Description

Thesis

The ADR’s  of Argentina based Pampa Energia (PAM), at $14.40 per share, offer a very attractive risk/reward in my opinion.  The opportunity exists because of the tremendously negative sentiment towards Argentinian financial assets. 

Argentina is going through one of its perennial fiscal and balance of payments crises. Capital flight precipitated a major liquidity crisis. The resulting currency run and  recession have led to a greater than 25% contraction in GDP measured in US Dollars. The ensuing popular discontent  ushered the return of a corrupt, populist government during the October 2019 general elections. This further exacerbated investors fears. The “century bond” issued in  2018 (ARGENT 7 â…› 2117), which marked the peak in investor optimism towards Argentina this cycle, is currently trading  at 48 cents on the dollar (up from a November 2019 low of 37), and investors are bracing  for yet another government debt restructuring. 

Pampa stock, which reached a high of  $72 per share in January 2018, declined as low as $12 in September. The consensus price target has declined from $80 per share at the peak to $23 per share.  Nobody, including myself and the company (in my opinion), has any certainty about the near term prospects for the company’s profitability.  But there are reasons to believe that, absent a Venezuela style outcome, the company will survive and thrive under most scenarios. 

Unlike other industry participants, the Company  is well capitalized and can survive the next four years without access to capital markets. Management, which owns 23% of the company, has experience navigating Argentina’s economic and political cycles and is in a liquidity position to take advantage of opportunities.  Management’s actions suggest that the stock is inexpensive. The company has repurchased 16 million ADR’s since 2018, reducing the shares outstanding to 67 million ADR equivalents. The board issued an authorization to buy an additional 5% of the shares in the fourth quarter notwithstanding  the results of the election.  Given adjustment that has occurred in the current account and fiscal balance and the overshooting of the currency, it is likely that the worst is behind for Argentina’s economy. A renegotiation of the government debt will further ease liquidity pressures.  The incoming government will likely be corrupt, incompetent, and will pursue unorthodox, interventionist, economic policies. However, I think that they will want to stay in power. They know from experience that excessive price controls lead to underinvestment which leads to shortages and which lead to popular upheaval. Although energy policy will remain unorthodox and unpredictable, I believe that, like the period from 2012 to 2015, they will provide different mechanisms, such as subsidies, to ensure that the energy sector remains solvent and continues to invest.  I think the impact on Pampa’s profitability has already been overly discounted by the market.  As the economy stabilizes, the government debt is restructured, and the liquidity crunch subsides, I think the stock could  double or triple from current levels. 

Background on Argentina

Argentina’s economy has been in relative decline since the 1940’s due to populist policies and corruption. 

The 1990’s were a period of hope. Peronist president Carlos Menem, under the guidance of Minister Domingo Cavallo,   embarked on a series of free market reforms and privatizations which succeeded in stabilizing inflation and attracting foreign investment.  However, the country was never able to institute the needed structural reforms during the good times.  Debt to GDP and fiscal imbalances grew. The balance of payments deteriorated and the currency became overvalued. The Tequila Crisis (1994), Asian Crisis (1997),  and Russian Crisis (1998), led to a contraction in liquidity for emerging markets.   Argentina lost access to capital markets and defaulted on its debt in 2002. 

From 2002 to 2015 Argetina was governed by  the  populist and  incompetent government of Peronist  Nestor Kirchner and his wife, Cristina Fernandez de Kirchner. Economic policy was unorthodox  and disjointed and corruption was rampant. The use of price controls across the economy eventually led to shortages of food and energy and ultimately precipitated the demise of Kirschner in the 2015 elections.

Hope and foreign capital returned in 2015 with the election Mauricio Macri, a non Peronist reformer committed to orthodox economic policies. The stock market doubled in US Dollar terms. Foreign investor enthusiasm returned enabling  the country to issue a 100-year bond in 2018.  However, President Macri inherited a difficult situation: a 5% current account deficit, a 5% primary fiscal deficit, high inflation, and an overvalued currency. Rather than pursue a drastic adjustment early in his mandate, he tried to pursue a gradual adjustment. In 2018, capital markets saw through these imbalances. Capital flight and  a currency run ensued. The Argentine Peso suffered a maxi devaluation, leading to skyrocketing local currency interest rates (60%+) and a deep recession. 

In October 2019, the Peronists won the general election with a typical Peronist, populist, interventionist  platform.  The new government took over in December 2019. With the Argentina 2117 bond trading at 47 cents, the markets are bracing for another debt default. The Merval Index has dropped over 70% peak to trough in USD terms,  to levels not seen since 2013. The new government has tightened exchange controls to control capital flight. Foreign investor sentiment is very negative, a mirror image of where it was at the end of 2017.  

Pampa Energia Background

Argentina privatized the electric utilities in the 1990’s. The buyers, mainly European utilities, were promised dollar denominated tariffs as an incentive to invest in the nation’s energy infrastructure. In the wake of the 2002 crisis, Argentina, in an effort to control inflation and ease the adjustment, reneged on its promise and froze electricity tariffs. The utilities, which had largely financed their expansion with dollar denominated debt, became practically insolvent. 

