At times Mr. Market comes by and offers you irresistible bargains. I think we're just being offered a tremendously cheap entry point into one of the major global energy companies with quite limited downside in the long run.
Before jumping to the pros and cons I'll quickly introduce the company with their own words:
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Gazprom is a global energy company. Its major business lines are geological exploration, production, transportation, storage, processing and sales of gas, gas condensate and oil, sales of gas as a vehicle fuel as well as generation and marketing of heat and electric power.
Gazprom views its mission in reliable, efficient and balanced supply of natural gas, other energy resources and their derivatives to consumers.
Gazprom holds the world’s largest natural gas reserves. The Company’s share in the global and Russian gas reserves makes up 18 and 72 per cent respectively. Gazprom accounts for 14 and 74 per cent of the global and Russian gas output accordingly. At present, the Company actively implements large-scale projects aimed at exploiting gas resources of the Yamal Peninsula, Arctic Shelf, Eastern Siberia and the Far East, as well as hydrocarbons exploration and production projects abroad.
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Gazprom's main area of business is obviously gas which accounts for roughly 60% of their overall sales. While almost 60% of the gas is sold in Russia less than 30% of the corresponding revenue is accounted for in their home country. This is grounded in the fact that domestic gas is sold at a much lower rate to local consumers. Last year the gas business accounted for 72% (73% in 2012) of the group's net income. Obviously most of this comes from European customers who drew 30% (26% in 2012) of their total gas consumption from Gazprom.
Around 30% of total sales come from Gazprom's subsidiary Gazprom Neft which produces oil, engages in refining activities and operates some 1,600 filling stations. The remaining revenues stem from Gazprom's heat and power generation facilities mainly in the Moscow area. These two are more or less (more in the latter case) side activities. One should bear in mind however, that Gazprom Neft alone contributed between $3 and $5 billion in net profits in each of the past 5 years.
Talking about past performance, how about a quick look at a weekly chart of the stock traded in Euro:
You can see that we are currently trading near a 10 year low and that the stock has had a rather volatile past in general. Owing to the 98 Russian crises and the subsequent state bankruptcy Gazprom's stock hit its low in 1999 and had an incredible run right up onto the financial crisis of 2008 since. All that was backed by an enormous expansion in their business activities. Revenues increased eightfold from $16B in 1998 to $132B in 2008.
Despite the increasingly weak performance of the stock business has further picked up since. Here's a rundown of the last 10 years key numbers (from Gazprom's annual reports & own calculations):
At around $4.50 per share the whole company is valued at $53B. Yes, that's less than two years of earnings. A company that has earned an average of $34B in net income in the last six years is valued at $53B.
Energy is out, Emerging Markets are out, Russia is clearly out, South Stream is cancelled, but that cheap? What's the reason for such a valuation? There are really plenty of reasons but I don't deem any of them a reason not to invest.
The main reason why the stock tanked in the recent past is the massive fall in the Ruble. Where you could have bought a dollar for more or less 30 Russian Ruble in the past years pressure started to mount on the currency with the Crimea and Ukraine crises. The rate peaked in December at over 80 RR for the dollar. That day was also the multi-year low in the Gazprom stock. So while the stock has been essentially flat on its main stock exchange in Moscow it has, just through exchange rate fluctuations, lost up to 60% in dollar. Would Gazprom generate all their revenues in Ruble this would be perfectly logical. However, as we've seen earlier, almost three quarter of the profit derives from exports which are settled in US dollars. On top of this Gazprom will even benefit from the fact that the dollar (main revenue) appreciates vs the Ruble (main costs) as they will have more Rubles per dollar to cover for their production costs back home.
The other main driver in the valuation of the stock has been the political situation between Russia and the west. I don't want to go into a political analysis of this as this in the end is a rather emotional debate on American Imperialism. Suffice to say that there is a reasonable fear of a (de facto) nationalization of Gazprom either through law or taxation. While I see this as the biggest long term threat to an investment into energy stocks (in any country) I think the probability in this case is lower than mostly anticipated. First of all, Gazprom has assets in European countries, mostly gas infrastructure in Germany. These assets would certainly be seized by dispossessed stockholders. Germany is too an important market for this to happen. Gazprom has countless joint ventures with European companies and is dependent on the know-how and capital these partners bring in in its exploration efforts, this again would be at stake in case of nationalization. Gazprom's close linkage to the Kremlin makes a Sistema scenario rather unlikely. Even if the worst is yet to come the 1998 state default left Gazprom stockholders untouched. However, a potential discrimination of foreign shareholders shouldn't be completely dismissed.
