Value + Catalyst


I sold my Gazprom ADRs yesterday. The shares popped nearly 22% after the company proposed a 60% increase in its 2018 dividend. If you are unfamiliar with Gazprom, it is Russia’s state-owned natural gas behemoth. It is also probably one of the cheapest non-distressed stocks in the world on an absolute basis.

While I increasingly work to expand my investing horizons, I have no illusions about my truest investing self.

My truest investing self is a Ben Graham-style bottom-feeder who is happiest scooping up feared and loathed investments at significant discounts to book value. This is stuff that’s gotten so cheap all you need is for things not to deteriorate too significantly and you will make some money. Meanwhile, if things break even a little bit your way you stand to make a lot of money. It is the kind of stuff that sometimes actually makes people angry when you tell them you own it.

There are not many places in the world today where you can find non-distressed businesses trading at massive discounts to book value or on 5x earnings or whatever.

But you can find them in Russia.

To me, it is beyond question that Gazprom trades at a massive discount to the value of its net assets. You don’t exactly have to be an accounting wonk to understand that. Gazprom controls almost 20% of global natural gas reserves and supplies nearly 40% of Europe’s natural gas. It trades at 0.3x book value.

The problem you have is that the market has to believe there is a realistic path to unlocking that value in order for the stock to trade up.

Read that again. Slowly.

It is critical to understand Gazprom doesn’t have to actually unlock any value for the stock to work. The market just has to believe it will. In fact, if the market begins to assign even a modest probability to management unlocking value, the stock will start to work.

This is still not straightforward for a company like Gazprom, where it’s pretty obvious the company is being looted and the Russian state is at a minimum complicit in the looting, if not itself the architect of the looting. There was a Sberbank equity analyst, Alexander Fak, who made a compelling case Gazprom is being looted primarily via its capex. (A bit too compelling a case, apparently, as Mr. Fak was fired soon after issuing his report)

Source: Morningstar (currency values in in RUB)

Which brings me to the reason I am content to sell my Gazprom ADRs now, despite the fact they may trade up further in the short-term. Because of all its capex, Gazprom is free cash flow negative. By my calculation, management is proposing paying out something like RUB 380 billion of dividends for 2018. Fine and dandy on a net income of RUB 1,456 billion but not so much on free cash flow of RUB -22 billion.

My take on this is that the Russian state is engaged in some first-class financial engineering: loot the company via capex and plug any holes with borrowing. Dividend Recap: SOE Edition!

As an investor, it’s never a good idea to rely on fat dividends that aren’t backed by robust free cash flow to support an investment case. Us bottom-feeders tend to learn this the hard way early on in our investing, by averaging down value traps.

Could Gazprom play this financial shell game forever? Sure. The company is a quasi-sovereign entity. But there is a price above which I am less and less thrilled about entrusting the fate of my investment to the amity and goodwill of the Russian state and for me that threshold was about $5.65 per ADR.

Maybe some day Gazprom’s capex will come down and the financials will make a bit more sense. If so, I may happily own it again. But for now this is one of those cases where “money talks and bullshit walks.”

My Larger Point

For those of you who are also Ben Graham-style bottom feeders, I cannot emphasize the importance of catalysts for these types of investments enough. In this day and age, stuff that gets this cheap tends to be cheap for a reason. To the extent you’re not looking at a value trap you are almost certainly looking at something where there is a major impediment to value realization.

One of the things I spend more and more time thinking about on the up-front now is how those impediments might be cleared. I must admit I didn’t spend enough time thinking about this with Gazprom when I initially invested.

Shareholder activism is one obvious solution. If an activist is involved, congratulations! You’ve got a catalyst. Whether the activist’s agenda is aligned with your own, and whether the activist will succeed in implementing that agenda, are different things all together. But you’re not dead in the water.

Another potential solution is a management team that’s good at capital allocation. Management teams that are thoughtful about capital allocation will take action to close obvious value gaps. In Gazprom’s case, what a thoughtful management team not involved in looting the company would be doing would be cutting back on capex to whatever extent possible and buying back stock hand over fist.

Be wary of situations where a stock is cheap but management is entrenched and is engaged in looting the business. Gazprom is an example of this in Russia. Biglari Holdings is a great example in the US.

Then again, to paraphrase Seth Klarman, everything’s a sell at one price and a buy at another. So maybe sometimes take your chances.

9 thoughts on “Value + Catalyst

  1. Good on you – nice trade. That said, I prefer not taking my chances on a being-looted-by-Putin company.

    There’s no contradiction in the two above statements. Every investor/trader picks his spots; finds his comfort level; decides what pools he/she can swim successfully in – I just know mine is not Russia. Clearly yours is – and I respect and am impressed by that.

