A slumbering oil giant is about to awaken

This once-hot company fell from grace with a series of costly missteps -- but its stars are aligning once again.

By StreetAuthority Jul 19, 2013 3:20PM
copyright Kevin Phillips, Digital Vision, age fotostockBy David Sterman

Less than a decade ago, Petrobras (PBR) was the hottest oil company on the planet. A massive offshore discovery led the residents of Sao Paolo and Rio de Janeiro to dance in the streets, looking ahead to the day when all that oil money would circulate through the economy.

Yet year after year, Petrobras has managed to disappoint its backers in new and novel ways. The oil giant vastly overspent to get those big oil fields ready for production, the Brazilian government sought onerous levels of taxes from the company, and investors had to sit idly by as the company issued massive blocks of new shares, leading to hefty dilution.

Just how badly did things turn out? Back in 2007, before Petrobras began the heavy lifting to start production on its major new oil fields, the company had 23% operating margins and earnings per share of around $3. By 2012, those two figures had fallen by half. At this point, most investors have simply abandoned ship. Yet it's time to give this broken stock a fresh look.

The looming payoff
Although Petrobras has clearly dropped the ball repeatedly over the past five years, a lot of foundation-building is set to pay off -- but not quite yet. Petrobras will probably deliver another set of weak financial results when quarterly results are released later this month, thanks to heavy spending on equipment maintenance and still-constrained output.
Yet that may mark the end of the era of reckless spending. In a March 2013 meeting with analysts, Petrobras' management, according to Merrill Lynch analysts, "indicated it is very focused on reducing costs over the next few years to improve financial returns. It suggested that this is the first time a serious cost-cutting program has been introduced at the company."

The wind down in spending should coincide with a long-awaited upturn in production as "pre-development" oil fields finally come online. It will be a slow ramp in the first few quarters, based on current production schedule, but starting with the first quarter of 2014, output should accelerate more quickly, leading analyst to expect Petrobras to have one of the highest growth rates in the industry for the next five years.

A cleaner balance sheet
One of the key drags on this stock has been a debt-laden balance sheet. Total debt, which stood at $69 billion at the end of 2010, swelled to $96 billion by the end of 2012. Management simply became too aggressive in its pursuit of oil and gas fields throughout Latin American and elsewhere.

Newly chastened by a collapse in its stock price, Petrobras is planning to sell up to $10 billion in assets this year. That target may prove conservative: "Potential sales of close to double the announced amount are possible, if all identified assets were actually able to be sold," said Merrill Lynch's analysts. That should help management keep a promise of avoiding further stock issuances.

Improving financials
A combination of better cost controls, slowing capital spending and rising cash flow should set the stage for quickly improving debt ratios. For example, the interest coverage ratio is expected to rise 3 percentage points from 2012 through 2015.

Mitigated currency risk?
One of the challenges of investing in an ADR (American depositary receipt) like Petrobras is the currency risk. If the foreign currency weakens against the dollar, the ADR will drop in value by a commensurate amount.

That explains some of the poor performance of Petrobras. In the summer of 2011, the U.S. dollar bought roughly 1.6 Brazilian reals. Yet the real has weakened so much that a dollar now buys 2.27 of them. In the past, that rapid devaluation caused pain for foreign investors, but the real now no longer carries the risk of overvaluation that it did a few years ago. In fact, when the Brazilian economy finds its footing and returns to its historical growth trajectory, the real should rebound, which would boost the performance of this ADR.

Risks to consider: The biggest risk to this turnaround play is plunging oil prices. Crude oil has actually traded up in recent months, but a bigger slowdown in China or elsewhere could lead to a big drop in oil.

Action to take:
Petrobras is an excellent case study in bad investment. Virtually every major move, both by management and the Brazilian government, has been to the detriment of shareholders. Yet with shares so deeply washed out, and management newly focused on improving returns, it's time to forget the past and focus on what appears to be a still-bright future.
David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority

Jul 19, 2013 4:24PM
Hmmm. Cost cutting? Usually that means cutting costs of things like maintenance, taking shortcuts on safety and don't expect the Brazilian government to provide anymore than the smallest amount of oversight. Result? A disaster waiting to happen. 
Jul 19, 2013 4:23PM
Too many great American Oil Companies for me to speculate on a foriegn stock - Thanks but I'll pass. My bet is on falling oil prices as America ramps up its production levels.
Jul 21, 2013 2:37PM
Invest in a company managed by politicians from a left party.....even a giant oil field can help the investors. AVOID
Jul 21, 2013 2:54PM

All I'm thinking about now is the Constellation of Orion..


Ever look at that ??


They have been aligned for Centuries.

Jul 21, 2013 12:57AM
Off and On....Jubak has touted this.
Jul 22, 2013 1:30AM
Jul 20, 2013 7:42AM
WOW... another propaganda Big Oil article. The 20th Century ended 13.5 years ago. It needed to take oil and gas exploitation to the grave with it. Oil and gas cannot recover our economy, they just buy us a war and placate geezers who have outlived their time on Earth.  
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