LUKOY - Lukoil

[JBird]

Lukoil- LUKOY

 

This Russian oil company accounts for 2.2% of the world’s oil production, and 0.8% of the world’s oil reserves. Lukoil’s reserves and operations are based in Russia. Its sales though are based primarily abroad. About 57% of Lukoil’s revenue is derived from international sales in both retail and wholesale markets.  It pays huge export tariffs for that business, about $22 billion last year.

 

Despite being such a prolific taxpayer, Lukoil has generated huge earnings for shareholders over the past 5 years. Here are the relevant figures:

 

Net income

2007: $9.5 billion. 2008: 9.1 billion. 2009: 7 billion. 2010: 9 billion. 2011: 10.3 billion. 2012: 11.0 billion.

 

Lukoil’s earnings come from very solid returns on equity:

2007: 23% 2008: 18% 2009: 12.5% 2010: 15% 2011: 15%

 

Management has maintained a healthy balance sheet and has used minimal debt. Here are the figures:

 

Debt-Equity ratio over the past 5 years:

2007: .17 2008: .19 2009: .2 2010: .18 2011: .13 Currently: .09:1

 

Quick ratio:

2007: .85 2008: .73 2009: .83 2010: 1.02 2011: 1.1 Currently: 1.4

 

Lukoil’s history is impressive however the value of Lukoil today is based solely on its future. The question of course is what will the economics of Lukoil look like 5 and 10 years from now? What will Lukoil generate in terms of owner earnings over that time? Intelligent minds will disagree, but some very conservative estimates will prove useful.

 

Owner earnings definition as stated by Warren Buffett:

(A) Reported Earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges less © the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

 

In order to estimate intrinsic business value I’m going estimate yearly owner earnings for the next 12 years and then apply a 7% discount rate to those earnings, a premium of 5% over the risk-free rate.

 

Calculation of Intrinsic Value

 

The left column in the following table is the net income estimate in billions. The next column is the estimate of owner earnings. I’ve projected that maintenance capital expenditures exceed depreciation charges by $500 million annually. The next column is the discount rate, and the far-right column is the present value.

 

10,000     9,500   1.07   8,878

10,500   10,000   1.14   8,771

10,500   10,000   1.22   8,196

10,500   10,000   1.31    7,633

11,000   10,500   1.4   7,500

11,500   11,000   1.5   7,333

11,500   11,000   1.6   6,875

11,500   11,000   1.71   6,432

11,500   11,000   1.83   6,010

11,500   11,000   1.96   5,612

11,000   10,500   2.1   5,000

10,500   10,000   2.25   4,444

 

Present value of future cash: $82,684,000,000

 

As an earnings stream estimate becomes more conservative, the likelihood of it proving accurate increases. My confidence that Lukoil is worth at least $80 billion is high simply because I believe my estimate is conservative.

 

One important variable that should be considered in valuing this company is the price of oil over time. The price of oil in 5 and 10 years is hardly knowable with any precision. It may rise as world reserves are depleted. It may fall as renewable energy sources become more economically viable. For the sake of my estimate, I held the price constant over time, a choice that may prove to be very erroneous.

 

A final variable well worth considering is the country-risk that Russia presents. The Russian Government has proved its ability to commit folly against Russian oil companies. Ten years ago the Russian Government brought down Yukos Oil swiftly and illegally. When I created a mathematical expectation of Lukoil’s stock performance over time, I did so with the assumption there was a 20% chance that the Russian Government would take Lukoil’s stock price to zero.

 

I would encourage anyone reading this to download Lukoil’s annual reports and make their own valuation. And remember: Value the company first. Look at the current price/market capitalization afterwards. The market is there to serve you, not to guide you.

 

[Edward]

A very nice writeup, however I must point out that this is all good and well for a western company, but in Russia, private property rights are not particularly well respected. Investing in such countries is quite a roll of the dice even at appealing valuations.

[JBird]

Agreed. As I said in the the second to last paragraph, I figured there's a 1 in 5 chance Lukoil goes to 0.

 

When I bought Lukoil shares, I had this quote in mind."I think if it’s cheap enough, you can afford more country risk or regulatory risk. It’s not complicated." Charlie Munger, Berkshire Meeting 2004

[constructive]

Given the regulatory risks, good management seems critical. What are your thoughts on Alekperov and the rest of the management team (compensation, insider dealing, etc.)?

 

The dividend is positive, I would probably not consider an emerging market company that paid no dividend or a very low dividend. Have they ever considered a buyback or are they just focused on acquisitions?

[turar]

Russia is, well, Russia. I would stay away. (And I'm pretty much very close to Russian myself).

[JBird]

I don't see regulatory risk as a major use, it's the political risk. Either way, management is always important. Alekperov is a gifted businessman with a loaded resume. I like that he's a major stockholder. When Conoco started selling its Lukoil stake in 2010, Alekperov started buying more. He owns 20% of the company now.

