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Petrobras: Is There Value After the Oil Stock Rout?

It’s been a rough run for Brazilian state-controlled oil giant Petrobras (PBR).  The stock has been in almost continuous decline since late 2009 and its U.S.-traded ADR has lost nearly two-thirds of its value since July.

This is a stock that was trading at over $70 per share in mid-2008. It now trades for barely one tenth of that value; the Petrobras ADR now trades at 2004 prices. It’s as if the massive mid-2000s bull market in Brazil and the rest of the emerging markets never happened.

So, what’s the story here? Why are investors giving Petrobras such a thorough thrashing?

It’s a long list, but I’ll start with the most pressing. Petrobras is engulfed in a nasty corruption probe that alleges the company systematically overpaid for assets and labor and that the proceeds were used by the government to give kickbacks to prominent politicians in exchange for votes. It’s so bad that Petrobras had to delay its third quarter earnings release  because its auditors refused to approve them.

This brings me to the second reason for Petrobras fall from grace: Dilma.  Brazilian President Dilma Rousseff is…ahem…not known for being friendly to business. Much of the  massive bull run in Brazilian stocks during the first half of the year was based on the believe that Dilma would lose reelection. And most of the brutal bear market that has endured since has been a result of her expected (and realized) reelection. Dilma herself has not been personally implicated in the kickback scandal…though dozens of congressmen from her party have. Dilma’s real damage is not due to corruption, however, but her preference for using the company as an instrument of the state.

Rather than allow Petrobras to be run like a normal, for-profit business, she has used it as a social policy tool. A cynic might say she forced Petrobras to keep retail gasoline prices low as a way of buying votes for reelection. (And yes, count me as a cynic in this case.)  Unfortunately for Petrobras shareholders, politics trump economics.

With profitability crimped by price controls, Petrobras has had to borrow heavily in order to fund capital expenditures. Petrobras is the most heavily indebted energy company in the world, with $106 billion in long-term debt. To put that in perspective, ExxonMobil (XOM)—which is eight times larger than Petrobras by market cap and three times bigger in terms of annual revenues—has only $12 billion in long-term debt.

And finally, while Brazil is now a major energy player, its largest reserves are located in deepwater fields that are expensive to exploit. One estimate puts the breakeven price for Brazil’s offshore fields at above $120 per barrel.  With the price of crude now hovering at about half that price, Petrobras’ greatest assets are essentially unexploitable.

Political corruption…a president that views the company as a piggy bank for social policies…a high debt burden…and massive quantities of oil that are too expensive to exploit at current market prices… No wonder investors have dumped Petrobras. But is the selling overdone?

At current prices, Petrobras trades for just 6 times expected 2014 earnings and 4 times expected 2015 earnings. It also trades for an almost pitiful 0.37 times book value and 0.41 times sales.

Any way you slice it, Petrobras is cheap. But if the last several years in Brazilian stocks has proven anything, it would be that cheap stocks can always get cheaper. Right now, Petrbras is a proverbial falling knife that I wouldn’t recommend you try catching with a large purchase just yet. Though I would recommend you consider averaging into the stock slowly over the next several months.

Petrobras is a stock that can move fast. It doubled in value between March and September of this year…before giving up all of those gains and more in the selloff. Buying it today, at decade lows, would likely be a fantastic entry point for a 3-5-year investment time horizon. Just expect it to be a wild ride in the meantime.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

 

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Big Tobacco Launches a “Safer” Cigarette. It Won’t Stem the Decline

You have to hand it to Big Tobacco.  As an industry, it’s a survivor.  It’s doing everything it can to reinvent itself in a world in which its core product—cigarettes—becomes more of a social pariah with every passing year.  Let’s take a look at what Big Tobacco is up to and what it might mean for investors in Big Tobacco stocks.

Reynolds American (RAI) made headlines this week by announcing the planned launch of the Revo, a “safe” cigarette that heats tobacco rather than burning it. Philip Morris International (PM) has a similar product in the works for sale overseas, which I highlighted earlier this year.

Yogi Berra, the Hall-of-Fame  New York Yankee catcher, might have called this a case of déjà vu all over again. Reynolds American launched a similar product two decades ago, but it never amounted to much. (Yogi Berra, incidentally, was once a celebrity endorser of Camel cigarettes, a Reynolds American brand.)

