A coming out party for the world's most valuable company: Aramco's long awaited IPO!
Aramco: History and Set Up
Aramco’s beginnings trace back to 1933, when Standard Oil of California discovered oil in the desert sands of Saudi Arabia. Shortly thereafter, Texaco and Chevron formed the Arabian American Oil Company (Aramco) to develop oil fields in the country and the company also built the Trans-Arabian pipeline to deliver oil to the Mediterranean Sea. In 1960, the oil producing countries, then primarily concentrated in the Middle East, created OPEC and in the early 1970s, the price of oil rose rapidly, almost quadrupling in 1973. The Saudi Government which had been gradually buying Aramco’s assets, nationalized the company in 1980 and effectively gave it full power over all Saudi reserves and production. The company was renamed Saudi Aramco in 1988.
The numbers that are laid out in the annual report are impressive, painting a picture of the most profitable company in the world, with almost unassailable competitive advantages, investors need to be clear that even after its listing, Aramco will not be a conventional company, and in fact, it will never be one. The reason is simple. Saudi Arabia is one of the wealthier countries in the world, on a per capital basis, and one of the 20 largest economies, in terms of GDP, but it derives almost 80% of that GDP from oil. Thus, a company that controls those oil spigots is a stand in for the entire country, and over the last few decades, it should not surprise you to learn that the Saudi budget has been largely dependent on the cash flows it collects from Aramco, in royalties and taxes, and that Aramco has also invested extensively in social service projects all over the country. The overlap between company and country becomes even trickier when you bring in the Saudi royal family, and its close to absolute control of the country, which also means that Aramco’s fortunes are tied to the royal family’s fortunes. It is true that there will still be oil under the ground, even if there is a change in regime in Saudi Arabia, but the terms laid out in the prospectus reflect the royal family’s promises and may very well be revisited if control changed. Should this overlap between company, country and family have an effect on how you view Aramco? I don’t see how it cannot and it will play out in many dimensions:
- Corporate governance: After the IPO, the company will have all the trappings of a publicly traded company, from a board of directors to annual meetings to the rituals of financial disclosure. These formalities, though, should not obscure the fact that there is no way that this company can or ever will be controlled by shareholders. The Saudi government is open about this, stating in its prospectus that “the Government will continue to own a controlling interest in the Company after the Offering and will be able to control matters requiring shareholder approval. The Government will have veto power with respect to any shareholder action or approval requiring a majority vote, except where it is required by relevant rules for the government.” While one reason is that the majority control will remain with the government, it is that it would be difficult to visualize and perhaps to dangerous to even consider allowing a company that is a proxy for the country to be exposed to corporate control costs. After all, a hostile acquisition of the company would then be the equivalent of an invasion of the country. The bottom line is that if you invest in Aramco, you should recognize that you are more capital provider than shareholder and that you will have little or no say in corporate decision making.
- Country risk: Aramco has a few holdings and joint ventures outside Saudi Arabia, but this company is not only almost entirely dependent on Saudi Arabia but its corporate mission will keep it so. Put differently, a conventional oil company that finds itself overdependent on a specific country for its production can try to reduce this risk by exploring for oil or buying reserves in other countries, but Aramco will be limited in doing this, because of its national status.
- Political risk: For decades, the Middle East has had more than its fair share of turmoil, terrorism and war, and while Saudi Arabia has been a relatively untouched part, it too is being drawn into the problem. The drone attack on its facilities in Shaybah in August 2019, which not only caused a 54% reduction in oil production, but also cost billions of dollars to the company was just a reminder of how difficult it is to try to be oasis. On an even larger scale, the last decade has seen regime changes in many countries in the Middle East, with some occurring in countries, where the ruling class was viewed as insulated. The Saudi political order seems settled for the moment, with the royal family firmly in control, but that too can change, and quickly.
Before we price and value Aramco, there are a few twists to this IPO that should be clarified, since they may affect how much you are willing to pay. The prospectus, filed on November 10, sheds some light:
- Dividends: In the ending on September 30, 2019, Aramco paid out an ordinary dividend of $13.4 billion, entirely to the Saudi Government, and it plans to pay an additional interim dividend of at least $9.5 billion to the government, prior to the offering. The company commits to paying at least $75 billion in dividends in 2020, with holders of shares issued in the IPO getting their share, and to maintaining these dividends through 2024. Beyond 2024, dividends will revert back to their normal discretionary status, with the board of directors determining the appropriate amount. As an aside, the dividends to non-government shareholders will be paid in Saudi Riyal and to the government in US dollars.
- IPO Proceeds: The prospectus does not specify how many shares will be offered in the initial offering, but it is not expected to be more than a couple of percent of the company. None of the proceeds from the IPO will remain in Aramco. The government will redirect the proceeds elsewhere, in pursuit of its policy of making Saudi Arabia into an economy less dependent on oil.
