Instead of repeating the mantra of why investing in this region has a measurably attractive reward to risk profile, valuations are attractive, the underlying economic outlook has more potential to surprise on the upside etc., we would like to take the opportunity here to demonstrate through an example or ‘investment’ thought process (in a Socratic dialogue format).
Q. So, Mr. Believer, if you have such a constructive view on Crude oil prices, how do you want to ‘play’ this thesis given your region in focus? Would you not just buy an oil company? Buy RTSI$ EFT?
A. Very cleverly phrased questions Mr. ETF and for some unsophisticated investors, it might well be the only choice, i.e. buying a Russian ETF or an Oil & Gas company (or ETF), but I believe this is the most obviously WRONG thing to do. I think the most efficient and direct way to ‘play’ this theme is via investing in SBERBANK.
Q. Mr. Believer, Don’t you think that’s just a call on the Russian market? Why not buy a ‘Russian Oil Company’?
A. Tax regimes facing Russian oil companies, by and large, make them less directly sensitive to crude oil prices above US$30/barrel. [Crude price increase from US$30 to US$60 per barrel would possibly result in roughly US$3/barrel of additional EBITDA]. The benefit occurs mostly to the Federal budget [US$30 to US$60/barrel means an additional revenue of US$105bn on an annual basis!] It does not mean that the oil companies don’t benefit, but the benefit is limited (they capture 10% of the move). Essentially, above US$30/barrel, the move in the price of Russian Oil would be ‘market based’ rather than ‘oil based’.
Q. What makes Sberbank a direct beneficiary of the Crude oil price move?
A. Clear understanding of earning drivers (and returns) for Sberbank allows me to understand the ‘direct linkage’ and I do this by:
Q. Can you talk me through the Operating drivers please?
A. Net loans and securities of Sberbank amount to roughly Rub18.1trn and we know that (excluding Jan-Mar of 2015 when the liquidity was extremely tight in the system) Sberbank can comfortably maintain Net Interest Margin of 5% (i.e. monthly revenue of Rub 85bn). With the size of the balance sheet and client base it has, a monthly run rate of net fees and commission of Rub 24-25bn is a very conservative estimate. Adding a low-end estimate of trading income, what is easy to see is an average monthly operating revenue of Rub 115-120bn.
If we assume that the bank will be able to maintain its cost of operations (i.e. cost to income ratio) at about 40% (the budget calls for better performance but we will ignore this), monthly operating profit would amount to Rub 70-72bn, or Rub840-860bn for the year (US$12-12.2bn at current f/x). The operating profit number has low variability under the current economic scenario of ‘tighter’ budgets, low consumer confidence and the sanctions regime.
Q .So far, Mr. Believer, everything is logical, but where is the link to Crude oil price?
A. The link is primarily through asset quality and the cost of risk. Normalised cost of risk for a dominant bank in a commodity dependant country could average around 100-125bp through the cycle given the mix of loan book, loan penetration, collaterals, fiscal and current account balance and overall inflation/interest rate environment. For FY2015, the cost of risk averaged 245bp (RAS accounts) and the budget calls for a range of between 250-300bps based on average crude price of US$35/barrel.
As mentioned earlier, should the crude oil price move up from US$30/barrel to US$60/barrel, the Federal Government collects an additional US$103.4bn per annum while the Russian oil companies generate an additional US$10.2bn per annum to the upstream EBITDA (i.e. roughly a 25% increase). US$103bn is equivalent to 8% of Russian GDP.
So putting this into context, we see potential upward movement in Crude oil price as ‘credit positive’ for the system. With higher oil price, liquidity in the system improves, transfer payments occur in time, suppliers get paid in time, infrastructure development gets funded, crowding-out of the private sector is reduced and discussions about additional taxes to fund the fiscal deficit die down, reducing uncertainty in the corporate sector. It has an impact of improving not only consumer confidence but also encourages corporates to look for investment opportunities. GDP growth outlook which today stands at negative 0.5-1.5% for 2016 changes to positive 1.0-1.5%
Sberbank’s management guidance for the cost of risk is 250bps to 300bps premised on crude oil price average of US$35/barrel for 2016. In absolute terms, this equates to RAS CoR of Rub 420-500bn (i.e. US$6bn to 7bn at current exchange rate).
Essentially, for US$5/barrel average above US$35/barrel, Cost of Risk for Sberbank declines by 25bps, (i.e. Rub 42bn => US$600m higher pretax profit), a 10% lift to pre-tax profit. Comparing this to the oil sector in Russia, a US$5/barrel increase would result in upstream EBITDA increase of US$1.9bn, less than 5% increase on EBITDA level. SBERBANK earnings are twice as sensitive to crude oil price move compared to the upstream crude oil sector in Russia.
Q. So, let me get this straight: Sberbank’s earnings number variation is mostly driven by cost of risk, so what do you think it will take to ‘beat’ the management’s conservative guidance/market expectation?
A. Average Brent price YTD (referring to the last 85 days) is US$34.6/barrel. An assumption of US$40/barrel for FY2016 requires me to believe that crude oil prices can average at about US$41/barrel for the remainder of the year (i.e. about 5% more than current price). This is most likely the bear case scenario in order for me to assume that crude oil can average US$40/barrel, my base case scenario is an average for the year ranging between US$45-50/barrel. At US$40/barrel scenario (the bear case), we are already in the realm of 225bps CoR , i.e. pre-tax profit of Rub450bn+. On our base line scenario for US$45-50/barrel, cost of risk would be 175-200bps resulting in pre-tax profit of Rub500-550bn (post tax number north of Rub 400bn).
Q. This is too long, can you summarise please!
A. Forecasting Sberbank’s operating profit is quite simple and steady and there is very little ‘confusion’ here. The single most important variable driving the profit number for Sberbank is Cost of Risk. Cost of Risk is largely a function of GDP dynamics and Federal Budget. A better outlook on Crude price means better ‘credit dynamics’ for the economy which directly leads to lower cost of risk. Full stop.
é Crude Oil Price = éCredit Dynamics = êCost of Risk = é Profits
Leverage to Crude prices is 2X that of oil companies.
Q. So what am I paying for Sberbank?
A. If you believe in the managements’ budget Crude oil price of US$35/barrel, you are paying 6.7X P/E and price to book of 0.9 for RoE of 14%. If you think we are more reasonable in our estimate, i.e. Crude price near US$45/barrel average at least, then you are paying 5.6X P/E and 0.85X P/BV for 16.7% RoE.