E-cigarettes work in roughly the same way. Tobacco is heated rather than burned, and the smoker inhales a relatively harmless nicotine-infused vapor rather than a cloud of carcinogenic smoke. The benefit of the Revo is that it looks and feels more like a real cigarette than its electronic competitors do. And while it’s far too early to be breaking down profitability, I think it’s safe to say that Revo is a better profit model for Big Tobacco. Revo is a real, branded cigarette sold in a pack that can be sold at a premium, not a generic bottle of refill fluid.

I’ve been skeptical of e-cigarettes for a long time. Yes, they could relight Big Tobacco’s prospects. But they are just as likely to speed the decline of traditional cigarettes, and Big Tobacco has no durable competitive advantage in the e-cigarette marketing free-for-all.

So, are Revo and its competitors the answer for Big Tobacco?

Not so fast.  One of the reasons that Revo’s predecessor failed was that multiple states sued Reynolds American for claiming that it was less harmful than a traditional cigarette.  Those claims were unsubstantiated by real studies. So, Reynolds will have to be careful in how it markets Revo this time around the wrath of regulators.  But neutering the marketing will make it a lot harder to build a following among smokers.

In a best case scenario, Revo might steal a little market share from traditional cigarettes and slow down the long-term decline of the industry.  But that is the best case, and even under this scenario Big Tobacco volume sales would continue to decline.  The more likely scenario is that Revo is a marketing flop that is forgotten in a year or two.

From the tone of this article, you might think that I’m a dyed-in-the-wool Big Tobacco bear. Nothing could be further from the truth. At the right price, industries in terminal decline can be great investments if management focuses on returning value to shareholders via dividends and buybacks. But the key is “at the right price.”  And right now, Big Tobacco stocks are expensive.

Reynolds American trades for 21.5 times trailing 12-month earnings…and at a cyclically-adjusted price/earnings ratio (the “CAPE” or “Shiller P/E”) of 26.0 times earnings.  The numbers for domestic rival Altria (MO)  are 22.5 and 24.3, respectively.  As a point of reference, the S&P 500 trades at 20.0 times trailing earnings and 26.6 times CAPE—a valuation that is 60.2% above its long-term average.

In other words, U.S. stocks are very expensive by historical standards, and Big Tobacco stocks are only a hair cheaper that the broader market.  And again, this is an industry in terminal decline—which should be trading at a substantial discount to the market average.

In the interests of full disclosure, I have very small positions in Altria and Philip Morris International that I have held for years in a long-term dividend reinvestment portfolio.  But I’m not adding any new funds to either, and I recommend steering clear of Big Tobacco at current prices.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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Can Big Beer Buy Its Way Into the Craft Beer Boom?

If you can’t beat ‘em…buy ‘em out.  That’s the approach Big Beer is taking in combatting the rise of microbrewing.  Anheuser-Busch InBev (BUD) announced last week it would be buying 10 Barrel Brewing Co., a microbrewery based on Bend, Oregon.  This follows BUD’s move earlier this year to buy Blue Point Brewing Co.

It’s easy enough to see BUD’s rationale.  Americans are drinking less beer than they used to, though they’re trading up in the craft beer they do buy. While total beer sales were down 2% last year, craft beer sales rose 17%.

Will this strategy work for Big Beer?

Let me answer that question with a question of my own.

Do you remember Killian’s Irish Red?  I used to love that beer.  It was a trendy craft brew about 20 years ago…before any of us had ever heard the term “craft brew.”

You never really see Killian’s any more.  When drinking independent craft brews became the defining image of hipsterism (well, that and growing a luxuriant beard), Killian’s association with Molson Coors (TAP) made it distinctly unhip. The brand has slid into irrelevance.

And then there is my favorite go-to beer: the Spoetzl Brewery’s Shiner Bock.  In the late 1990s, no self-respecting college boy in Texas would be seen drinking Bud Light.  It was Shiner Bock or nothing. (Ok, so maybe I went to a snobby school—TCU.  I can’t speak for the unwashed masses at Texas A&M or Tech.)

The popularly of Shiner led to imitations—most notably BUD’s Ziegenbock, marketed as “for Texans by Texans.”

Ziegenbock isn’t a bad beer.  But it’s always been seen as a cheap imitation…and that is marketing death when marketing an upscale product.

