Petroleo Brasileiro Petrobras SA (ADR) (PBR), Centrais Eletricas Brasileiras SA (ADR) (EBR): This Brazilian Energy Play Is Still Looking Good

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Millions of Brazilians are currently protesting in their country, demanding better public services. The country’s economy has been performing poorly, missing analysts’ growth estimates in the last five quarters. In first quarter of 2013, the economy registered growth of just 0.5%, while analysts were expecting 0.9%. The markets are now looking for modest growth at best due to weak fiscal policy and increasing inflation. The country has finally moved to increase its benchmark interest rates to offset inflation, but Standard & Poor’s has already cut Brazil’s sovereign credit rating to BBB, which is dangerously close to “junk.”

Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR)

Meanwhile, two of the leading US-listed Brazilian firms, Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR), also known as Petrobras, and Centrais Eletricas Brasileiras SA (ADR) (NYSE:EBR.B), also known as Eletrobras, have also had their ratings cut by the S&P to BBB with a negative outlook. The former is a leading semi-public energy firm, while the latter is an electric power generation, transmission and distribution company.

Brazil’s capital markets are represented in the iShares MSCI Brazil Index (ETF) (NYSEARCA:EWZ), which has dropped by 18% in the last three months. The fund has recorded a net outflow of $790 million in the same period. The ETF represents total net assets of $5.7 billion and includes 81 large and mid-cap Brazilian stocks, including Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR) and Centrais Eletricas Brasileiras SA (ADR) (NYSE:EBR.B). Petrobras, including preference shares, is the biggest holding in the ETF with a weight of 11.7%, while 0.5% of funds are allocated to Eletrobras.

With mounting economic and social challenges, and the poor performance of Brazilian real against the dollar, I believe that iShares MSCI Brazil Index Fund will most likely under-perform in the coming months.

Meanwhile, Centrais Eletricas Brasileiras SA (ADR) (NYSE:EBR.B) has been struggling with falling transmission and generation sales. Speculations abound regarding a significant drop in the company’s revenue in the near future due to the planned reduction in electricity prices by the government. About a month ago, Eletrobras posted an enormous quarterly net loss of $17.8 billion. With a trailing-12 months profit margin of -25%, a return on equity of -11.3% and a year-over-year quarterly revenue drop of 15.6%, Eletrobras is currently the opposite of an attractive investment.

Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR) has been selling foreign assets as it wants to focus on its domestic reserves. It has a massive $237 billion five-year investment plan, which is by far the largest program of corporate spending in the world. The company aims to sell its foreign assets to increase focus on Brazil’s southeast coast on the Atlantic seabed which, according to some estimates, hold reserves of 100 billion barrels of liquids. The assets on sale include oil fields, refineries and exploration rights in several countries including Japan, Peru, the United States and Argentina.

The company’s decision to leave Peru was identified in a recent Reuters report but no official word has come out yet. It has recently agreed to sell its 50% stake in the African operations to Brazil’s investment bank, Banco BTG Pactual, against $1.5 billion. It has also planned to sell its 49% stake in a subsidiary which operates 13 small hydroelectric dams with capacity of 291MW to Companhia Energetica Minas Gerais (ADR) (NYSE:CIG), more commonly known as CEMIG, for $303 million. Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR) also sold its six exploration blocks located in the U.S. Gulf of Mexico for $110 million.

While Petrobras originally wanted to raise $14.8 billion from asset sales between 2013 and 2017, it received a lackluster response from the potential buyers so the target was later reduced to $9.9 billion.

The company’s investment plan is ambitious in the truest sense of the word; it is 1.6 times Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR)’ annual sales, 2.6 times its market cap and 10 times its current cash reserves. Petrobras has recently given some bad news to its investors; its much-awaited Comperj refinery, aimed at lowering Brazil’s fuel imports that have hit the profits of Petrobras, will now start operations from August 2016 – that is one year later than scheduled.

Add that to the ratings downgrade and we have the main reasons behind the performance of the company’s stock.

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