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Having the Brazilian government own a majority controlling interest in Petroleo Brasileiro or Petrobras (NYSE: PBR) can be both a blessing and a curse for investors who own the rest of the company. The policies of Brazil’s President Dilma Rousseff have taken a toll on the company’s profitability making the next election a potential catalyst for a major turnaround. The possibility that a more business friendly government could be elected to power has attracted value investors such as Marketocracy Master Mike Koza who sees the potential for a double in four years.
Ironically, on the day I scheduled my call with Mike (August 8, 2014), Petrobras announced their earnings. And, the results reported by the company were less than the consensus expectations. In a year/year comparison, while production was up 1.7%, EBITDA was down 10.2%. The company’s press releasestated the reduction in earnings was due to, “rising fuel costs, debt costs, and operating expenses.” Until PBR announced its quarterly earnings, the stock had been performing well, growing 15.7% YTD.
Mike’s Marketocracy track record shows an annualized return over the last 10 years of 15% with an investment style similar to Warren Buffett’s. Berkshire Hathaway and the S&P 500 both show annualized total returns just short of 9% during the same period.
You can view Mike’s top five holdings, learn more about his strategy, and track his progress with monthly Performance Insights emailed directly to you at the end of each month by visiting our website.
One of Mike’s holdings is Petrobas. His Marketocracy model portfolio has averaged 15% a year for the last 10 years.
Ken Kam: Mike, how much of your portfolio do you have invested in Petrobras?
Mike Koza: I’m looking at the portfolio right now, and it looks like it is about 12% of my holdings.
Ken Kam: Why do you have so much allocated to PBR?
Mike Koza: The company is a good company, and I started to notice it when it was at $11 per share. It’s a state sponsored monopoly, so there is no real competition. In a way, it’s similar to Sinopec [Shanghai Petrochemical] (NYSE: SHI) in that it has the full backing and protection of the national government.
Ken Kam: So have there been any issues?
Mike Koza: There are associated risks, and they are primarily political. While it is fair to call them political risks, they have become part of the business risks for Petrobras. The Brazilian government controls 54% of the company, so the Brazilian President Rousseff determines much of what happens to the company. At present, she is continuing the populist philosophies of President Lula DaSilva. Essentially, she has politicized the business to the point where it is difficult for the company to make larger profits than it would under a less restrictive environment.
Ken Kam: How is she doing that?
Mike Koza: The upstream business, the oil production end of the business, is doing fine, and it is profitable. However, the refining end of the business is what is most problematic. First, the company has to import oil to meet the needs of Brazilians. Second, the controlling government forces the company to discount fuel at least $10 per barrel. This is what has created a drag on the overall business. President Rousseff is not allowing the CEO, Maria das Graças Silva Foster, to capitalize expenses in the open market and make a profit. Additionally, there are improvements that need to be made to the refinery business. The company does not have the refining capacity to meet the needs of the Brazilian people. Because of the politics, Foster is forced to use local businesses for capex spending. This limits her ability to improve the efficiency of the company.
Ken Kam: So taking all of that into account, I will ask again, why such a large position in the company?
Mike Koza: President Rousseff is very unpopular. Polls show that she only has 36% support for reelection. That is not enough to get out of the first round of elections. If the election goes to a second round, then I predict she will lose. Aecio Neves has presented himself as more pro-business, so that bodes well for the future. If Rousseff loses, the margins for PBR will improve, since they will be able to run themselves more like a business instead of a government program.
Ken Kam: What did you think about the earnings report?
Mike Koza: I think that it was a big miss on earnings, but my opinion about the overall potential for PBR has not changed much. The revenues were in line. I don’t know what the analysts were using in their models that caused the company to miss by so much. Production in July was up 4% from the 2nd quarter average and up 2% from June. The company still claims it can meet its 7.5% production growth target. Again, President Rousseff has to let Foster do her job, and run Petrobras like a company rather than a government entitlement. As I said earlier, when Rousseff goes, and I believe she will, the business environment should improve.
Ken Kam: What about the debt? It appears to be growing. Any concerns there?
Mike Koza: As long as the debt is used for offshore exploration and more oil deposits, I have no concerns. They definitely need to improve their refining program, too. I know the debt/equity level is higher (0.81 v. 0.24) than that of its peers. However, if there was ever a company that was too big to fail, this definitely fits the bill. Brazil does have a democratic process in place, and the Brazilian people are shareholders as well. Unlike China and Russia, Brazil is still a democracy, so they have a responsibility to their people. China can shut down Sinopec any time it wants, and Russia did shut down Yukos. This will not happen to Petrobras. S&P still gives the company an investment grade (BBB-) on its bonds, so it is still considered a safe debt. I will watch the debt to make sure it is not too excessive.
Ken Kam: Let’s assume that the current government stays in power. Do you still see a double in the next five years?
Mike Koza: I do, but I actually have a four year time frame on this stock. The price-to-book (P/B) ratio makes the company very cheap. Right now the P/B ratio is 0.68. If it normalizes to its historical average (1.3) or the industry average (1.45), that alone will cause a rise in the price. The average return on equity for the past few years is almost 14%, so the book value should grow from $24/share to around $39/share. Even at the current P/B ratio, that means the stock price should grow to $27 in four years. If the P/B ratio returns to more normal levels, then I predict that the price will end up in the range between $51-$57 in four years.
My TakeMike performed the proper due diligence that leads him to believe that Petrobras has the potential to double, and I like Mike’s approach with this company. He buys at a discount and sells at a premium. For example, he bought PBR on March 3, 2014 at $11.07/share, and then he added to his position on March 17 at $10.31/share. With his previous additions to his position, his cost basis is almost $13. Since then, he has sold some of his positions for $13.97/share and $15.35/share on April 17 and May 20, respectively. I asked him the reason for the sell off. His answer? Mike limits his positions to no more than 12% of the overall allocation of the portfolio. In the process of re-balancing, his investors made a tidy 15% in realized gains on the sold positions.
Even if the political winds in Brazil do not change in the near future, Mike still sees growth in the stock’s price in the next few years. This is important for the value investor. Find the levels of safety, and then find the opportunities for growth. Based on PBR’s current fundamentals, Mike still sees the potential for a double within the next four years. This provides investors a margin of safety while we wait to see whether Brazilian politics will provide the catalyst for a quicker return.
Connect with Ken Kam onLinkedIN.
Disclosure: I am the portfolio manager for mutual and hedge funds advised byMarketocracy Capital Management, an SEC registered investment advisor. Before relying on the opinions expressed in this article, you should assume that Marketocracy, its affiliates, clients, and I have material financial interests in these stocks and may hold or trade them contrary to these opinions when, in our view, market conditions change.
http://www.forbes.com/sites/kenkam/2014/08/15/politics-creates-opportunity-for-a-double-in-petrobras/
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