Last week, a CNBC headline read “Brazil tumbles deeper into its worst-ever depression.”
As it turned out, the country recorded a 3.6% contraction in 2016. According to CNBC, the country recorded eight consecutive quarters – most in its history –Â of gross domestic product decline.
The largest exchange traded fund (ETF) by assets, iShares MSCI Brazil Capped ETF (ARCA:EWZ), with $5.49 billion fell 2.98% that day. In particular, the state-owned troubled Petróleo Brasileiro S.A. (PBR, Financial), or Petrobras, experienced the index’s second-worst performance with a 4.5% decline while its ADR shares fell by 7.5%.
Petrobras and Brazil’s economy and politics have not failed to reappear in headlines since early 2015 when information about bribery between the oil company and Brazil’s President Dilma Rousseff, now impeached, emerged.
Nonetheless, reviewing Petrobras’ recent operations should shed some light on whether investors should start collecting some of the troubled company’s ADR shares and hope for the best in the long term.
Earnings performance
Petrobras reported its third quarter fiscal 2016 operations on Nov. 10, 2016. The 192.4 billion Brazilian real ($60.8 billion) oil company delivered 20% sales decline to $60 billion and $5.6 billion profit loss in its nine months of operations compared to the same year prior.
Petrobras explained that its operations are in Brazilian reals and that during the recent nine months operations, the currency fell by 12% vs. the U.S. dollar affecting its figures. As an example, Petrobras’ gross profit, total sales minus cost of sales, experienced a 12% decline but could have had just 6% decline minus foreign exchange application.
Meanwhile, the oil company still experienced a severe impairment in its operations that led to the near $6 billion loss during the period.
As Reuters reported, the unexpected loss came after Petrobras drastically reduced the value of oil fields and other assets amid a severe downsizing and weak oil prices.
“The message we want to convey is that these impairments are nonrecurring and that we don't expect them to happen, not at least in this magnitude, in the coming future." Â –Â Petrobras Chief Financial Officer Ivan Monteiro
Petrobras ADR shares fell 8.7% on Nov. 10, 2016. Nonetheless, the oil company is expected to report its full-year 2016 results on March 21.
Total return
Petrobras ADR shareholders were bountifully rewarded for the past year as the shares exceeded Standard & Poor's 500 index’s total return performance by four times. Interestingly enough, since the Bill & Melinda Gates Foundation Trust sued Petrobras back in 2015, the ADR shares returned a total of 129%.
Valuation
Petrobras ADR shares currently trade at a good discount compared to peers. According to GuruFocus data, the oil company had a forward price-earnings (P/E) ratio of 8.6 times vs. the industry’s 16 times; price-book (P/B) value multiple of 0.74 times vs. the industry’s 1.1 times and price-sales (P/S) ratio of 0.67 times vs. the industry’s 1.
Petrobras has not paid a dividend in the past 12 months at least.
Petróleo Brasileiro S.A.
According to company filings, Petróleo Brasileiro S.A. was incorporated in 1953 as the exclusive agent to conduct the Brazilian federal government’s hydrocarbon activities.
Petrobras began operations in 1954 and since then has been carrying out crude oil and natural gas production and refining activities in Brazil on behalf of the government.
As of Dec. 31, 2015, the Brazilian federal government owned 28.67% of total Petrobras outstanding capital stock and 50.26% of the company’s voting shares.
Petrobras loss its exclusivity in its oil-related business brought by a new law in 1997. Nonetheless, Petrobras remained one of the world’s largest integrated oil and gas companies secondary to its former sole producer and supplier status in Brazil.
Most of Petrobras’ domestic proved reserves are located in the adjacent offshore Campos and Santos Basins in southeast Brazil – near its refinery.
As of Dec. 31, 2015, Petrobras had proved developed oil and gas reserves of 5.162 billion barrels of oil equivalent and proved undeveloped reserves of 4.989 billion barrels of oil equivalent in Brazil.
