Petroleo Brasileiro SA (PBR, Financial), or Petrobras, has been downgraded from buy to sell by UBS Group AG (UBS, Financial). The Swiss banking giant believes Petrobras' fortunes could be coming to an end amid rising geopolitical risks intertwined with various company-specific risk factors.
In its published note, UBS stated it believes there is an "upcoming switch in the company's direction." The memo outlined vital risks related to Petrobras' organizational structure and debt reduction. In said, "Six years have passed, and we now believe these phases are on a path of reversion, with the upcoming years looking more somber than the heights Petrobras has reached."
Furthermore, the zeitgeist surrounding Brazil's private markets is much different than before the nation's recent election, in which Luiz Inacio Lula Da Silva was victorious. Financial market participants are unsure whether the left-wing leader will be as friendly to the country's energy sector as his predecessor, Jair Bolsonaro, was, therefore assigning a substantial systemic risk premium to the industry and Petrobras' stock.
Will Petrobras regain the form it experienced earlier this year, or will it sink into the abyss after UBS's downgrade?
Energy stocks – possible mean reversion
Oil and gas prices have recently found calm after a tremendous rally ignited by the war in Ukraine and a pandemic-driven global supply shortage. On Tuesday, oil settled at its lowest price since Jan. 3, touching the $75 handle before consolidating around $80 per barrel.
Technically speaking, commodity prices are settled in advance, and 2023's recession risk, coupled with possible supply recoveries, could act as key catalysts in driving energy prices down to their moving averages. Therefore, this will substantiate a potential slump in related stocks such as Petrobras.
Energy stocks have outperformed the broader market since the turn of the year. However, investors must keep in mind the economy and the financial markets alike are cyclical vehicles; thus, rallies never hold into perpetuity.
Despite owning most of the Brazilian energy market, Petrobras will likely exhibit the same sensitivity to the economic cycle as its sector peers.
Political risk in Brazil
The incoming resident of Brazil, Lula da Silva, has a rocky past with Petrobras after being accused of being part of a group of politicians that overcharged the company for services and reportedly accepted unethical monetary benefits.
According to Bloomberg, the financial markets could price in his history with Petrobras, while potential price caps could also be considered a primary risk by market participants.
Furthermore, JPMorgan analyst Rodolfo Angele said investors will be on their toes as they are uncertain about Lula da Silva's plan for the economy and the company. He wrote, "This new administration has openly criticized how Petrobras has been run and has also discussed likely changes at the company... The main ones should be on capital allocation and pricing policy for fuels sold domestically."
Based on anecdote, investors are not playing a wait-and-see game with Petrobras as the stock has shed around 30% of its market value in the past month.
Quantitative metrics and price action
Although most qualitative analysts are throwing caution to the wind, various quantitative metrics indicate Petrobras is a bargain waiting to be snapped up. For example, GuruFocus' valuation box suggests the stock is undervalued by a significant amount, with its projected free cash flow per share value exceeding the $43 mark.
Furthermore, the company recently delivered a robust third-quarter earnings report, revealing Ebitda of $17.2 billion, the second highest in the company's history. In addition, Petrobras cleared free cash flows of $10.1 billion, allowing it to announce a lucrative shareholder compensation package containing $8.5 million in share buybacks. Thus, Petrobras does not only offer potential price gains, but also presents investors with a special dividend yield of more than 40%.
Despite the company's impressive quantitative metrics, it needs to be considered that the financial markets often emphasize political risk and ignore idiosyncratic strengths. For example, various Chinese companies have produced stellar financial results this year, yet financial market participants have underscored the corporate events due to heightened geopolitical risk.
Lastly, Petrobras could run into capital structure problems if Lula da Silva does indeed implement price caps and unfavorable restructuring. The company is exposed to a dangerous debt burden, leaving its debt-to-equity ratio above 80%. In arrears, it successfully facilitated its interest payments due to its impressive profit margins; however, receding profitability from demand destruction and political tussles will likely put investors at risk.
Concluding thoughts
Petrobras has been one of the best-in-class energy stocks during the past two years. However, political pressure and cyclical exposure have placed it in the firing line. The likes of UBS and JPMorgan recently flagged concerns, leaving the market in a tizzy.
The stock is undervalued and pays an illustrious special dividend. However, embedded risks are stacking up, meaning the company's investors might reassess their stance in due course.
