How low can you go? Doing the Petrobras Limbo!

A few months ago, I suggested that investors venture where it is darkest, the nether regions of the corporate world where country risk, commodity risk and company risk all collide to create investing quicksand. I still own the two companies that I highlighted in that post, Vale and Lukoil, and have no regrets, even though I have lost money on both. At the time of the post, I was asked why I had not picked Brazil's other commodity colossus, Petrobras, as my company to value (and invest in) and I dodged the question. The news from the last few days provides a partial answer, but I think that the Petrobras experience, painful though it might have been for some investors, provides an illustration of the costs and benefits of political patronage.

Petrobras was founded in 1953 as the Brazilian government oil company, and for the first few decades of its life, it was run as a government-owned company from its headquarters in Rio De Janeiro. Until 1997, it had a legal monopoly on oil production and distribution in Brazil, when the domestic market was opened up to foreign oil producers. Petrobras was listed as a public company in 1997 on the Sao Paulo exchange and as a depository receipt on the New York Stock Exchange soon after. The arc of fortunes for the company can be traced in the changes in its market capitalization over time, reported in US dollars in the figure below:

In the last decade, Petrobras has seen both highs and lows, becoming the fifth largest company in the world, in terms of market capitalization, in 2011 and then seeing a precipitous drop off in market prices in the years since. To understand where Petrobras is now and to make sense of where it is going, you have to look at both its rise in the last decade and its fall in this one.

The rise of Petrobras from minor emerging market oil company to global giant between 2002 and 2010 can be traced to three factors. The first was the discovery of major new reserves in Brazil in the early part of the last decade, which catapulted the company towards the top of the list of companies with proven reserves. The fact that these reserves would be expensive to develop was mitigated by a second development, which was the sustained surge in oil prices to triple digit levels for much of the period, making them viable. The third was an overall reduction in Brazilian country risk from the stratospheric levels of 2001 (when the country default spread for Brazil reached 14.34%, just before the election of Lula Da Silva as President) to 1.43% in 2010, when Brazil looked like it had made the leap to almost-developed market status. In 2010, the company signaled that its arrival in global markets and its ambitions to be even more by raising $72.8 billion from equity markets.

The hubris that led to the public offering may have been the trigger for the subsequent fall of the company, which has been dizzying because of the magnitude of the decline, and its speed. After peaking at a market capitalization close to $244 billion in 2010, the company has managed to lose a little bit more than $200 billion in value since, putting it in rarefied company with other champion value destroyers over time. While a large portion of the blame for the decline in the last few months (especially since September 2014) can be attributed to the drop in oil prices, note that Petrobras has already managed to destroy $160 billion in value prior to that point in time.

Petrobras: Governance Structure
To understand the Petrobras story, you have to start with an assessment how the company is structured. When the government privatized the company, it did so with the objective of raising capital for its treasury but it did not want to release control of the company to the shareholders who bought shares in the company. Using "national interest" as a shield, the government devised a game where it would be able to control the company, while raising billions in capital from investors. The basis for that game, and it is not unique to Petrobras, was to create two classes of shares, one with voting rights (common shares) and one without (called preferred shares, in an Orwellian twist), and offering the latter primarily to investors. The government retains control of more than 50% of the voting shares in the company and another 11% is controlled by entities (like the Brazilian Development Bank, BNDES, and Brazil's sovereign wealth fund) over which the government has effective control. Not quite satisfied with this rigging of the game, the government also retains veto power (a golden share) over major decisions.

Shareholding as of February 2015

Using this control structure, the government has created the ultimate rubber stamp board, whose only role has been to protect the government's interests (or more precisely the politicians who comprise the government at the time) at all costs. Brazilian company law does require that the minority shareholders (anybody but the government) have board representatives, but as this story makes clear, these directors are not just ignored but face retaliation for raising basic questions about governance. To be fair to Ms. Dilma Rousseff, government interference has always been the case in Petrobras, and her predecessors have been just as guilty of treating Petrobras as a piggybank and political patronage machine, as she has. Lula, who stepped down with great fanfare, as president just a few years ago was equally interventionist, but high oil prices provided the buffer that protected him from the fallout.

A Roadmap for Value Destruction
Just as looking at companies that have created significant amounts of value over time is enlightening because of the insights you get into what companies do right, Petrobras should become a case study for the opposite reason. Put in brutally direct terms, if you were given a valuable business and given the perverse objective of destroying it completely and quickly, you should replicate what Petrobras has done in five steps.

Step 1 - Invest first, worry about returns later (perhaps never)
Invest massive amounts of money in new investments, with little heed to returns on these investments, and often with the intent of delivering political payoffs or worse. Between 2009 and 2014, Petrobras stepped up its capital expenditures and exploration costs to more than 35% of revenues, well above the 15-20% invested by other integrated oil companies, while seeing its return on capital drop to 5% (even as oil prices stayed at $100+/barrel for the bulk of the period).

Step 2 - Grow, baby, grow, and profitability be damned
Petrobras has grown its revenues from $17.4 billion in 1997 to $135.8 billion in 2014 and displaced Exxon Mobil as the largest global oil producer in the third quarter of 2014, while letting profit margins drop dramatically. The government contributes to this dysfunctional growth by putting pressure on the company to sell gasoline at subsidized prices to Brazilian car owners.

