K.

Please note: When calculating these ratios I removed the effects of the US Federal Tax Reform and impairments from Exxon’s full year profits.

Resource Nationalisation & The Russian Communist Party

Yes, surprisingly they’re still around, however thankfully they’ve failed to win any elections and their 2018 campaign only attracted 11.77% of the vote. Recently one of their brilliant policies *sarcasm* was for the renationalisation of the oil and gas sector, which is always a risk when investing in countries run by authoritarian governments.

Presently this is only a small fringe risk as President Putin seemed to dismiss the idea, stating it “would be a difficult and highly dangerous process, which could have negative consequences not only for the sector but for the whole economy”. Combining his public opposition with his immense control over Russia, as well as his friendship with the Oligarchs who benefit from private property and I see little reason to believe there’ll be large scale re-nationalization. In my view any re-nationalization will be limited to the Bashneft-Rosneft situation, whereby the Kremlin wields its massive influence to ultimately have a state-controlled company takeover a smaller private company. Therefore, at this present moment I believe the probability of an investor in an already state-controlled firm forcibly losing their investment is too low to warrant concern.

Risk Management

Even though I believe these unique political risks will ultimately have a minimal long-term impact, the situation could change quickly and catch many investors off guard. Therefore, I strongly suggest that all Gazprom shareholders regularly monitor their exposure and take measures to limit their risk. To the best of my knowledge there are no derivative contracts available since most Russian shares, including Gazprom, are only traded over the counter. This leaves investors with only simple strategies, such as limiting the size of their total investments in Russian companies. Since the primary political risks have now been discussed, the remainder of this article will focus on Gazprom’s financial position, growth potential and expected return.

Financial Position

I always place a high importance on a company’s financial position, as it provides a degree of safety should an unexpected economic shock occur. Since Exxon’s financial position is often considered the gold standard for the sector, I will compare Gazprom’s financial position to that of Exxon, see the table below.

Table and Calculation Source: My own work.

Date Source: Gazprom 2018 Q1 Results and Exxon 2018 Q1 10-Q.

I believe that after reviewing these metrics it’s evident that Gazprom’s overall financial position is quite close to that of Exxon, with the differences in all metrics excluding their credit rating being immaterial. I’m quite surprised by the large difference in their credit rating and based on my research I feel this is unwarranted. Whilst I understand and agree that the political risk associated with Gazprom and emerging markets in general weighs down their credit rating, I still believe the extent in this situation is excessive. Regardless of my views on credit ratings, I believe Gazprom’s financial position is strong enough to weather any realistic economic shock that the future may hold.

Future Growth Potential

Even though Gazprom is already a massive company, there are still projects underway that should continue growing the company and earnings higher over the long-term. These projects primarily focus around the company expanding its already massive gas transportation system further into Europe, as well as entering the massive Chinese market, see below.

Source: Gazprom Investor Day Presentation (previously linked).

Whilst various western government may be displeased, Gazprom’s market share in Europe will likely continue to grow due to declining European production, uneconomically competitive LNG supply and steady demand, see below. Even though the overall market demand is only expected to stay broadly the same, the size of the market combined with Gazprom’s dominate and growing market position should still translate to modest growth for the company.

Source: Gazprom Investor Day Presentation (previously linked).

Whilst the steady demand in the European gas market may seem lacklustre, the growth potential in the Chinese market is more exciting, which by 2035 is expected exceed the European market, see above and below. Gazprom will enter the Chinese market for the first time after completing their Power of Siberia pipeline in 2019 and is expecting their market share to increase to at least 10% by 2025, with future growth to follow.

Source: Gazprom Investor Day Presentation (previously linked).

To complete an already bullish case for their gas demand, the domestic demand within Russia itself is expected to continue growing modestly over the long-term, see below. Since Gazprom is a state-controlled national champion in gas production, they’re in prime position to fulfill this additional demand with their share of production expected to increase from 66% to over 69%.

Source: Gazprom Investor Day Presentation (previously linked).