 

The entire Lukoil board and management team was paid about $32 million in aggregate last year, and in my view that's an appropriate figure. Overall I'm happy with Lukoil management for two reasons. They've proven their ability to allocate capital effectively, vis-à-vis their capital investment strategy and conservative capitalization structure. Secondly, they've dealt with the Russian Gov quite well and have not committed any of what I'd call management sins.

 

Since 2007, Lukoil has spent $3.6 billion on share repurchases. Shares outstanding have been reduced by about 8.5%. Last June management announced that it set aside another $2.5 billion for additional buybacks to be made over the next 2.5 years.

[constructive]

Thanks for the response, sounds promising. Yes, I was using regulatory and political interchangeably.

 

Do you have any other Russian investments or is this it? The market appears very cheap, but it seems a limited number of good companies are accessible to Western investors. I've looked through some of them and Lukoil is the main standout. The other one that caught my eye was Farmstandart.

[fareastwarriors]

jbird,

 

Any updates?

[JBird]

Russian inflation is running at 7% this year. Rather embarrassingly, this was not a factor I adequately considered in my valuation- a staggering error. If inflation continues at this pace or accelerates, my original valuation is flat out terrible.

 

The company itself is doing well.

 

My valuation now has a dramatically higher discount rate;  8% real return plus a 7% inflation rate, 15%.

 

And I personally use a range of intrinsic value estimates and then weight them by probability. But applying this to Lukoil earnings and Russian inflation feels like I'm running against quantum indeterminacy. This just got way closer to my too hard pile.

 

[Packer16]

Does inflation really matter when most of their assets are in oil with much of it being sold abroad?  The US oil companies were in similar situation in the 1970s and they did fine.  I can see if you think oil is going down but there product price should increase with inflation.

 

Packer

[JBird]

Yes, I suppose if oil prices rise in proportion to production costs the damage is nullified. Is it reasonable to expect oil prices to rise at 7% per annum though? Comments welcome!

[Packer16]

Maybe not in US$ or Euros but in roubles if the rouble depreciates versus the $ and euro per purchasing power parity.

 

Packer

[JBird]

2012 Sales: 25 billion in Russian sales, and 113 billion in International sales. If 78% of their sales are not denominated in Rubles, it appears they're somewhat insulated from ruble inflation. Their nominal production costs will rise with ruble inflation but theoretically this is offset by ruble depreciation in purchasing power relative to their foreign revenue dollars.

 

"A substantial part of our revenue is either denominated in US dollars or is correlated to some extent with US dollar crude oil prices, while most of our costs in the Russian Federation are settled in Russian rubles. Therefore, ruble inflation and movements of exchange rates can significantly affect the results of our operations. In particular, the appreciation of the ruble against the US dollar generally causes our costs to increase in US dollar terms, and vice versa. The appreciation of the purchasing power of the US dollar in the Russian Federation calculated on the basis of the ruble-dollar exchange rates and the level of inflation in Russia was .7% in 2012. At the same time, the nominal appreciation of the US dollar amount to 5.8% (based on average ruble-dollar exchange rates for 2012 and 2011)" - 2012 Annual

 

If I'm interpreting this correctly, the US dollar appreciated 5.8% against the ruble but the change in relative purchasing power was just .7%, due to ruble inflation.

 

Ruble inflation in 2012: 6.6%. 2011: 6.1%

Average exchange rate for the period (ruble to dollar) 2012: 31.09 2011: 29.39. That's 5.8% YoY increase.

 

Edit: Sorry Packer, I didn't see your post when I wrote this! Thanks for your comments.

 

 

[LowIQinvestor]

JBird,

 

Thought these quotes from BP's earnings release may help you:

 

"the quarter was adversely affected by:

 

- lower oil prices;

- an unusually high underlying effective tax rate of 45%, compared to 35% a year earlier, largely due to the impact of the stronger dollar on a basket of currencies; and

- lower post-tax income from Russia, driven by rouble depreciation and the lagging effect of Russian oil export duty, which has a disproportionate effect in periods of falling  prices."

 

[fareastwarriors]

.Lukoil Billionaire CEO Buying Spurs Share Gain

 

 

http://www.bloomberg.com/news/2013-07-24/lukoil-billionaire-ceo-buying-spurs-share-gain-russia-overnight.html

 

 

...

OAO Lukoil (LUKOY), Russia’s second-largest oil company, climbed to an eight-week high in New York after the crude producer said billionaire Chief Executive Officer Vagit Alekperov bought $498 million of shares since late June.

 

...

[LowIQinvestor]

Valuation Spurs Gazprom Head Stake Buy: Russia Overnight

 

http://www.bloomberg.com/news/2013-08-04/valuation-spurs-gazprom-head-stake-buy-russia-overnight.html

[LowIQinvestor]

Can't get this idea off my mind...