Pampa Energia traces its origins to 2005 when Marcelo and Damian Mindlin, two Argentine entrepreneurs, raised money from mainly US and Chilean investors to acquire controlling equity stakes in the quasi bankrupt utilities. They were  betting that the Government policy was unsustainable and electricity rates would ultimately have to rise to incent investment in the sector. I participated in the two investment vehicles that were raised, Dolphin I and Dolphin II. 

Initially, the funds bought a controlling stake in Transener, the electricity transmission monopoly, from National Grid. The second meaningful  acquisition was  Electricite de France’s controlling stake in Edenor, the electricity distribution company in the north of Buenos Aires. Over the following years, the funds acquired electricity generation assets and invested in greenfield electricity generation and natural gas production operations. 

Pampa Energia was the combination  of all these assets under a single holding company, Pampa Energia (PAM), which began trading on the NYSE in 2009 for $12/share. From 2010 to 2018, the company used internally generated cash and money raised from debt and equity issuance  to acquire assets and invest in greenfield electricity generation projects. In 2016, the company completed the opportunistic $1.4 billion acquisition of Petrobras’ assets in Argentina, on the heels of the “lava jato” scandal in Brazil. In January 2018 Pampa’s stock peaked at $72/share giving it a  market capitalization of $6 billion. 

Pampa Energia- Business Summary 

Today Pampa Energia is the largest fully integrated electricity company in Argentina. For a detailed description please read the annual report or 20F form filed with the SEC. 

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Power Generation 

The largest IPP (Independent Power Producer) with 4.8 GW capacity and .5GW of projects under construction: 3 hydro plants, 3 wind farms, 9 thermal plants. 

Accounts for 12% of the country’s electricity generation. 

Generated $420 million of EBITDA from electricity generation in the TTM ended 3Q19. 

Upstream Oil and Gas 

The upstream segment  produces 50 boe per day of mostly natural gas sold to combined cycle plants. 

Generated $192 million of EBITDA from upstream operations in the TTM ended 3Q19.

Electricity Distribution

Owns 52% of Edenor (EDN), the electricity distribution monopoly in northern Buenos Aires,  which has 3.1 million end users and sells 20TWh of electricity. 

Generated $141 million of EBITDA from electricity distribution. 

Power Transmission

Owns 26.3% of Transener (TRAN AR) which owns 20,933 km of transmission lines and accounts for 85% of electricity transmission in the country. 

Gas Transportation and Midstream

Owns 25.7% of Transportadora de Gas del Sur (TGS) which owns 9,231 km of natural gas transportation pipelines and produces 1 million tons of NGL’s annually. 

Other assets and  holding company expenses

The company has other divisions such as Petrochemicals (styrene, styrene rubber, and polystyrene) and Refinor (24.8kbpd of refining capacity and 90 gas stations), but the cash generation from these assets merely offsets holding company expenses.

See below from Pampa’s December 2019 corporate presentation: 

Capitalization 

As of 3Q19 Pampa Energia had $491 million of minority interest. I have adjusted minority interest used in the EV calculation  to $121 million. The minority interest related to the 48% minority ownership of Edenor (EDN). Edenor (EDN) has a current  market capitalization of $253 million. 

Thoughts on Valuation 

As of 3Q19, Pampa Energia’s consolidated trailing twelve month EBITDA was $627 million. Additionally, it owns stakes in  two publicly traded unconsolidated affiliates reported under the equity method. Transener (TRAN AR)  is 26% owned by Pampa and  had a TTM EBITDA of $141 million. Transportadora de Gas del Sur (TGS) is 26% owned by Pampa and had a TTM EBITDA of $379 million. The combined market value of these stakes today is $350 million. 

If one adjusts the enterprise value of Pampa Energia for the market value of its  unconsolidated subs  ($2,510 million enterprise value - $350 million market value of unconsolidated subs) one arrives at an adjusted adjusted enterprise value $2,160. Based on a TTM consolidated EBITDA of $679 million, the company is trading at an EV/EBITDA of 3.4x. 

A normalized EBITDA multiple, based on the company’s trading history and regional comparables,  would be 7-8 times EBITDA. Such a multiple would yield a market capitalization of $2.9 to $3.5 billion versus $1 billion today.  I am not suggesting that this is where the stock should trade today. I am suggesting that this is where it is likely to trade when liquidity conditions in Argentina normalize. 

Note that I am not applying a holding company discount to the value of the stakes at TGS and Transener, but bear in mind that these stocks are as equally depressed as Pampa. 

Estimating Normalized EBITDA

The biggest challenge to an investment in Pampa is that it is impossible to estimate the future profitability with any degree of certainty. At the beginning of 2018, the consensus  EBITDA estimate for 2020 was $1.7 billion. That estimate has since declined to $750 million, roughly in line with TTM consolidated EBITDA.  The range of estimates highlights the uncertainty. The lowest estimate today is $412 million, and the highest estimate is $1 billion.

