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.