Another factor to consider is the weakening gas demand in Europe. Although long term perspectives are still very promising demand was slightly down in the recent years as gas power plants became less profitable. Just recently Gazprom signed deals to connect Turkish and Chinese consumers to their networks which will more than offset the losses in the European market. Since North Sea gas will be running out in the years to come and is also associated with higher production cost Gazprom's position on the European market is hardly to deteriorate.
Additionally to the aforementioned issues the plunge in oil prices does certainly not help to create a brighter short term sentiment for the stock.
So there is a multitude of reasons which brought the stock to these levels. What is to expect from the future? My assumptions are that Gazprom will be able to further grow their business. While there might lay rough roads ahead in their home market the European business will continue to provide the biggest chunk of income. Since there is ever more €/$ and ever less energy resources (which are ever harder to extract) I can't come up with a scenario where gas prices are deemed to fall off a cliff. The opposite is to expect.
Looking at Gazprom’s balance sheets doesn’t deliver any bad news. Equity ratio stands at 71.9% with literally no goodwill or intangible assets on the asset side. Most global oil companies run on an equity ratio of around 40% so Gazprom looks very solid. Total current assets (RR 2.9T or $ 85B) almost make up for total liabilities (RR 3.9T or $ 114B). All these figures are as of Q2 14 so there might have been some movement due to the sliding Ruble although cash and accounts receivables are unlikely to be balanced in Ruble.
So what is the fair value of Gazprom in say 2020? If one assumes a 7% increase YOY in Gazprom's revenue and put their past profitability onto that we would end up just shy of $250B annual revenue in 2020 and net income of $60B. Let's say Gazprom will, along the way, trade at a P/E ratio of 8, this will put the total market value at $420B or 35$ per share. If we give that scenario 50% probability and have two further scenarios, one with flat business and a P/E ratio of 5 in 2020 (30%) and one with nationalization (20% - accounting for other risks as well) we get a mathematical target share price in 2020 of
(0.5*$35.00) + (0.3*$15.10) + 0 = $22.03
Compared to the current share price of $4.50 this would offer an opportunity to quintuple your money, translating into a 30% annual return. Any dividends would be on top of that.
While there are literally no investors left to sell out their Russian investments I'm happy to take the risk of short term volatility at the benefit of acquiring a solid asset rich business at bargain prices.
I’ve accumulated a quite significant position for my portfolio at an average price of around €3.85/$4.50 and intend to hold on to this position for at least a couple of years.
As with any investment ideas, do your own research and never buy anything because someone else thinks it's a great idea.
Before jumping to the pros and cons I'll quickly introduce the company with their own words:
-------------------
Gazprom is a global energy company. Its major business lines are geological exploration, production, transportation, storage, processing and sales of gas, gas condensate and oil, sales of gas as a vehicle fuel as well as generation and marketing of heat and electric power.
Gazprom views its mission in reliable, efficient and balanced supply of natural gas, other energy resources and their derivatives to consumers.
Gazprom holds the world’s largest natural gas reserves. The Company’s share in the global and Russian gas reserves makes up 18 and 72 per cent respectively. Gazprom accounts for 14 and 74 per cent of the global and Russian gas output accordingly. At present, the Company actively implements large-scale projects aimed at exploiting gas resources of the Yamal Peninsula, Arctic Shelf, Eastern Siberia and the Far East, as well as hydrocarbons exploration and production projects abroad.
-------------------
Gazprom's main area of business is obviously gas which accounts for roughly 60% of their overall sales. While almost 60% of the gas is sold in Russia less than 30% of the corresponding revenue is accounted for in their home country. This is grounded in the fact that domestic gas is sold at a much lower rate to local consumers. Last year the gas business accounted for 72% (73% in 2012) of the group's net income. Obviously most of this comes from European customers who drew 30% (26% in 2012) of their total gas consumption from Gazprom.
Around 30% of total sales come from Gazprom's subsidiary Gazprom Neft which produces oil, engages in refining activities and operates some 1,600 filling stations. The remaining revenues stem from Gazprom's heat and power generation facilities mainly in the Moscow area. These two are more or less (more in the latter case) side activities. One should bear in mind however, that Gazprom Neft alone contributed between $3 and $5 billion in net profits in each of the past 5 years.
Talking about past performance, how about a quick look at a weekly chart of the stock traded in Euro:
You can see that we are currently trading near a 10 year low and that the stock has had a rather volatile past in general. Owing to the 98 Russian crises and the subsequent state bankruptcy Gazprom's stock hit its low in 1999 and had an incredible run right up onto the financial crisis of 2008 since. All that was backed by an enormous expansion in their business activities. Revenues increased eightfold from $16B in 1998 to $132B in 2008.
