When the crisis in the Ukraine reached the front page of the news in March, I looked to the gurus for guidance on whether to start looking at Russian stocks. At the time, there was no indication of anyone buying. It looked like they were sitting on the sidelines at that time. Now that the fund managers have disclosed their holdings for the first quarter of 2014, we can see that First Pacific Advisors has found some value in Russia with their purchases of Gazprom (OGZPY, Financial), Lukoil (LUKOY, Financial) and Rosneft (OJSCY, Financial). Francisco Garcia Parames of Bestinver also purchased shares of Gazprom.
These companies are trading at deep discounts with Gazprom being the cheapest. With the turmoil in the Ukraine, investors might have to hold onto their positions for a long time before their valuations return to normal levels. Let’s take a closer look at the three companies:
OAO Gazprom (OGZPY)
Market Cap: 99.02 billion, P/E: 2.70
Business Predictability: Not Rated, Financial Strength: 6/10, Profitability & Growth: 8/10
Gazprom is the largest extractor of natural gas in the world. The company was created in 1989 when the Soviet Ministry of Gas Industry transformed itself into a corporation. The company is 50.01 percent owned by the Russian government. The stock is trading with a P/E of 2.70 with a price-to-book ratio of 0.40. It is up 2 percent year-to-date and 11 percent for the past year.
Looking the financial statements, Gazprom has increased its revenue every year for the past 10 years, except 2009. The company has a low debt-to-equity of 0.15 and an interest coverage ratio of 34.85. Net income has been down since 2011 with natural gas prices retreating from their all-time high in 2008. Net income is also down partly due to repayments to European customers and higher taxes. The Russian government also has a cap on natural gas prices for domestic use within Russia. The stock currently has an earnings yield of 32.7 percent and a return on equity of 11.82 percent.
In recent news, China and Russia signed a deal last week worth about $400 billion. The deal calls for Gazprom to supply China National Petroleum Corp with 38 billion cubic meters of gas annually for 30 years. A pipeline infrastructure needs to be built, and the gas is due to begin flowing in late 2018. Russia will invest $55 billion in fulfilling the contract while China will invest $22 billion. The risk is the large capital expenditures that will be needed to build up the infrastructure.
OAO Lukoil (LUKOY)
Market Cap: 43.78 billion, P/E: 4.20
Business Predictability: Not Rated, Financial Strength: 8/10, Profitability & Growth: 6/10
Lukoil is Russia’s second largest oil company. The company was formed in 1991 when three state-run companies were merged. Lukoil’s largest shareholders are key managers Vagit Alekperov and Leonid Fedun owning 20.92 and 9.5 percent of the shares, respectively. The stock is down 8 percent year-to-date and down 11 percent for the past year. It is trading with a P/E of 4.30, and a price-to-book ratio of 0.50.
Looking at the financial statements, Lukoil has increased its revenue every year for the past 10 years, except 2009. The company has a low debt-to-equity ratio of 0.12, high interest coverage of 26.15, and has been buying back shares for the past four years. Earnings per share dropped 28 percent in 2013. The company states that it was due to asset impairments. The stock currently has an earning yield of 25.4 percent and a return on equity of 9.93 percent.
In recent news, France’s Total SA (TOT) signed a deal on May 23 that will set up a joint venture with Lukoil to develop the Bazhenov oil formation in western Siberia. Siberia is believed to have some of the world’s largest shale oil deposits. Lukoil will have a 51 percent stake in the joint venture and Total will have 49 percent stake.
OJSC Rosneft Oil Co. (OJSCY)
Market Cap: 70.69 billion, P/E: 9.60
Business Predictability: Not Rated, Financial Strength: 6/10, Profitability & Growth: 8/10
Rosneft engages in the exploration, development, production and sale of crude oil and gas, petroleum products and petrochemical as well as market of outputs. It became Russia’s leading extraction and refinement company after purchasing assets of former oil giant Yukos at state-run auctions. In March 2013, it became the largest listed vertically integrated oil company in the world in terms of both oil reserves and production volume after the acquisition of TNK-BP. The company is 75.16 percent owned by the Russian government. The stock is trading at a P/E of 9.60 and a price-to-book ratio of 0.70. It is down 10 percent year-to-date and flat for the past year.
Looking at the financial statements, Rosneft has increased its revenue every year for the past 10 years, except 2009. The revenue for 2013 was up over 50 percent compared to 2012. The company has a higher debt-to-equity ratio of 0.44 than the other Russian energy companies, but it is still lower than the industry average of 0.6. The interest coverage is at a high level of 12.62. Earnings per share increased 46 percent in 2013 compared to 2012. The large increase in revenue and earnings include production from the TNK-BP acquisition. According to research from Gazprombank, the company now produces about 5 percent of global oil.
In recent news, the CEO of Rosneft, Igor Sechin, was placed on the U.S. sanction list on April 28. The sanction has had little effect on the company, if any. On Friday, May 23, ExxonMobil (XOM) signed a deal with Rosneft at a forum in St. Petersburg. Some U.S. oil companies avoided the event after U.S. State Department officials called for a boycott. The pact solidifies a joint project to drill for oil in the Arctic and Siberia and to liquefy natural gas for export to the Far East.
Conclusion
All three of the Russian energy stocks above are undervalued and selling at deep discounts due to geopolitical tensions in the region. Gazprom is selling at the biggest discount compared to the rest of the Russian energy companies. In close second is Lukoil, followed by Rosneft. If the U.S. were to take another step with more sanctions, it would be against state-owned companies. Lukoil is the company to own if there is worry about additional sanctions because it is not majority owned by the government. Gazprom is the best overall play for the long term due to its low valuation.
I chose to compare the companies to CNOOC (CEO) for valuation. CNOOC is a major oil and gas company in China that is also trading at a discount to its peers. I also chose to value the stocks in comparison with CNOOC because it is in an emerging market, and I wanted a more conservative comparison than against the overall industry. For the valuation, I found the average prices of the companies compared to CNOOC using key financial ratios. The PEG ratio used is based on a five-year EBITDA growth rate.
| Company | P/E | PEG | P/B | P/S | Price | Priced At CNOOC's Valuation |
| OGZPY | 2.7 | 0.2 | 0.4 | 0.6 | 8.41 | $23.09 |
| LUKOY | 4.2 | 0.5 | 0.5 | 0.31 | 57.04 | $155.54 |
| OJSCY | 9.6 | 0.4 | 0.7 | 0.57 | 6.65 | $11.00 |
| CEO | 8.5 | 0.3 | 1.4 | 1.7 | 176.81 | $176.81 |
If the companies were located in a region other than Russia, they would be trading at 2 to 3 times their current prices. Once tensions cool, the stocks should revert back to normal valuations, providing a large upside from their current prices. The risk is that it might take years for that to happen. Even with tensions in the area, the Russian energy companies are still able to make large deals and maintain their revenue streams. It will be interesting to see how First Pacific Advisors (Trades, Portfolio) handles its new Russian holdings and if Francisco Garcia Parames (Trades, Portfolio) will add other Russian securities to his portfolio.