This brings me back to the problem facing Big Beer.  BUD, TAP and SABMiller (SBMRY) can compete based on quality and variety.  Hiring new brewmasters  and letting them experiment like mad scientists could easily create beers that rival Boston Beer (SAM), Spoetzl and the legions of brewpub startups across America.

The problem is one of marketing and—to a lesser extent—economies of scale.  Craft beer has become a luxury good subject to the changing whims of fashion, and brand reputations are fragile. When your brand is associated with the common proles, it loses its cachet and it’s hard to convince the fashionable to pay up for them.  And this doesn’t just apply to blue-blooded patricians. The bearded hipster wearing “vintage” clothes from a thrift store can’t be seen drinking a Bud Lite either.  It violates their anti-establishment ethos.

Another issue is economies of scale.  The beauty of Big Beer operations is their massive and efficient production and distribution.  But this goes completely out the window when you buy a locally-produced microbrew.  Mass producing it and selling it nationally—or globally—kills the “buy it local” vibe that made it popular to begin with.  But keeping it local neutralizes Big Beers marketing and distribution power.

Could BUD and the rest of Big Beer take a play out of Warren Buffett’s book; buying a company outright but leaving its management in place and maintaining a low profile? Maybe.  But it’s hard to see regional microbrews having much of an impact on the bottom lines of companies with tens of billions in annual sales.

So, what are investors to do here?  From the tone of this article, you might think I was a Big-Beer bear.  Nothing could be further from the truth.  I’m actually a major long-term bull in Big Beer because of its exposure to emerging markets.  As I wrote in July, BUD gets about half its sales in Latin America, while SABMiller and Heineken (HEINY) get a disproportionate amount of their revenues from emerging Africa.

This year, exposure to emerging markets has been a major negative, particularly since the dollar began to aggressively rise late this past summer.  But if you believe, as I do, that emerging markets represent the better long-term bet, then Big Beer remains one of best long-term investments to make on any significant pullbacks.

Disclosures: Long HEINY.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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The Death of the iPad?

Apple (AAPL) knocked the ball out of the park in this week’s earnings release, boosting quarterly revenues by 12% and earnings per share by 20%.  And these numbers included less than three weeks’ worth of iPhone 6 sales. (The iPhone 6 and iPhone 6 Plus were only released on September 9.)  Gross margins actually expanded a little, from 37% to 38%, proving that Apple remains—at least thus far—immune from price competition.  With the momentum from the phone launch still building, I expect Apple to finish calendar year 2014 with a bang.

Investors in Apple stock have a lot to celebrate right now.  But iPad sales are distinctly not one of them.  iPad sales actually fell during the quarter from 13.1 million to 12.3% million.

Of course, some of this weakness is due to would-be tablet buyers sitting on their wallets until the latest-generation models came available early this quarter, and were this an isolated incident I would be tempted to leave it at that.  Unfortunately, it’s not.  iPad sales have been consistently weaker than expected for most of 2014.

What gives?  Are we witnessing the death of the iPad?

Yes.  Or more accurately, “sort of.”

I’ll start with the most obvious point.  Apple made a strategic decision to cannibalize its own business with the IPhone 6 Plus.  The larger-screen phone makes a tablet redundant;  an iPad becomes a larger version of your phone except without the ability to make regular voice calls.  I consider this the right decision, as it makes the iPhone—Apple’s biggest moneymaker— more competitive with larger-screen Android devices.  Forgone iPad sales are acceptable collateral damage in the far more important smartphone war.

But iPad sales had started to decelerate long before the iPhone 6 Plus was released, and the story is a little more complex than that.  What I see happening to iPads—and to tablets in general—is what happened to PCs starting around 2012.

Two years after the 2010 launch of the Apple iPad, PCs sales actually went into year-over-year decline, and have continued their decline until now.  The most recent sales data shows PC sales as flat this year rather than down, but the fact remains that the tablet radically changed the PC market.  The upgrade cycle got stretched, as consumers made do with their older desktops and laptops a little longer and diverted the funds they would have used to upgrade to a tablet instead.  And in some cases—particularly in the lower-end consumer market—buyers ditched their PCs altogether, as a tablet was more than sufficient for their modest computing needs at home, such as reading books and emails and checking Facebook.

