The Petrobras Absurdity: Yield Exceeds P/E (NYSE:PBR)

PBR stock: 7% yield and 4x P/E

My last two articles on Petróleo Brasileiro S.A. (NYSE:NYSE:PBR) were published in late 2022 and early 2023. As seen in the chart below, I argued for a bullish thesis on the stock in both areas. My bullish thesis at that time was largely motivated by geographical diversification and also the expectation for robust oil pricing given the Russian/Ukraine war. Quote:

Firstly and obviously, as an international company, PBR provides geographical diversification, which is particularly advantageous for investors who are primarily exposed to the U.S. market only.

Additionally, PBR is well-positioned to benefit from the current commodity cycle in the next 3~5 years. In the near term, the ongoing conflict in the Russian/Ukraine region should keep oil prices high and provide support for their business.

Petrobras stock indeed has delivered terrific returns since then, with stock prices rallying close to 50%. Combined with the generous dividends, the total returns have been close to 100% since my last writing. The trouble with a working bull thesis is that it tends to defeat itself. As prices go up, valuations expand, and risks heighten.

However, in the case of PBR, the goal of this article is to argue that it remains a compelling BUY thesis despite the large price rallies in the past 1~2 years. First, the considerations in my earlier articles are still valid. Second, the stock is still trading at a low valuation in my view and features a generous dividend yield at the same time. The contrast is so extreme that it borderlines absurdity in my view. As seen in the chart below, its FWD dividend yield sits around 7%, exceeding its FWD P/E (only about 4x) drastically – that is if you only consider the absolute numerical values without the percentage sign.

Moreover, to be elaborated next, I think even such single-digit FWD P/E is exaggerated due to the market’s pessimistic outlook for its FWD EPS.

PBR stock: EPS outlook

The next chart shows consensus EPS estimates for PBR stock in the next few years, together with the implied FWD P/E ratios. Based on the chart, analysts have a consensus EPS estimate of $3.98 for PBR by the end of fiscal year 2024, which is within 1% of its EPS for the prior fiscal year. As such, the implied FY1 P/E is the 4.1x quoted above. Looking further out, consensus estimates then expect its EPS to decline over the next few years to $3.61 by FY 2025 and eventually to only $3.27 by FY 2027. The implied P/E would rise in tandem to about 5x by 2027.

Even though a 5x P/E is by no means expensive by any standards, I’d like to argue that the market’s outlook is too pessimistic and even the 4x~5x FWD P/E ratios are exaggerated.

First, let me start by acknowledging the headwinds that PBR could be facing. The income for the Exploration and Production division could dwindle due to fluctuations in crude oil prices. Moreover, the results of the Refining, Transportation & Marketing segments are quite sensitive to operating expenses and thus could suffer diminished refining margins given the heightened inflation and labor costs.

But I think the positives are more than enough to offset these negatives and lead to sustained EPS growth (or at least stable EPS). First, PBR has a well-diversified pool of incomes. For example, its Gas & Power segment tends to be less correlated with its Exploration and Production division and should keep generating robust earnings regardless of oil price swings in my model.

Second, I think there is a good chance that oil prices would swing in the upward direction from the current level. The detailed reasoning is provided in my other article. The gist includes inflation, geopolitical conflicts (as quoted below), and the tendency of high energy prices to be self-sustaining. Among all the inflation drivers identified in recent CPI data, fuel/energy cost is a key factor (and shelter is another). Among all these factors, fuel/energy plays an underpinning role in my view because they are ultimately needed to address the other factors (e.g., building more shelter, producing the raw materials to do so, and producing more fuel/energy in the first place):

Historically, oil prices have been rising more rapidly than inflation. However, the price appreciation of oil between 2014 and now did not even keep up with inflation. If oil prices were to rise in tandem with CPI during this period, it would be about $114 per barrel now.

Besides inflation, I see a few more geopolitical catalysts that could drive oil prices higher such as the Russia/Ukraine war mentioned above and the potential production cuts by the OPEC (Organization of the Petroleum Exporting Countries).

Finally, PBR boasts a strong reserve to sustain long-term growth. In 2023 alone, proved reserves

were 10.9 billion barrels of oil equivalent (“BOE”), noticeably higher compared to the previous year’s level of 10.5 billion BOE. Thanks to such improvement, the reserve could support boosted prosecution without jeopardizing long-term growth prospects. For example, the reserves-to-production ratio remained at 12.2 years, the same as 2022’s number.

Downside risks and final thoughts

In terms of downside risks, PBR faces largely the same risks that are common to its peers in the oil & gas universe. As aforementioned, some of these risks are fluctuations in oil prices, geopolitical instability, our ongoing shift towards renewable energy, and also environmental regulations. Although there are some risks that are more particular to PBR and deserve a special mention. The top on my mind is government control: Unlike many of the U.S. oil stocks we are familiar with such as XOM and CVX, Petrobras is a state-owned company in Brazil. This means the Brazilian government has a significant influence on the company’s operations and strategic direction, which may not always be in the best interest of its shareholders. To compound the issue, Petrobras has been involved in major corruption scandals in the past (and also recent past). While the company has taken steps to improve governance, there’s a risk of future scandals which could damage its reputation and financial performance. Also, compared to its U.S. peers, Petrobras has a higher debt burden (see the next chart below). This can limit its financial flexibility and make it more vulnerable to economic downturns.

To conclude, my verdict is that these risks have been well compensated by its compressed valuation multiples and high dividend yields – which, to reiterate, forms a contrast that borderlines absurdity in my view. Under current conditions, Petrobras stock offers an attractive package combining value, current income, and international exposure to the energy sector. Lastly, I disagree with the consensus estimates of its EPS growth, which are too pessimistic given the catalysts I am seeing. With its single-digit P/E ratio and the market’s pessimistic sentiment, any EPS growth has the potential to trigger an outsized price appreciation.