Step 3 - Pay dividends like a regulated utility (even though you are not)
Petrobras has a history of paying large dividends, partly because it had the cash flows to pay those dividends in the 1990s and partly to supports it voting share structure. The preferred (non-voting) shares that the company has used to raise capital, without giving up control, come with dividend payout requirements that are onerous, if you have growth ambitions.

Step 4 - Borrow money to cover the cash deficit
If you want to eat your cake (by investing large amounts to generate growth) and have it too (while paying large dividends), the only way to make up the deficit is to raise fresh capital. In 2010, Petrobras did raise $79 billion in fresh equity but it has been dependent upon debt as its primarily financing in every other year. As a consequence, Petrobras had total debt outstanding of $135 billion at the end of 2014, more than any other oil company in the world.

Step 5 - Destroy value (Mission accomplished)
If you over invest and grow without heeding profitability, while paying dividends you cannot afford to pay and borrowing much more than you should be, you have created the perfect storm for value destruction. In fact, the way Petrobras has been run so defies common sense and first principles in corporate finance, that if I were a conspiracy theorist, I would be almost ready to buy into the notion that this is part of a diabolical plan to destroy the company hatched by evil geniuses somewhere. I have learned through hard experience, though, that you should not attribute to malevolence what can be explained by greed, self-dealing and bad incentive systems.

It is worth noting that none of the numbers in the last section can be attributed to the drop in oil prices. In the most recent twelve month data that you see in these graphs represent the year ending September 30, 2014, and the average oil price during that year exceeded $100/barrel.The government of Brazil, working through the management that they installed at Petrobras, have pulled off the amazing feat of destroying more than $200 billion in value with no help from outside.

A Contrarian Bet?
When a company falls as fast and as far as Petrobras has, it attracts the interests of contrarian investors and the company looks attractive on the surface, at least using some conventional multiples.

Petrobras looks very cheap, at least using equity multiples (PE and Price/Book) but the results are mixed with enterprise value multiples.

All of these multiples are affected by the fact that oil prices have dropped dramatically since the most recent financial statements and that the earnings numbers, in particular, will dive in the coming quarters. Given that Petrobras was already reporting sagging profits, before the oil price drop, I am almost afraid to think of what the numbers will look like at today's oil prices (which are closer to $50)., but I will try anyway. Looking at the annual revenues over time at the company and relating them to the average oil prices each year, here is what I find:
Thus, if you assume that the current oil price of $51.69 is close to the average for this year, the normalized revenues for Petrobras will be $61.3 billion, a drop off of about 55% from the $135.8 billion revenues in the 12 months ending September 30, 2014.
If you apply the operating margin of 10.82% that Petrobras reported in the trailing 12 months to these revenues, you arrive at an operating income of $6,638 million, prior to taxes. At that level of earnings, the value that I get for the company is $62.4 billion, well below the $135.1 billion owed by the company, making its equity worth nothing. In the matrix below, I look at the value per share under different combinations of base year income (ranging from $6,638 million at the low to $28.7 billion at the high) and return on invested capital on new investments (again ranging from a low of 2.67%, with income normalized for low oil prices, to 13.36% as the high):

Assuming no high growth period, stable growth rate of 2% and cost of capital of  11.17%. Adding a high growth period reduces value in all the return on capital scenarios, except one (average over last 10 years)

The red numbers represent the dead zone, where the value of the business is less than the debt outstanding and they dominate the table.  In spite of the reckless abandon shown by its management, there remain some bright spots, if you are an optimist. The first is that the company is one of the largest oil producers in the world and if oil prices rebound, they will see a jump in revenues. The second is that the exploration and investments over the last decade have given the company the fifth largest proven oil reserves in the world, though the proportion of these reserves that will be viable at today's oil prices is open to question. The third is that if the Brazilian government stops pulling the strings and management stops its self destructive behavior, profit margins and returns will improve. In the most optimistic spin, you can assume that Petrobras will be able to keep its trailing 12-month intact at $135.8 billion, improve its operating margin to the 21.1% that it earned in 2010 and its return on capital to 13.36% (10-year average), while reducing its debt ratio to 43.5% (average over last 5 years). With those assumptions, which border on fantasy, Petrobras would be worth $8.11/share (R$ 22.55/share) well above the current stock price of $3.28/share (R$ 9.12/share).  You are welcome to try out different combinations of your assumptions in this spreadsheet and see what you get.

Final Thoughts
There are always lessons to be learned from every calamity and Petrobras qualifies as a calamity. The first is to recognize that there every reason to be skeptical when politicians claim "national interest" and meddle incessantly in public corporations. In most cases, what you have are political interests which may or may not coincide with national interests, where elected politicians and government officials use stockholder money to advance their standing. The second is that those who have labeled "value maximization" as the "dumbest idea" and pushed for stakeholder wealth maximization, a meaningless and misguided objective that only strategists and Davos organizers find attractive, as an alternative, should take a close look at Petrobras as a case study of stakeholder wealth maximization gone amok. In the last five years, Petrobras has enriched countless politicians and politically connected businesses, subsidized Brazilian car owners and provided jobs to tens of thousands of oil workers, leaving stockholders on the outside looking in. Anyone who argues that this is a net good for Brazil has clearly not grasped the damage that has been done to the country in the global market place by this fiasco.

Attachments

1. Petrobras valuation spreadsheet