Despite the increasingly weak performance of the stock business has further picked up since. Here's a rundown of the last 10 years key numbers (from Gazprom's annual reports & own calculations):
At around $4.50 per share the whole company is valued at $53B. Yes, that's less than two years of earnings. A company that has earned an average of $34B in net income in the last six years is valued at $53B.
Energy is out, Emerging Markets are out, Russia is clearly out, South Stream is cancelled, but that cheap? What's the reason for such a valuation? There are really plenty of reasons but I don't deem any of them a reason not to invest.
The main reason why the stock tanked in the recent past is the massive fall in the Ruble. Where you could have bought a dollar for more or less 30 Russian Ruble in the past years pressure started to mount on the currency with the Crimea and Ukraine crises. The rate peaked in December at over 80 RR for the dollar. That day was also the multi-year low in the Gazprom stock. So while the stock has been essentially flat on its main stock exchange in Moscow it has, just through exchange rate fluctuations, lost up to 60% in dollar. Would Gazprom generate all their revenues in Ruble this would be perfectly logical. However, as we've seen earlier, almost three quarter of the profit derives from exports which are settled in US dollars. On top of this Gazprom will even benefit from the fact that the dollar (main revenue) appreciates vs the Ruble (main costs) as they will have more Rubles per dollar to cover for their production costs back home.
The other main driver in the valuation of the stock has been the political situation between Russia and the west. I don't want to go into a political analysis of this as this in the end is a rather emotional debate on American Imperialism. Suffice to say that there is a reasonable fear of a (de facto) nationalization of Gazprom either through law or taxation. While I see this as the biggest long term threat to an investment into energy stocks (in any country) I think the probability in this case is lower than mostly anticipated. First of all, Gazprom has assets in European countries, mostly gas infrastructure in Germany. These assets would certainly be seized by dispossessed stockholders. Germany is too an important market for this to happen. Gazprom has countless joint ventures with European companies and is dependent on the know-how and capital these partners bring in in its exploration efforts, this again would be at stake in case of nationalization. Gazprom's close linkage to the Kremlin makes a Sistema scenario rather unlikely. Even if the worst is yet to come the 1998 state default left Gazprom stockholders untouched. However, a potential discrimination of foreign shareholders shouldn't be completely dismissed.
Another factor to consider is the weakening gas demand in Europe. Although long term perspectives are still very promising demand was slightly down in the recent years as gas power plants became less profitable. Just recently Gazprom signed deals to connect Turkish and Chinese consumers to their networks which will more than offset the losses in the European market. Since North Sea gas will be running out in the years to come and is also associated with higher production cost Gazprom's position on the European market is hardly to deteriorate.
Additionally to the aforementioned issues the plunge in oil prices does certainly not help to create a brighter short term sentiment for the stock.
So there is a multitude of reasons which brought the stock to these levels. What is to expect from the future? My assumptions are that Gazprom will be able to further grow their business. While there might lay rough roads ahead in their home market the European business will continue to provide the biggest chunk of income. Since there is ever more €/$ and ever less energy resources (which are ever harder to extract) I can't come up with a scenario where gas prices are deemed to fall off a cliff. The opposite is to expect.
Looking at Gazprom’s balance sheets doesn’t deliver any bad news. Equity ratio stands at 71.9% with literally no goodwill or intangible assets on the asset side. Most global oil companies run on an equity ratio of around 40% so Gazprom looks very solid. Total current assets (RR 2.9T or $ 85B) almost make up for total liabilities (RR 3.9T or $ 114B). All these figures are as of Q2 14 so there might have been some movement due to the sliding Ruble although cash and accounts receivables are unlikely to be balanced in Ruble.
So what is the fair value of Gazprom in say 2020? If one assumes a 7% increase YOY in Gazprom's revenue and put their past profitability onto that we would end up just shy of $250B annual revenue in 2020 and net income of $60B. Let's say Gazprom will, along the way, trade at a P/E ratio of 8, this will put the total market value at $420B or 35$ per share. If we give that scenario 50% probability and have two further scenarios, one with flat business and a P/E ratio of 5 in 2020 (30%) and one with nationalization (20% - accounting for other risks as well) we get a mathematical target share price in 2020 of
(0.5*$35.00) + (0.3*$15.10) + 0 = $22.03
Compared to the current share price of $4.50 this would offer an opportunity to quintuple your money, translating into a 30% annual return. Any dividends would be on top of that.
While there are literally no investors left to sell out their Russian investments I'm happy to take the risk of short term volatility at the benefit of acquiring a solid asset rich business at bargain prices.
I’ve accumulated a quite significant position for my portfolio at an average price of around €3.85/$4.50 and intend to hold on to this position for at least a couple of years.
As with any investment ideas, do your own research and never buy anything because someone else thinks it's a great idea.