    To play off your closing quote, everything’s a buy at a price for someone, but not everyone. I’m a value guy like you and I have a few pools where I’ll do a “Gazprom” like trade. I’m also willing to stop swimming in a pool if it no longer works for me or try a new one if I believe I’ve studied my way to an edge.

    Limiting my pools (but being willing to expand or contract the list) has made me a much better investor / trader.

    All that said, I’m always impressed by a good trade in a value play – and your Gazprom one was a heck of a good one. Well done.

  2. Nice read on Gazprom. I will also have a look at some other writings at your blog 🙂

    I also invested in the ADRs* some time ago. I performed a valuation on the basis that the ongoing big projects will produce some valuable Cash Flows not so far into the future and that the FCFF is good, even after incorporating the ‘looting’.
    A risk factor that I was very aware of at that time however was, if retail investors will ever have the access to the Company’s Cash…

    *) as a German investor I was not able to buy the common Gazprom Shares via my current broker. Still looking for a broker capable of that, since BNY as the ADR Sponsor takes a small cut on each dividend payment

  3. Have you bothered to take a close look at Gazprom’s accounts and recent presentation materials, as well as conference calls? I’m guessing not given that your views are informed mostly by assumption and conjecture rather than facts.

    Firstly, GAZP’s adjusted FCF in 2018 was US$7.8bn, not negative. In the accounts, cash placements in term deposits & other short term money market instruments for cash management purposes is considered a net cash outflow. GAZP has clearly presented its underlying FCF adjusting for these metrics. The FCF comfortably covers the dividend.

    Secondly, management changes have happened and the company’s corporate governance and capital management attitudes are clearly improving. They communicated they intended to move towards a 50% dividend payout by 2020, but the market didn’t really believe them – they were like ‘we will believe it when we see it’. Well, the company just voluntarily boosted its previously advised dividend by 60% (under new management), so that is some fairly strong evidence that they are actually serious about their dividend commitment. To date, the market is only placing any value on the cash flows they are paying out as a dividend, so hiking the payout from 15% to 25% justifies a 65% increase in the share price assuming it is sustainable.

    Thirdly, your assertion that all their capex is tantamount to stolen money is misinformed. Now, no one is going to argue that their capex is 100% well governed. However, it’s a question of degree, and the vast bulk of this capex is demonstrably going into projects with tangible value. For a start the Power of Siberia mega-pipeline will provide an export route into China which will be a very valuable asset long term, not to mention the Turkstream and Nordstream 2 projects. They constructed Power of Siberia at a pace of 2km per day – not bad for a supposedly inefficient state owned company. You’ll also not their high level of reserve replacement and continuing production growth. Despite these mega investments – the cash flows of which will accrue in future years – the company has remained consistently FCF positive, including in 2018 where as noted they generated an enormous US$7.8bn FCF. And capex will peak in 2019 and drop off after these mega-projects are completed.

    The company is currently making a low-teen ROE with low debt despite power prices in Russia being regulated (46% of their gas is sold domestically for US$1.75/mcf, vs. US$6.80/mcf into Europe in 2018). Deregulation will happen at some point. In addition, they are carrying the cost of many large projects not yet contributing to earnings. When you adjust for these factors, GAZP is one of the most profitable O&G companies in the world on an ROIC basis.

    The prejudice you demonstrate, as well as your lack of awareness of the positive changes that are happening, is widespread and is precisely the reason why this is one of the best opportunities out there in global markets at the time. I already held quite a few but immediately bought more after the dividend announcement at US$5.50-5.75. I was probably in the market buying your stock off you.

    Time will tell, but in my opinion this analysis is seriously in error.

    1. Solid rebuttal. I am (perhaps excessively) skeptical of the short-term deposit adjustment. My trust threshold for management here is extremely low. Maybe too low. And there is certainly an opportunity cost associated with excessive paranoia.

      Of course, I am still a believer in the value of the underlying assets. As written above, assuming management continues to “walk the walk” on dividends and the capex program I may happily own shares again in the future, especially as both would go a long way toward further re-rating the stock. I think there is a potential double or triple here. But my original investment thesis has played out so I have exited for now.

      Appreciate you taking the time to comment in detail.

  4. “The problem you have is that the market has to believe there is a realistic path to unlocking that value in order for the stock to trade up.” This is absolutely accurate: value investing only works if the market (i.e. other people with investable cash) wake up that the security/company/whatever is undervalued. Value, ultimately, is subjective and no matter how many DCF analysis people do will get it. You need a reason for the value to move from X to Y and sometimes that requires people to become activists in the best or worst sense of the word.

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