Assessed Blog 2 - Petrobras: Riding the pipeline of Capital Structure to Value Destruction

‘Capital structure’ is an element of Corporate Finance which receives less glamourous recognition in today’s mainstream media; it may not necessarily attract mutual readers in with discussions of colossal acquisitions, or mouth-watering dividend pay-outs. However, the capital structuring of an organisation is, undeniably, a fundamental aspect which contributes towards a company’s – and ultimately its shareholders – success (Myers, 1984).

This blog will try to present the importance of capital structuring through presenting oil “galactico”, Petrobras.

Petrobras is a semi-public Brazilian multinational energy company which was once the guiding light and shining hope in Brazil’s developing economy, but in its current state, analysts suggest the company should be one of the most fearful for its future in this time of deflating global oil prices.

Now, in theory, there are potential advantages to a company being part-owned by a government: they benefit from government surpluses to run sound business projects; they enjoy financial autonomy; profits are utilised for further expansion activities; government facilitates development by taking up projects where private sectors hesitate to invest (Chang, 2007). Unfortunately for Petrobras, some of these “advantages” have been corrupted and ultimately left the company in a fragile state. The key underlying issue which can be linked to Petrobras’ fragility is the company’s unsustainable capital structuring.

It must be remembered that Petrobras has an abundance of investors (shareholders) on the New York Stock Exchange and Sao Paolo Stock Exchange who have a very legitimate stake in the company’s financial performance. But this stake is apparently being diminished by the overbearing Brazilian government and consequently destroying value creation throughout the organisation.

The government’s heavy influence in Petrobras’ operations has possibly led to less incentive for producing profits and less incentive to improve long-term value as government agencies are incentivised to spend entire budgets and grow larger, allowing them to acquire more power and bigger budgets for next year. Petrobras spent a relatively similar amount on capital expenditures ($135bn) between 2011 and 2014 as the public Supermajor companies. However, in the same time period, the company’s debt has grown from $70bn to $140bn whilst their EDITDA ratio has deterred from 31% to 22% (Forbes, 2015). It has been argued Petrobras is being used more as a political tool, rather than a value creating company (Livsey and Armstrong, 2015) and this has led to some directors – who are also government officials – driving overly-ambitious projects in Brazil’s coast which have required more and more debt financing.

Debt financing is widely accpeted as cheaper than using equity through its ability to lower the required rate of return, and simultaneously lowering the WACC of a company (Lee, 1996). Although, there can be a tipping point at which it endangers a company’s sustainable competitiveness and value creation (Myers, 1984), and with the anti-inflation of oil prices impacting the industry, Petrobras have been left exposed to dangerous repercussions. The company could not generate enough cash flow to cover its financing when the price of oil was at $90 per barrel, if this price continues to drop Petrobras will retrench further. Credit ratings firm, Moody’s, recently stripped Petrobras of its investment grade rating (Forbes, 2015), highlighting that shareholder value has been damaged over recent years, this aligns with diving share price at the company (Figure 1).

Figure 1: Petrobras share price: 2011-2014

 

Source: www.nasdaq.com (2015)

It is clear that a poor managerial approach to capital structuring has placed Petrobras in this dangerous position. This case provides a stance that shareholders are indeed an invaluable aspect of an organisation which can drive success. It could be argued that if shareholders (investment funds etc.) had a greater stake in Petrobras over the Brazilian government, their desire for value creation may have awoken the company earlier to these very serious capital structure issues.

The Brazilian government may have to face a harsh reality: it will have to either sell a portion of its assets to direct competitors or raise finance through equity, and therefore risk losing its controlling stake in the company.

Assessed Blog 1 - Shareholder wealth vs Stakeholders: Business’ Biggest Battle

Shareholder wealth vs Stakeholder legitimacy

The age old theory surrounding a corporation’s primary financial objective dictates that a company must only use its resources and engage in activities designed to increase its profits, so long as it engages in open and free competition without deception or fraud. This notion was initially proposed by Adam Smith in 1776, but has since been advocated and developed by numerous scholars - most noticeable of its enthusiasts being Milton Friedman (1970). This concept has been widely accepted amongst Anglo-American organisations, and various organisations operating in free-enterprise and private-property social systems.