Petrobras also participates in oil products –Â petrochemicals –Â business, natural gas market and domestic power market.
As of 2015, Petrobras operated in 12 countries (1).
Hydrocarbon production
In terms of production, Petrobras derived 92.6% or 2.386 million barrels of oil equivalent of total hydrocarbon production from Brazil followed by 4.6% from South America –Â excluding Brazil, 1.6% from North America and 1% from Africa.
Proven reserves
In terms of proven reserves, Petrobras experienced a 20% reduction in its total oil and gas products –Â down to 10.43 million barrels of oil equivalent as of December 2015 compared to 13.061 million barrels of oil equivalent the year prior. As observed, the oil company reported a 2.187 million barrels of oil equivalent revision of its previous estimates in these reserves.
Average production costs and selling prices
In review, Petrobras has had operations in several countries but gathered most of its products from Brazil.
In 2015, when oil prices declined 51% – inflation adjusted – Petrobras Brazil’s sales per barrel also declined by 52% at $42.16 per barrel. This made Petrobras’ gross profit per barrel decline by 59% (2). Nonetheless, Petrobras still had a (suggested) profit margin of 69% per barrel in 2015 vs. 81% the year prior.
Petrobras also experienced the same magnitude of declines in both profits and sales per barrel (average) in North America but held at a profit margin of 93% in 2015 –Â highest among North America, Brazil and South America excluding Brazil operations.
Previous years
(Petrobras 20-F and Financial Report, Inflationdata.com)
Looking back, Petrobras recorded a loss in 2014 despite having an average crude oil price in the $90 to $95 range.
Company filings identified that Petrobras recorded $16.8 billion impairment and another $2.5 billion write-off in 2014. Bulk or $11.7 billion of the impairment was from second refining units of Refinaria Abreu e Lima and Complexo Petroquàmico do Rio de Janeiro.
Refinery impairments in 2014
According to Petrobras, Refinaria Abreu e Lima is the most modern refinery the company has built, and it already contributes to the national demand for petroleum products. The refinery has a processing capacity of 230,000 barrels of oil per day.
Meanwhile, Complexo Petroquàmico do Rio de Janeiro had a processing capacity of 165,000 barrels of oil per day and was about "82% of physical progress in the works in February 2015."
Assets impairments in 2014
Petrobras also recorded $3.8 billion impairments in domestic and international assets related to exploration and production of crude oil and natural gas mainly resulted "from lower international crude oil prices." This is when Brent Crude price was at $98.99 on average in 2014, according to company filings.
Petrobras also recorded $1.2 billion impairments in petrochemical assets "resulting from a decrease in economic activity, lower margins in the international market and modifications in tax regulations."
Write-offs in 2014
As mentioned earlier, Petrobras also overpaid $2.5 billion in an acquisition that was uncovered during an investigation –Â Lava Jato investigation (3).
Other expenses in 2014
Petrobras also recorded a 376% increase in such expenses to $5.3 billion in 2014 from $1.1 billion the year prior (see pages 94 to 95 of Petrobras 20-F filing for explanation).
In summary, Petrobras had been experiencing heavy business reductions even before the start of the oil industry downturn in 2015 and 2016.
Cash, debt and book value
As of September, Petrobras had cash and cash equivalents of $22.4 billion. The world's most indebted major oil firm had $122.5 billion in debt or a debt-equity ratio of 1.5 times vs. 1.75 times the same period last year, according to Morningstar data.
Petrobras also had 1.4% of $247.4 billion assets in goodwill and intangibles while having a book value of $79.95 billion compared to $72.9 billion the year prior.*
*Goodwill and intangibles figure seem not to matter here as Petrobras had written down assets in terms of billions as these are related to the weak oil price.
(Financial Report, Petrobras)
Debt in the near and the long term
As per its filings, more than one-third of Petrobras debt is due in 2021 and thereafter. Anticipating Petrobras’ free cash flow –Â cash flow from operations minus capital expenditure –Â for fiscal 2016 should be looked upon in order to gauge its capabilities in meeting these important obligations.
