Petrobras: Pricing Amargeddon, With a Muddle Through Likely

I had to write a brief note about the panic whipped up by UBS’ downgrade of Petrobras, cutting its price target from R$47 to R$22 on fears of a policy shift under the incoming Lula administration. This combined with quarterly ex-dividend day, to send the shares sharply lower and extend their slide since the election.

This Reuters article sums up recent events nicely- namely Lula is over-hauling PBR management and seeking a strategic shift from monster dividend pay-outs, towards increased investment in renewables and possible domestic price caps.

All of which seems scary, until you remember that Petrobras trades at 2x earnings and is a cash machine well below current oil prices. Fears like this have been swirling around the company for years, are really nothing new and are already baked into the price several times over.

Companies don’t trade on a PE of 2 if they aren’t already heavily discounting something and the comments we have seen from Lula thus far fall drastically short of justifying the current price.

My own buying opportunity came nearly two years ago, as Bolsonaro ousted his own appointee Roberto Castello Branco in early 2021 and the stock fell to $7.50, not long after I published this piece. Since then, the comany has paid out $7 in dividends, despite continuing price cap fears and multiple (seriously!?) CEO removals.

I believe some kind of continued muddle along is the likely result here, too.

For starters, the CEO Caio Paes de Andrade’s term runs until April next year. Even if Lula fired him tomorrow, the company mandated 45 day vetting period would see him stay on until early next year. Remember that every quarter brings another dividend of around 10-15% of the current price. April may give him the chance to declare two more dividends.

Further, it needs to be remembered that the Brazilian government is PBR’s majority shareholder and a huge beneficiary of its payouts. Lula has already signalled his hopes to keep the financial markets happy content and cooking the golden goose would simply be against his own self-interest.

My baseline assumption is we will see the dividend reduced to something like a 10-20% current yield, with the rest reinvested in operations. A portion of this will be renewable, but all governments are acutely aware of their energy security after the Russian invasion, and it is crazy to think Lula would compromise Brazil’s here.

Some of this will certainly be squandered, but much of it will ultimately increase future productive capacity and, ultimately, profitability. Lula’s vision is for a diversified and integrated energy giant-a cooked goose is no use to anyone .

We can already see a similar model in BP and Shell in Europe, who have committed to increasing their renewable mix over time, to align with government and societal expectations. Though, no-one is pretending this can be done overnight and the renewable divisions are still relatively small parts of the business.

For many institutional market participants, this shift would actually reduce terminal risk and possibly make the company more investable. It is worth noting the Euro supermajors are still paying strong dividends and that PBR is starting from a much lower valuation.

Pricing uncertainty

I don’t mean any of this to sound like I am 100% confident in the outcome here. We are dealing in an EM SOE with a history of corruption scandal.

But returning to first principles, as investors we are trying to buy cashflow streams extremely cheaply. There are some possible futures where this goes very badly, but I believe they are relatively unlikely.

While any reader would be right to be sceptical of my judgement given I am currently frozen in a couple of Russian securities, the situation is very different here. The worst-case scenario is not a zero (although I don’t think my Russian holdings will be ultimately either) and looks something like a total removal of the dividend, with a fleeing of foreign investors seeing the price plummet. Earnings would collapse, but we are currently on a 2 PE, after all.

Even then, Lula’s term would eventually end and the company would still be sitting on enormously valuable, long-life reserves.

The opposing bull-case would be minimal dividend cuts, some political posturing around price-controls and a broad continuation of current profitability. Despite this being a higher probability outcome, in my opinion, the current price of entry matches the former.

As stated above, I believe a mix of the two is the most likely outcome. The dividend is cut to a lower, but still strong yield, the company restarts its renewable programs and, in time, the market marches upward as it realises the armageddon it has been pricing in isn’t arriving.

I read this analyst comment with amusement, as I was perusing reactions to the situation:

“My best advice: Wait and see what Petrobras actually does. See what the valuation looks like then, before deciding whether to invest in it.”

Embracing uncertainty at the right price remains an evergreen strategy in markets and I believe PBR’s current malaise will prove a good example in time.

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.