The biggest source of uncertainty is prices in dollars which are determined by two factors, regulation and the foreign exchange rate. The regulatory environment in Argentina is always uncertain because the Government does not honor contracts and,  in times of economic stress, forces the utility sector to reduce prices to help control inflation. 

Even under the last year of the Macri presidency natural gas prices were frozen. The  environment has become even more uncertain with the incoming Fernandez administration.  The new administration has yet to say anything about its energy policy. But, it is clear to all market participants that they will not honor contracts. Nobody, not even the company, knows what the government will do. Additionally, there is uncertainty about other factors such as the level of inflation which impacts costs  and the level of the exchange rate which impacts the translation of Peso tariffs into US dollar revenues. 

Electricity prices are the biggest driver of Pampa’s profitability because power generation accounts for 66% of Pampa’s consolidated EBITDA. Of  Pampa’s power generation, 40% is “new energy” and 60% is “legacy energy.” “New energy” tariffs are governed by contractual PPA’s in US dollars and, in theory, should not be affected by the change in government. “Legacy energy” is remunerated under Resolution 1/19 which gives a lot of leeway to the regulator to determine the inflation adjustments. Nobody  knows how the new administration will remunerate “legacy energy” and many market participants expect the new administration to violate the terms of PPA agreements. For a detailed explanation of the regulatory framework for electricity in Argentina, I suggest reading pages 30 to 53 of the 2018 annual report. 

I have experimented with different scenarios using different inputs, and have concluded that modelling is not particularly helpful in reaching an investment conclusion. My conclusion is that nobody knows what what EBITDA will be in 2020 and 2021, but I believe that the final number will fall in between the range of analysts estimates, somewhere around $500 million and $700 million.   

Rationale for Recommending Pampa Given Tremendous Uncertainty

I acknowledge that it is difficult to defend the case for investing in Pampa Energia stock when I have no idea what profitability will be. Below I list the reasons why an investment in Pampa stock makes sense: 

Management  

Management is savvy and competent. They own 23% of the company, and their interests are broadly aligned with investors. Management has created value in the past. One can criticize this management for overpaying itself with options, but  one cannot criticize management for failing to create value for shareholders. They are good operators, and they are smart allocators of capital. Investors in the original Dolphin vehicles did very well and were treated fairly. Management saw the political risk early  and raised $1 billion of debt when the markets were open. They have since used over $500 million to repurchase $84 million of debt and have reduced the share count from 83 million to 67 million ADR’s. In October, the board authorized an additional $50 million dollar share repurchase. 

The liquidity position is healthy and will enable the company to survive the crisis 

The company has a net debt/EBITDA ratio of 1.9x and $584 million in cash as of 3Q19. It  does not have any meaningful maturities until 2023. Additionally, management wisely decided to curtail new investments since 2018. In 2019, the company will complete the majority of  the 471 MW it has under construction. As a result,  consolidated capex should decline from a TTM level of $698 million to $220 to 250 million in 2020. This will enable the company to survive a reduction in EBITDA.  

The rest of the sector is more levered

The fact that other players in the sector have greater liquidity concerns favors Pampa, in my opinion. The market is already assuming that regulators will lean on the energy sector to help mitigate inflation, but I think the government understands that driving the weaker players to bankruptcy with aggressive price control policies will be counterproductive and will disinsent investment. If anything,  Pampa could be a logical buyer of assets from distressed players. 

The government will not shoot itself in the foot

The government realizes that in order to reactivate the economy, it will need to  incent investment, especially in the energy sector. I believe that they will act more rationally than what the market is expecting.

I believe the worst of the economic contraction is behind us 

The economy has contracted over 25% when measured in US dollars. The current account deficit has gone from 5% to zero. And, the primary fiscal deficit has gone from 5% to 1%. The currency has overshot in real terms.  It is likely that the worst is behind for Argentina’s economy, and renegotiation of the government debt in 1H20 will further ease liquidity pressures. 

Risks 

Political risk 

There is always a risk of outright expropriation, as occurred in Venezuela, or of economic expropriation via aggressive price controls. I think that the risk of expropriation is very, very low.  Although hard to believe for outsiders, I believe that the Argentine legal system still affords some rights to equity owners. I also think that the corporate sector in Argentina can collectively exert a lot of pressure on the government. The government needs the private sector to invest in order to reactivate the economy. If the worst case scenario unfolds,  I think it would take years to occur. 

Mark to market risk 

I think the biggest risk to investing in this stock is mark to market risk. Headlines will not be pretty. There will be a lot of public confrontation between the government and the energy sector in the next six months. Earnings will also be a headwind because they will decline in 2020 but we do not know by how much. Earnings could surprise on the downside. 

Catalyst

Reprofiling of Argentina sovereign debt in 2020

Economic recovery in Argentina in 2020