Monday, February 25, 2013

KazMunaiGas E&P: A True Bargain

Kazakhstan is a huge country that shares its borders with Russia on the North, China on the East and the Caspian Sea on the West. Despite its huge size, the country is home to only 17 million people and has a GDP of $200bn (lower than Portugal) or $12k per capita. Even so, the middle income nation has a per capita income similar to Turkey or Mexico. Supreme Chancellor Nazarbayev has been ruling the country for more than two decades and maintains strong popular support. He has been pushing Kazakhstan towards greater integration with the rest of the World.

The country was one of the last decade's hot emerging markets, with the equity market rising 26 fold between 2001 and 2007. Following the onslaught of the 2008 crisis, the four major banks were rescued and the stock market plunged by more than 75%. Now, five years later, the financial sector still faces challenges.
What caught my attention were the oil & gas reserves:  Kazakhstan is the World's 18th largest oil producer and has plenty of opportunity to grow production, as recoverable (proven) oil reserves stand at 5.5bn tons (9th on the World ranking). To put this into perspective, it would take the largest oil tanker ever built, the Norwegian Knock Nevis, about 10’000 trips to carry all the oil reserves.
One of the companies banking on these huge reserves is KazMunaiGas Exploration & Production (KMG EP). After 1991, when Kazakhstan declared itself an independent country, all the state controlled oil&gas related assets were grouped into a state controled company called National Company KazMunaiGas (NC KMG), then in 2004 KMG EP, a subsidiary of NC KMG, was created from the merger of two companies. Finally in 2006 KMG EP carried out its IPO, with NC KMG remaining a majority shareholder (2/3 stake).

Source: KMG EP investor day presentation

KMG EP has grown through acquisitions of exploration rights from its parent company at very favorable prices, as the later has repeatedly ceded to KMG EP the right of first refusal on transactions in hydrocarbon properties. Since the IPO production has averaged 245Kbpd and the company holds enough reserves to maintain production at current levels for 20 years.
Usually the objective of a company’s management is to maximize value for its shareholder, and KMG EP’s management has been doing just that, but not in the way you would expect. Since the state is the majority shareholder, KMG EP is plagued by bureaucracy, and is forced into projects that aim to please the people and consequently the government, not exactly the minority shareholders. Besides this, NC KMG has been borrowing money from KMG EP to finance its own projects, not exactly a good example of corporate governance. You can say that KMG EP’s management aims to maximize the value for the majority shareholder, but not exactly for the minority one.
But, as with most value investments, while the outside looks repealing, the value is on the inside, and for that some digging is needed. There are several relevant facts that make KMG EP a very attractive investment at current prices.
The company has an immaculate balance sheet, with no debt and $4.1bn in cash & equivalents, which accounts for more than half of the value market assigns to the company (market capitalization of $7.5bn).
KMG EP generates about $1.5bn in profits every year. Profit margin is high, at 25%, despite tax increases in recent years and the company being forced to sell at least 20% of its production for domestic use, at a considerably lower price than what it gets for the rest of its oil from international markets.
The shares trade for 5 times earnings (2.25 if you back-out cash) and at an enterprise value to EBITDA ratio (EV/EBITDA) of just 1.6. Calling this KMG EP cheap would be putting it mildly.
The company’s operations are very inefficient, but there is a substantial modernization process underway, targeted at making the company more efficient and increasing production on existing wells. KMG EP also has an ambitious exploration program in progress which targets increasing the company’s reserves. This exploration plan eclipses past exploration efforts: for the past 5 years the exploration CAPEX was $25mn/yr, but it is now projected to be $300mn over the next 5 years.

Source: KMG EP investor day presentation

In its effort to open itself to the world, the Kazakh government has plans to privatize via stock exchange listing many state owned enterprises, with NC KMG planning to be listed in 2015. This can act as a medium-term catalyst to improve corporate governance. Of course the government can always do what it wants, but with its objective of rebuilding its capital markets and improving its image before the rest of the World, I don’t think they will do anything too stupid. Besides, China’s sovereign fund has a 10% stake in KMG E&P, and you don’t really want to upset your best Client…
Time arbitrage is defined as taking advantage of the opportunity for long-term profit offered when short-term investors sell due to disappointing short-term macro or business progress. In other words, you buy undervalued assets that are being neglected by the general investment community and sit on your hands until they come to their senses. The sitting on your hands part is more difficult that it appears, as a constant feed of news and reports make you want to do something. KMG EP rewards its investors with an 8% dividend, which should help with the ‘sitting on your hands’ part!
I just wrote about a political sensitive company in a former communist country that has been amassing assets acquired from its parent, and where government has recently increased taxes. But it is all about how much you pay for something, and here you are paying very little: just $2 per barrel, for a company with reserves of 2bn barrels of oil and 40’000 km2  in exploration assets (about the size of Switzerland). This one is promising!

Disclosure: I may buy shares in KazMunaiGas E&P during the next weeks.

1 comment:

  1. I have worked about 10 years in Kazakhstan and hold a large stake in KMG EP. While I tried to diversify into Russian oil companies, I could not find there such a high dividend and growth prospects at the same time. That is, the Russian companies are fundamentally alright, but I need the dividend as well. Some Canadian companies pay a similar level of dividends, but they are far more expensive and have significantly smaller resource base.