I agree with past comments--- It is no doubt cheap (4 PE) but how do you accurately handicap the political risks?

 

Anywhere else this company would be trading 50-100% higher.

 

http://www.bloomberg.com/news/2013-02-06/lukoil-billionaire-alekperov-instructs-son-not-to-sell-his-stake.html

 

"The billionaire said he “always buys shares” in Lukoil and neither he nor other key holders offer them for sale on the market. The company is trading at half its true value, he said. "

[John Hjorth]

At which market/exchange are the board members already invested in this stock doing their trade?

[fareastwarriors]

Here in the U.S., I would probably trade the Sponsored ADR,  ticker: LUKOY. It is on OTC Pinksheets.

 

It seems like it has prretty good volume.

[JBird]

Can't get this idea off my mind...

I agree with past comments--- It is no doubt cheap (4 PE) but how do you accurately handicap the political risks?

 

“We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each- no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

 

It doesn’t work that way.

 

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations may vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have a .05 chance of performance fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

 

The above may make the whole operation sound very precise. It isn’t.” - Buffett Partnership Letter 1966

 

Look at the stock as if it were a weighted dice. You have a range of possible outcomes and each outcome has a different probability. To handicap the political risk, or price in the possibility of this going horribly against you, assign a higher probability to the possible outcome of the stock being worth .5x the current price, or .00x the current price.

[John Hjorth]

Here in the U.S., I would probably trade the Sponsored ADR,  ticker: LUKOY. It is on OTC Pinksheets.

 

It seems like it has prretty good volume.

fareastwarriors,

 

Thank you for info. It's much appreciated.

[JBird]

Russian oil news, though not Lukoil specific:

 

http://www.bloomberg.com/news/2013-11-24/putin-bets-on-gazprom-purge-as-slowdown-threatens-legacy.html

[Packer16]

I took a plunge into the Russian oil space with this name.  The company is selling for about 15% of US majors and EM majors on a reserves basis and less than 50% on an EBITDA basis.  The interesting thing is other Russian sectors (telecom and media) do not sell at a discount to other Western firms.  I watched some of Jim Rogers latest talks on Russia and was caught.  Jim Rogers also got me hooked on commodities in the mid 00s.  Then you have Jim Grant and mcdep bullish with most of the market saying Russia???? Just look at the reaction of some of our CoBF folks who I would consider to be above average value investors.  So you definately have a hated asset class. 

 

On a quality basis Lukoil is the best in Russia and has about the same upside as other more opaque players like Rosneft and Surgutneftgas.  The disclosure is great (see their website).  This is in combination of changes in Russia observed by Jim Rogers and friend of mine who used live in Russia is what makes me bullish on this idea.  We will see.

 

Packer

[tombgrt]

I took a plunge into the Russian oil space with this name.  The company is selling for about 15% of US majors and EM majors on a reserves basis and less than 50% on an EBITDA basis.  The interesting thing is other Russian sectors (telecom and media) do not sell at a discount to other Western firms.  I watched some of Jim Rogers latest talks on Russia and was caught.  Jim Rogers also got me hooked on commodities in the mid 00s.  Then you have Jim Grant and mcdep bullish with most of the market saying Russia???? Just look at the reaction of some of our CoBF folks who I would consider to be above average value investors.  So you definately have a hated asset class. 

 

 

 

The negative reaction really stood out for me as well. Sure Lukoil and the other Russian based majors deserve a discount but this might be a bit much. I didn't know about mcdep, thank you.

 

 

For those interested: http://www.mcdep.com/mr131203.pdf

[leftcoast]

Packer, do you have any links to the Jim Rogers talks re: Russia? I'd be interested to read/watch them. Would also be interested to hear what your friend in Russia is seeing that gives you confidence.

 

I'm no expert on Russia, but my first thought is to wonder how much of the very recent improvements (releasing political prisoners, investing in infrastructure) are due to the international spotlight that accompanies the Olympics?

 

Rich Russians Sparring With Putin Over $48 Billion Olympics Bet

http://www.bloomberg.com/news/2013-11-26/rich-russians-sparring-with-putin-over-48-billion-olympics-bet.html

Putin is staking Russia’s image -- and his legacy -- on his pet Olympics project. ... Sochi 2014 might as well be renamed Putin 2014, says Scott Antel, a partner at DLA Piper LLC in Moscow, who has worked on hotel projects in the region.

...

“This was a deal with the devil,” Antel says. “You will do your civic duty and build facilities in Sochi so we can have this coming-out party for the new Russian state. This is your indirect taxation to be allowed to continue with your main business activity.”

 

Putin shows inmates mercy before the Olympics

http://www.post-gazette.com/opinion/editorials/2013/12/30/Russian-releases/stories/201312280007

Russia has released from prison three high-profile, news-making sets of prisoners, likely in an attempt to clean up the country’s poor human rights record in advance of the Sochi Winter Olympic games in February.