In review, Petrobras was still able to raise $6.75 billion in dollar-denominated bonds mid-2015. According to Business Insider, Petrobras hired the investment-banking unit of Banco do Brasil SA, Bank of America Corp., JPMorgan Chase & Co. and Banco Santander SA to handle the bond sale.
Further, the new bonds were rated "B3" by Moody's Investors Service, six levels below investment-grade.
Cash flow
(20-F and Financial Report, Petrobras)
From January to September 2016 operations, Petrobras’ cash flow from operations fell by 2.2% to $18.9 billion compared to the year-earlier period.
Capital expenditures and investments in investees were $10.16 billion leaving Petrobras with $8.75 billion in free cash flow –Â compared to $2.5 billion in the year-earlier period. Nonetheless, Petrobras suspended its dividend payouts since fiscal 2015.
(20-F and Financial Report, Petrobras)
Other than Petrobras' cash flow operations, the company seemed loyal in its debt repayments. In its recent three-quarters of operations, the endeavoring oil giant paid three times its free cash flow in debt repayments. Also, Petrobras appeared to have a reduced appetite for debt intake in recent years.
Conclusion
The once $300 billion Brazilian oil company is now trying to recuperate from heavy business operations reductions. These reductions were already occurring prior to the oil price downfall in recent years, a couple and a half of a billion dollars of which were related to corrupt scheme present inside the company.
Meanwhile, Petrobras was still able to grow its book value despite these massive write-downs and despite being named as the most indebted company in the world.
The company’s cash flow allocation also demonstrated some prudence as it allowed for more debt repayments –Â even exceeding its free cash flow in recent years.
(Petrobras ADR shares and p/e ratio in one-year, GuruFocus)
Petrobras represents a unique and high risk-high return proposition. ADR shares represent a 33% upside should the company trade to its ongoing book value –Â expecting no share dilution moving forward. Nonetheless, asking a 30% margin would indicate a value 7% less than today’s market valuation or $8.7 per ADR share.
In summary, Petrobras ADR shares are a hold with a target price of $10 per share.
Notes
(1) 20-F: “In Latin America, our operations extend from exploration and production to refining, marketing, retail services, natural gas and electricity power plants. In North America, we produce oil and gas and have refining operations in the U.S. In Africa, through a joint venture, we produce oil in Nigeria and have oil and gas exploration in other countries.”
(2) Me: Gross profit was defined in this article by subtracting cost per barrel (average) from sales per barrel per stated country.
(3) 20-F: In 2009, the Brazilian federal police began an investigation called “Lava Jato” (Car Wash) aimed at criminal organizations engaged in money laundering in several Brazilian states. The Lava Jato investigation is extremely broad and involves numerous investigations into several criminal practices focusing on crimes committed by individuals in different parts of Brazil and sectors of the Brazilian economy.
Over the course of 2014, the Brazilian Federal Prosecutor’s Office focused part of its investigation on irregularities involving Petrobras’s contractors and suppliers and uncovered a broad payment scheme that involved a wide range of participants. According to testimony from Brazilian criminal investigations that became available beginning in October 2014, former senior Petrobras personnel conspired with contractors, suppliers and others from 2004 through April 2012 to establish and implement an illegal cartel that systematically overcharged Petrobras in connection with the acquisition of property, plant and equipment. Two former Petrobras executive officers (diretores) and one former executive manager were involved in this payment scheme, none of whom has been affiliated with us since April 2012; they are referred to in this annual report as the “former Petrobras personnel.” The overpayments were used to fund improper payments to political parties, elected officials or other public officials, individual contractor personnel, the former Petrobras personnel and other individuals involved in the payment scheme. We did not make the improper payments, which were made by the contractors and suppliers and by intermediaries acting on behalf of the contractors and suppliers.
(p. 3, 20-F fiscal 2014 Petrobras)
Disclosure: I am long Petrobras ADR shares.
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