Emerging Market Risk Revisited: Petrobras
EM equity investors were given another reminder of the political risk inherent in the asset class last week, when Brazilian president Jair Bolsonaro ousted the CEO of oil giant Petrobras (Petróleo Brasileiro S.A.). The highly rated Roberto Castello Branco (himself a Bolsonaro appointment in 2019) is to be replaced by, Joaquim Silva e Luna, an army general with no oil and gas experience, to run the state-owned enterprise.
Having recently taken on the topic of government meddling in EM markets with regards to my concentrated holding in the filipino media conglomerate ABS CBN, I was keen to tackle the subject again.
Markets reacted forcefully, with the Brazilian Real down 5% and many leading equities experiencing sharp drops including Banco Bradesco, Itau Unibanco, Embraer, Telefonica Brasil and Ambev all down 10-20% in USD terms. Companies with state control or exposure to regulation fared amongst the hardest hit.
But of course, Petrobras itself was the deserving main victim, falling 30% with investors now wondering how much the company will be stunted to assist the president's bid for re-election. What was a well-run company exposed to the strengthening oil price, paying down debt and projecting generous cash flows, is now in question.
Branco was widely lauded within investing circles for his leadership and business acumen and had been running the company and allocating capital well. But then he raised Bolsonaro's ire a fortnight ago when he commented publicly that the truck strike hitting Brazil was not his concern. A fair comment as the CEO of a corporation serving its shareholders, but with the president's support looking shaky after a year of Covid bumbling, the temptation to play populist was too much.
Bolsonaro accused Petrobras of excessively hiking the domestic diesel price, which had led to the strike and political backlash. Declaring he would drop diesel excises temporarily to ease the burden, the president also made the seemingly contradictory statement that he “can’t and wouldn’t interfere at Petrobras - even if something will happen at Petrobras in the coming days... something needs to change. It will happen,” on Feb 18.
On February 5, Petrobras had released changes to the way it calculated the price parity it used to calculate domestic fuel prices, by comparing them to international pricing over a full year- as opposed to a month, as per the previous known policy. Soon after the company announced that petrol would be up 10% and diesel by 15% starting in March. Not unreasonable given the surge in oil prices globally since November, but not popular.
Soon after, the candidacy of Luna was announced, making the transition a foregone conclusion given that the government controls nearly 2/3 of the shares and over half the board seats at Petrobras.
It is not necessarily Luna's lack of oil experience that has spooked the market (after all, Branco had none either when appointed to the role), but his military background and sycophantic attitude towards the president. Branco was a free-marketeer and went down fighting for those beliefs. Luna is a former defence minister and army general, with a history of nationally-significant building projects, including his most recent role running the Itaipu hydroelectric dam on the Paraguayan border.
Since the announcement, Luna has stated publicly his fidelity to the president and tried to balance his comments stating: “Priorities will be set in consensus with the other directors and the board, but always thinking in what’s good for the company. Without forgetting about investors, consumers and the Brazilian population.”
Of course, the full effect of the new leadership will only be known in time and Petrobras stock has been hammered in anticipation. The company recently announced it had generated $22b in free cash flow for 2020- a remarkable achievement, in my opinion, in a year where the oil price went negative- and the market cap has now been discounted to $52b (net debt of $76b, EV of $128b).
An P/FCF of 2.5x is an extremely rare bird in markets, especially in today's insane environment. Even more so, one paying down debt and committing to higher dividend payments over the next several years, but this is the crux of the issue. How do you discount political risk like this?
I am an avid believer that there is a price low enough to make just about any security a good investment. But what if Luna reintroduces the fuel subsidies of the past, crippling the company or embarks on job-creating capex at the behest of the president? These are the possibilities the market is focused on right now, but alternatively, Bolsonaro is up for re-election within 18 months and is polling poorly, due to his pandemic response. After all, investors will live or die by the cash flows Petrobras delivers over decades, not just the next year.
In fact, political shenanigans are more the norm, than the exception, at the company and anyone who bases their thesis on continuous expert governance may be showing their naivety. The following 2018 headline probably had some investors feeling deja vu last week: Petrobras shares plunge 20% after CEO Pedro Parente resigns amid strike.
The company was also involved in the the shocking 2014 corruption scandal dubbed Operation Car Wash, which lead to the impeachment of Dilma Rousseff (who had been Petrobras chairwoman at the time) and the jailing of former president Lula.
My approach to investing in a company like this would be simply to demand an astronomical margin of safety. For example a simplistic and conservative approach might be to assume cash flow is beaten back to $10b/year (which would be quite a hit if Brent stays above $60 this year), giving a FCF yield of 20%. Comparing this to the US 10yr Treasury below 2% would seem to indicate a fairly healthy risk premium with a lot of room for error.
I don't know the price I would pay for Petrobras yet, but as I already own Lukoil and Gazprom, I know there likely is one.
There are potential positives for the company too. In fact, it's hard to imagine a worse environment than Brazilian equities have faced over the last five years, with rolling recessions and the plummeting oil price. I would argue many bad futures are priced in, while positive surprises could be wildly bullish.
The Real has lost over 2/3 of its value against the dollar since the last EM cycle peaked a decade ago. Examples like this are why I don't hedge foreign exchange, as most of the markets I invest in have cheap currencies and I am hoping mean reversion could be a boost to any returns I might make. Brazil appears no different- my attempt at what Dan Rasmussen of Verdad Advisors has called "a hedge you're paid to take".
Brazil also boasts favourable demographics and, of course, exposure to the emerging middle class that was popular to talk about in the early 2010s, but not many mention anymore- it's still happening as far as I can tell though!
Bolsonaro will also be acutely aware that while he can pinch high profile enterprises a little, it would be disastrous for his economy if international markets took flight and dried up on his watch. Confidence, liquidity and investor management remain vital in economy with significant US denominated debt.
The president's choice of economic minister is evidence he knows this. Paulo Guedes is a successful banker and free marketeer, who received a PhD from the University of Chicago and has been seen as a shining light next to the populism of his boss. Once again, it is impossible to predict the path Bolsonaro will take if he feels the next election is slipping away from him. Guedes has clearly been sidelined with this decision, but his private opposition is almost certain and his continued presence, a relief.
So while I think there is cause for concern over the Brazilian president's actions over the last fortnight, the resulting volatility has also produced opportunities. I normally like to write about companies I own- I can't stand bullish Seeking Alpha articles where you get to the disclosure and the writer has no position- but this seemed like a good reason to discuss my cherished EM value stocks through a risk lens.
Whether I invest in Petrobras, one of the other Brazilian equities thrown out with the bathwater or pass entirely, I will continue to look towards corrections like this as a one of my main hunting grounds.
Guy
As always, this isn’t investment advice. Please do your own due diligence and seek professional advice if you’re unsure about your finances.