- Trading constraints: Once the offering is complete, the shares will be listed on the Saudi stock exchange and its size will make it the dominant listing overnight, while also subjecting it to the trading restrictions of the exchange, including a limit of a 10% movement in the stock price in a day; trading will be stopped if it hits this limit.
- Inducements for Saudi domestic investors: In an attempt to get more domestic investors to hold the stock, the Saudi government will give one bonus share, for every ten shares bought and held for six months, by a Saudi investor, with a cap at a hundred bonus shares.
- Royalties & Taxes: In my view, it is this detail that has been responsible for the delay in the IPO process and it is easy to see why. For all of its life, Aramco has been the cash machine that keeps Saudi Arabia running, and the cash flows extracted from the company, whether they were titled royalties, taxes or dividends, were driven by Saudi budget considerations, rather than corporate interests. Investors were wary of buying into a company, where the tax rate and the royalties were fuzzy or unspecified and the prospectus lays out the following. First, the corporate tax rate will be 20% on downstream taxable income, though tax rates on different income streams can be different. The Saudi government also imposes a Zakat, a levy of 2.5% on assessed income, thus augmenting the tax rate. In sum, these tax rate changes were already in effect in 2018, and the company paid almost 48% of its taxable income in taxes that year. Second, the royalties on oil were reset ahead of the IPO and will vary, depending on the oil price, starting at 40% if oil prices are less than $70/barrel, increasing to 45% if they fell between $70 and $100, and becoming 80% if the oil price exceeds $100/barrel.
The initial attempts by the Saudi government to take Aramco public, as long as two years ago, came with an expectation that the company would be “valued” at $2 trillion or more. Since the IPO announcement a few weeks ago, much has been made about the fact that there seem to be wide divergences in how much bankers seem to think Aramco is worth, with numbers ranging from $1.2 billion to $2.3 trillion. Before we take a deep dive into how the initial assessments of value were made and why there might be differences, I think that we should be clear eyed about these numbers. Most of these numbers are not valuations, based upon an assessment of business models, risk and profitability, but instead represent pricing of Aramco, where assessment of price being made by looking at how the market is pricing publicly traded oil companies, relative to a metric, and extending that to Aramco, adjusting (subjectively) for its unique set up in terms of corporate governance, country risk and political risk. In the table below, I look at integrated oil companies, with market caps in excess of $10 billion, in October 2019, and how the market is pricing them relative to a range of metrics, from barrels of oil in reserve, to oil produced, to more conventional financial measures (revenues, earnings, cash flows):
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- If you price Aramco based on its revenues of $356 billion or on its book value of equity of $271 billion, its value looks comparable or slightly higher than the value of Exxon Mobil and Royal Dutch, the largest of the integrated oil companies.
- That pricing, though, is missing Aramco’s immense cost advantage, which allows it to generate much higher earnings from the same revenues. Thus, when you base the pricing on Aramco’s EBITDA of $224 billion, you can see the pricing rise to above a trillion and if you shift to Aramco’s net income of $111 billion, the pricing approaches $1.5 trillion.
- The pricing is highest when you focus on Aramco’s most valuable edge, its control of the Saudi oil reserves and its capacity to produce more oil than any other oil company in the world. If you base the pricing on the 10.3 billion barrels of oil that Aramco produced in 2018, Aramco should be priced above $1.5 trillion and perhaps even closer to $2 trillion. If you base the pricing on the 265.9 billion barrels of proven reserves that Aramco controls for the next 40 years, Aramco’s pricing rises to sky high levels.
- Production limits: Aramco not only does not own its reserves in perpetuity, with the rights reverting back to the Saudi government after 40 years, with the possibility of a 20-year extension, if the government decides to grant it, but it is also restricted in how much oil it can extract from those reserves to a maximum of 12 billion barrels a year.
- Governance and Risk: We noted, earlier, that Aramco’s flaws: the government’s absolute control of it, the country risk created by its dependence on domestic production and the political risk emanating from the possibility of regime change. To see how this can affect pricing, consider how the five companies on the integrated oil peer group that are Russian (with Gazprom, Rosneft and Lukoil being the biggest) are priced, relative to the global average:
While I will offer three different approaches to valuing Aramco, they will all be built on a few common components.
- First, I will do my valuation in US dollars, rather than Saudi Riyals, since as a commodity company, revenues are in dollars and the company reports its financials in US dollars (as well as Riyal). This will also allow me to evade tricky issues related to the Saudi Riyal being pegged to the US dollar though the reverberations from the peg unraveling will be felt in the operating numbers.