However, as time has progressed, the pluralism of western societies has increased and technology has advanced substantially; consequently the power and legitimacy held by numerous stakeholder groups within the business environment has grown exponentially. Many academics have noted the amplified scrutiny society places on corporate social behaviour and the ease of exploiting any controversial business activity via limitless media outlets (Coleman et al., 2010; Freeman, 2004; Magness, 2008).

Tax avoidance

Corporation tax avoidance has become one of the more heavily scrutinised business practices within the media, especially amongst Anglo-American companies within western societies (e.g UK and USA). With the aim of maximising shareholder wealth, a multinational company may use the management of tax payments as one strategic manoeuvre of controlling and minimising the firm’s financial outgoings.

This could be achieved through the strategic structuring of an organisation. Apple Inc. is one of the (more than few) companies which have been heavily scrutinised for such organisational structuring. For example, an offshore subsidiary of the company (Apple Operations International) “which from 2009 to 2012 reported a net income of $30bn, but declined to declare any tax residence, filed no corporation income tax return and paid no corporate income taxes to any national government for five years” (Peston, 2013). Another Apple partner, conveniently based in low-tax Ireland, Apple Sales International, purchases Apple’s finished products from a manufacturer in China and then re-sells them “at a substantial markup” to other parts of Apple’s territory. This Irish-based subsidiary generated around $74bn in profits but may have paid little income taxes to any national government on the bulk of those funds.

According to Friedman’s (1970) proposal, Apple’s approach is perfectly fine, and perhaps a great strategic move. The company’s tactic has acted within the confines of the law – although one or two loopholes may have been discovered along the way – and has evidently provided the company with maximised profits which can ultimately be utilised to improve shareholder wealth through various methods (improved dividend payments, reinvestment into company expansion etc.). Apple have merely utilised ‘Taxation Treaties’ which have set up between countries and enabled corporations to only be taxed in one of those countries used during the strategic process. Apple have clearly been rather astute in their tax management and subsequently reduced their potential tax payments significantly, allowing for maximised net profits, which is a statistic many (if not all) of their investors will love.

However, on the other side of this discussion’s spectrum, Freeman’s Stakeholder Theory (2004) argues that a company’s responsibility must consider all of its key stakeholders (Figure 1). Although tax avoidance can be viewed to have great benefits for some of the stakeholders shown in Figure 1 (e.g. financers, employees, customers), this behaviour could arguably have some detrimental implications for other stakeholders.

Figure 1: Stakeholder Approach: Core Stakeholders of a Firm

Source: Freeman, Harrison & Wicks, 2007, cited in Beauchamp et al., 2009: 61

Firstly, it is clearly evident that governments are being controversially snubbed of corporate tax payments, which plays a significant role in government/federal income. For example, in the US, corporate tax generated 32.1% of all federal taxes in 1952. Today the proportion has fallen to around 9% (Kocieniewski, 2011; Peston, 2013). Part of that monumental decrease could be down to external factors influencing different tax category increases (imports, income and wealth, social contribtions etc.), however the 9% figure still reflects the US system is achieving poor figures from corporation tax (Kocieniewski, 2011).

These findings remain consistent with a broad trend of multinationals paying a much smaller proportion of public sector costs in all the world’s developed economies. Considering this is a time when government debt within many western countries is intensifying, it seems unfair that big multinational companies are not fairly contributing towards optimally repairing damaged economies.

Of course, it is not just Apple who have been scrutinised for their ability to find loopholes within tax payment regulations. Other high profile accusations of similar behaviour have been made about Google, Amazon and Starbucks, just to name a few. If this behaviour continues, and governments fail to implement efficient and agile regulations which can counteract unethical tax avoidance strategies from multinational corporations, it could erode the infrastructure of the global economy which once allowed these companies to thrive. The implications of this could ultimately be detrimental to all shareholders and stakeholders involved.