Their oil business, Gazprom Neft, has also outlined plans to modestly grow their upstream and downstream volumes by 2025, see below. This should further support the growth underpinned by their gas business and help modestly increase their earnings in the long-term at consistent commodity prices.

Source: Gazprom Neft 2017 Annual Report.

Whilst Gazprom’s higher oil and gas volumes should translate to higher earnings, the exact extent is impossible to ascertain with certainty due to the unpredictable nature of commodity prices. Therefore, when preparing the two following expected returns I have kept my growth assumptions quite conservative to provide a degree of safety.

Expected Return – Discounted Dividend Model

Normally when discussing valuation most articles will quote a price target, however this time I will use a different approach by calculating the rate of return offered by the future dividend stream at the current share price. Readers can then compare this to their required rate of return to decide whether they feel the shares are over or under-priced. The unique political risks are the primary reason for this approach, as I believe they wouldn’t be accurately reflected in the required rate calculated through common methods, such as the capital asset pricing model.

Since there are various unpredictable factors that can materially affect the returns, I have provided both a lower and upper end scenario. The three main variables altered in each scenario were, Gazprom’s profits, their payout ratio and the Ruble to USD exchange rate.

Scenario One – Low End

The lower end scenario assumed their profits for 2018 will be 11.45% higher than 2017, which is the same percentage their 2018 first quarter profits increased year over year. I believe this is quite a conservative assumption given oil and gas prices have increased further since the end of the first quarter. After 2018 it was assumed that their profits will only grow slowly at 2.5% p.a., which I believe is very conservative and doesn’t require materially higher oil and gas prices or surging production.

The payout ratio was assumed to remain the same as 2018, at 27%, until 2021 when it then increases to 35% after the company passes its peak capital spending, see below. This scenario is assuming that the company never meets the Russian government’s request for state-controlled companies to set their payout ratios at 50%. Finally, the Ruble to USD exchange rate was assumed to remain at the current depressed level of only $0.16 throughout all years.

Source: Gazprom Investor Day Presentation (previously linked).

Combing these factors produces an impressive 10.67% rate of return, at their last share price of $4.46, as of 03.Aug.18.

Scenario Two – Upper End

The upper end scenario assumed their profits increase 15% each year until 2021, after which it only increases slowly at 2.5% p.a. This profit growth arises from a combination of their growth projects and higher oil and gas prices. Whilst this may sound extreme, their profits in 2021 would still be slightly below their high point in 2011, at 1,307 billion Rubles. Therefore, should oil and gas prices continue to strengthen over the coming years and their production levels continue to increase, I believe this scenario is quite possible.

The payout ratio was assumed to remain at 27% until 2021 where it then increases to 50%, in line with the Russian government’s request. Finally, the Ruble to USD exchange rate was assumed to steadily increase each year by $0.02, topping out at $0.24. Whilst no one can accurately predict future currency movements, considering the Ruble has a positive correlation with oil prices and its historical trading activity above $0.30 pre-2014, I believe this assumption is quite possible. Furthermore, it should be remembered that this scenario is the upper case and hence why a more favourable exchange rate was assumed.

Combing these factors produces a massive 22.85% rate of return, at their last share price of $4.46, as of 03.Aug.18.

Expected Return – Share Price Estimation

Using the annual dividends estimated for the previous expected returns, I also estimated Gazprom’s future share price based upon their present market yield of approximately 5.5%. It was estimated that in the lower end scenario their dividend payment in 2022 (for 2021’s profits) would be $0.406/share, which at a 5.5% yield would translate to a share price of $7.38 – 65% above their current share price. The upper end scenario estimated their dividend in 2022 would be $1.27/share, which at the same yield would translate to a share price of $23.09 – a massive 418% above their current share price.

Conclusion

Since my required rate of return is below my conservative low end expected return of 10.67%, I believe Gazprom shares are undervalued and present an excellent long-term investment opportunity. Obviously the future is unknown and there are numerous factors that could derail these expected returns, however the sheer size of these returns provides a degree of safety in case the future is less favorable than expected. Therefore, during the previous month I purchased shares in Gazprom as the opportunity was simply too desirable to overlook.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long OZGPY, XOM, RDS.B. 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.