Petrobras Faces A Great Dilemma

On Monday, Brazilian state-run oil giant Petrobras (NYSE:PBR) announced its earnings results for the third quarter that ended on September 30. According to the companys press release, Petrobras made a net profit of $81.1M, primarily thanks to the increase in exports, the growth of oil prices and gains from the sale of Nova Transportadora that occurred earlier this year.

The earnings news come out just a couple of days later after Anthony Mace, a former CEO of SBM Offshore, pleaded guilty to a corruption scheme as a part of the Operation Carwash, a criminal investigation, which is conducted by the judicial branch of the Brazilian government along with the Brazilian police in cooperation with US authorities to reveal the money laundering schemes that were conducted by Petrobras top officials.

In addition, this week, Brazilian pension funds started a joint arbitrage case against Petrobras, as they accumulated heavy losses during the last few years when they invested in the Brazilian company. Petros Funda莽茫o fund alone expects to win around $2.1B, which will have a serious impact on Petrobras financials, as during Q3 it already spent another $600M in non-recurring charges.

Also, following the Q3 report, Goldman Sachs reiterated its “sell” rating and raised the question regarding the future cash flow sustainability. All of this is a sign that Petrobras is still a troubled company and its hard to say when it will recover from the current downfall, as its $21 billion asset sale program was frozen by the court this year.

Valuing oil companies sometimes could be tricky, especially if they are heavily connected to the government, as it is in the case with Petrobras. When we looked at Petrobras’ financials, we saw its metrics like revenue and EBIT to be highly volatile from year to year, primarily due to the ever-changing price of oil and the involvement of the government both legal and illegal in the affairs of the company. Using the traditional methods of the discounted cash flow model, we made a forecast of Petrobras growth in the upcoming years, which could be seen in the table below:

Source: Capital IQ, Own estimates

Based on our predictions, we believe that the companys revenue growth rate is going to be declining, as the current asset sale program is under question and the company doesnt have a lot of options to improve the current situation.

The tax rate in the model for FY17 is the same as for FY16, and it will continue to grow up to 15%, which is the rate that the company had in 2013, when it had a profit. Also, weighted average cost of capital (WACC) is 10.7%, where the cost of equity is 9.35% and the cost of debt is 11.8%.

When we combined all of that data, we saw fair value of Petrobras to be $8.99 per share, which is lower from the current price of ~$9.80 per share.

Source: Own estimates

After that, we made a comparable analysis, where we studied the performance of Petrobras in comparison with its peers from the oil sector. In the table below we could see that Petrobras has higher multiples for metrics like sales and EBIT for the FY17, in comparison with the industrys median, while its equity value is smaller than Exxons (NYSE:XOM), Shells (NYSE:RDS.A)(NYSE:RDS.B) and Chevrons (NYSE:CVX) equity value.

When we analyzed Petrobras’ valuation multiples, we found out that the companys fair price is $4.58 per share, which represents a downside of more than 55% from the current market price.

Source: Capital IQ, Own estimates

Note: A number of companies from the table do not trade publicly on the US markets and its hard to find the real multiples of their numerous metrics due to different currencies and accounting techniques. Thereby we crossed some parts of the table and didnt included various multiples when finding the industrys average and median.

After conducting DCF and comparable analysis, we decided to consolidate all of our findings and came to a conclusion that Petrobras trades at an upside of ~25% from its final fair value of $7.89 per share:

Source: Own estimates

The dilemma of Petrobras is that politics plays a great role in how the companys stock is moving. And while the energy sector is recovering from the plunge that occurred in the last two to three years, Petrobras couldnt use the full potential of this recovery, as the corruption scandal seems to be a never ending story, which makes investors cautious regarding investing in this Brazilian giant. In addition, the corruption on the highest levels means that the shareholder interests are not a top priority of the state-run company and there is every reason to believe that the stock will continue to be trading at a distressed territory, as the news regarding the corruption will continue to be making headlines in the foreseeable future.

We made our analysis before the earnings results and started to short Petrobras stock at the beginning of November. Despite the recent tumble, we still hold our short position in the company and believe that there’s more downside to come, as the business will continue to be non efficient, despite the rising oil prices.

Disclosure: I am/we are short PBR.

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.

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