- Second, I will use an expected inflation rate of 1.00% in US dollars, representing a rough approximation of the difference between the US treasury bond rate and the US TIPs rate. Third, I will use the equity risk premium of 6.23% for Saudi Arabia, representing about a 0.79% premium over my estimate of a mature market premium of 5.44% at the start of November 2019.
- Finally, rather than use the standard perpetual growth model, where cash flows continue forever, I will use a 50-year growth period, representing the fact that the company’s primary asset, its oil reserves, are not infinite and will run out at some point in time, even if additional reserves are discovered. In fact, at the current production level, the existing reserves will be exhausted in about 35 years.
While the dividend discount model is far too restrictive in its assumptions about payout to be used to value most companies, Aramco may be the exception, especially given the promise in the prospectus to pay out at least $75 billion in dividends every year from 2020 and 2024, and the expectation that these dividends will continue and grow after that. There is one additional factor that makes Aramco a good candidate for the dividend discount model and that is the absolute powerlessness that stockholders will have at the company to change how much it returns to shareholders. To complete my valuation of Aramco using the promised dividends, I will make two additional assumptions:
- Growth rate: I will assume a long term growth rate in dividends set equal the inflation rate, and since this valuation is in US dollars, that inflation rate will be 1%.
- Discount rate: Rather than use a discount rate reflecting the risk of an oil company, I will be one that is closer to that demanded by investors in REITs and oil royalty trusts, investments where the bulk of the returns will be in dividends and those dividends are backed up by asset cash flows.
The valuation picture is below:
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Based upon my assumptions, the value of Aramco is about $1.63 trillion. Seen through these lens, this stock is a dressed-up bond, where dividends will remain the primary form of return and there will be little price appreciation.
The reason that dividend discount models often fail is because they look at the actual dividends paid and don’t factor in the reality that some companies pay out more than they can afford to do in dividends, in which case they are unsustainable and will fall under that weight, and some companies pay too little, in which case the cash that is paid out accumulates in the firm as a cash balance, and equity investors get a stake in it. While I noted that Aramco has signaled that it will pay at least $75 billion in dividends over the next five years, it has not indicated that it will cease investing and with potential dividends, you value the company based upon its capacity to pay dividends, rather than actual dividends. In computing the potential dividends, I assumed that the company would be able to grow earnings at 1.80% a year, and be able to do so by continuing to generate sky high returns on equity (its 2018 return on equity was about 41%). However, the shift from promised dividends to potential dividends will also expose investors to more of the risk in an integrated oil company and I adjust the cost of equity accordingly:
Download spreadsheet |
Download spreadsheet |
In summary, what is surprising about the valuations of Aramco, using the three approaches, is how close they are in their final assessments, all yielding values around $1.65 trillion. That said, there are three additional considerations that none of these models have factored in.
- Political Risk: While these models adjust for country risk in Saudi Arabia, I have used the default spread of the country as a proxy, but that misses the risk of regime change, a discontinuous risk that will have very large and potentially catastrophic effects on value. While you may believe that this risk is low, it is definitely not zero.
- Upside limits: When you invest in any large integrated oil company, you are making a bet on oil prices, with the expectation that higher oil prices will deliver higher income and higher value. While that assumption still holds for Aramco, the royalty structure that the Saudi government has created, where the royalty rate will climb from 40% at current oil prices to 45% if they rise above $ 70 and 80% if they rise above $100/barrel will mean that your share of gains, as an equity investor, on the upside will be capped, dampening the value today.
- Price setter/taker: While the largest publicly traded oil companies in the world are still price takers, Aramco has more influence on the oil price than any of them, as a result of Saudi Arabia’s role in the oil market. Put simply, while the power of the Saudi government to set oil prices has decreased from the 1970s, it does continue to wield more influence than any other entity in this process.
Over the weekend, we got a little more clarity on the IPO details, with a rumored pricing of $1.7 trillion for the company’s equity and a planned offering of 1.5% of the outstanding shares. That price is within shouting distance of my valuation, and my guess is that given the small size of the offering (at least on a percentage basis), it will attract enough investors to be fully subscribed. At this pricing, I think that the company will be more attractive to domestic than international investors, with Saudi investors, in particular, induced to invest by the company’s standing in the country. It will be a solid investment, as long as investors recognize what they are getting is more bond than stock, with dividends representing the primary return and limited price appreciation. They will have no say in how the company is run, and if they don’t like the way it is run, they will have to vote with their feet. If they are worried about risk, the research they should do is more political than economic, with the primary concerns about regime stability. The one concern that you should have, if you are a Saudi investor, with your human capital and real estate already tied to Saudi Arabia’s (and oil’s) well being, investing your wealth in Aramco will be doubling down on that dependence.
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Source: http://aswathdamodaran.blogspot.com/2019/11/a-coming-out-party-for-worlds-most.html
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