Moving forward to 2014, we see similar dynamics at play.  Consumer Intelligence Research Partners finds that American iPad buyers tend to hold on to their tablets for 2-4 years between upgrades.  The lifespan of an iPhone is shorter, at 2 years or less.  (On a side note, my smartphones tend to have a life of about 12-15 months; I’m a heavy user, and I have two rambunctious young boys in the house that have a talent for finding new and exciting ways to break them.)

Frankly, iPads don’t change that much from generation to generation, or at least in ways that would persuade a user to upgrade.  Processing power and networking speed is fast enough at this point to last you a few years.

What does this mean for the Apple iPad and for tablets in general?

Let’s look at the PC market for clues.  The PC is not “dead” by any stretch.  I sit in front of one for at least nine hours per day, as do most professionals, and that won’t be changing any time soon.  But I’m not buying a new one any time soon; I might use a given PC for 4-5 years between upgrades.   That’s where most iPad users are today.  They use their iPad regularly but there is no compelling reason to upgrade, particularly if you already have a new phone.  That’s a recipe for slow growth.

The good news for Apple stock is that it really doesn’t matter.  I have argued for years that Microsoft (MSFT) was an attractive stock even in the face of declining PC sales because of its cheap price, its strength in its other business lines, its solid balance sheet and its ability (and willingness) to aggressively raise its dividend.

Today, Apple is in the same position.  As I reasoned in “Why Carl Icahn is (Kinda) right about Apple Stock,” Apple stock is being priced by Wall Street as a no-growth company.  But its balance sheet is a fortress, it is aggressively raising its dividend and repurchasing its stock, and its other product lines outside of the iPad are stronger than ever.

Disclosures: Long AAPL in Dividend Growth Portfolio

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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What Does Larry Ellison’s Departure Mean for Oracle?

Larry Ellison, founder and long-time chief executive of Oracle (ORCL), took the financial media by surprise yesterday by stepping down as CEO.  He will be replaced by current co-presidents Mark Hurd and Safra Catz, who will serve as co-CEOs.

I had always expected Ellison to be the kind of CEO that would die in the saddle with his boots on.  He has a well-deserved reputation as a control freak, and his stewardship of Oracle has made him the world’s fifth wealthiest person.  He also has one of those larger-than-life personalities that could have been the inspiration for a James Bond movie villain.  He owns the Hawaiian island of Lanai, for crying out loud, and owns a yacht nearly the length of a football field.  And though it has never been confirmed, I fully believe that somewhere, on one of his properties scattered across the globe, he has a tank full of sharks with frickin’ lazer beams attached to their heads.

A man like that doesn’t’ quietly go into retirement, and indeed Ellison has indicated that he plans to retain the title of Chief Technology Officer in additional to serving as executive chairman.  But at age 70, he is finally willing to share some of the day-to-day management.

What does any of this mean for Oracle stock?

It means more of the status quo.  Hurd and Catz are very capable executives, but neither are transformational figures.  And both will be operating with Ellison’s rather long shadow over them for the foreseeable future.

Oracle also faces competitors on all fronts in its database and cloud businesses, from established heavyweights like IBM (IBM), SAP (SAP) and Microsoft (MSFT) to relative upstarts like Salesforce.com (CRM).  It’s a brutally competitive market, and with corporate spending in deep freeze for most of the past five years, growth has been hard to come by.

That said, slow revenue growth has been an issue for the S&P 500 as a whole, so Oracle’s problems are hardly unique.  And Oracle stock is reasonably attractive at current prices.  Oracle trades for 17 times trailing earnings and just 11 times expected forward earnings.

Oracle-shares-outstanding

Oracle has also been a heavy buyer of its own stock (see chart), and like the rest of Big Tech has become a reliable dividend payer.  Since initiating a quarterly dividend of 5 cents a shares in 2009, Oracle has more than doubled the payout to 12 cents.

Wall Street did not react well to yesterday’s announcement—or to Oracle’s uninspiring earnings release—and Oracle’s stock price is down about 5% today.  But at current prices, there is a lot of pessimism built into to the stock price.  At these prices, Oracle can deliver lukewarm results for the next several quarters running and still likely match the S&P 500’s returns.  And if maybe—just maybe—Oracle’s cloud initiatives finally start to gain steam, the Oracle stock could enjoy a nice 20%-25% rally.

Disclosures: Long MSFT

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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