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Petróleo Brasileiro struggled to keep pace with the industry during December 2013 when its share price took a dive and is still finding support price level. However, the future of Petrobras looks bright as it is going forward with new projects which will provide good revenues to the company while it cuts costs through downsizing. This can prove to be a good time for investing in the company as the prices are low.

Introduction

Petróleo Brasileiro S.A. (NYSE:PBR), a Brazil-based energy company, is divided into three segments. The upstream segment deals with the development, extraction and production of crude oil and natural gas (including biofuels). The midstream segment deals in logistics, export, refining crude oil and natural gas. The downstream segment is concerned with the sale of natural gas, crude oil and oil related products in domestic and international markets. Petrobras is one of the largest oil companies in the world and has a presence in over 25 countries. However, it did not show promising results during 2013 and closed the year with an almost 30% negativity whereas the industry experienced a growth of around 21%. The company is still trying to find support level as its share price continues to decline in 2014.

(click to enlarge)

Source: YCharts

Fundamentals

During the third quarter of 2013 the revenue of the company remained constant and its operating expenses increased. This led to a decrease in net income, which closed at $1.6 billion (a 43.5% decline), while the long-term debt increased by 17.8% during the year. The company has also agreed to repay 40% of the $100 billion that was required to develop the Libra offshore oil region. Even though production output remained almost the same as the second quarter of 2013, the major reasons for the decline in operating income were higher expenses and higher import costs of diesel due to the elevated international price of oil products.

"In addition to the impact of the break between market and domestic fuel prices at a time of strong demand, we have also had greater expenses with dry and sub-commercial wells," Chief Executive Maria das Graças Foster said in a statement accompanying the results. "We plan to reduce our debt levels over the coming months."

Company

Industry

Sector

Current Ratio

2.12

1.64

1.72

Quick Ratio

1.67

1.16

1.48

Dividend Yield

2.11

4.69

4.23

Payout Ratio(TTM)

53.18

19.05

54.43

*As of 30 Sep 2013 Source: Reuters

Petrobras has been performing well in terms of its overall financials. It was able to report higher liquidity ratios (both current and quick) than the industry average which puts it in a comfortable position to pay off short-term obligations without the need to seek financing from other sources.

Petrobras paid a dividend of $0.09 per share and has a current dividend yield of 2.11%, which is lower than the industry average and indicates that there may be room for further growth in dividends as the company starts to earn more profits. Furthermore, the company's CFO yield is 38% which also shows that it has the ability to pay higher dividends. However, the payout ratio of the company is quite higher than the industry's which might create some liquidity concerns in the future.

Recent Developments

Petrobras recently completed the P-55 platform which was one of nine projects expected to be completed during 2013. The platform is expected to produce 180,000 barrels of oil and treat 4 million cubic meters of natural gas per day. The P-55 platform is one of the largest semisubmersibles ever built. It will be producing oil from 11 wells which will be transported to land via undersea pipelines.

At the start of December 2013, Petrobras managed to make winning bids for 49 oil and natural gas blocks put up for auction by Brazil's National Petroleum Agency (ANP); 16 of which will be operated by the company and the remaining by its partners. The company will have to pay $55 million as a signing bonus and this investment is part of its long-term plan to expand presence near existing operations in order to increase production and reserves (as per the company's Business and Management Plan 2013-2017).

Petrobras, along with the consortium BM-S-9, submitted a Declaration of Commerciality (DOC) to the ANP for the Carioca region. The company has a 45% stake in BM-S-9 and is the operator of the consortium. The Carioca oil field has expected recoverable reserves of approx. 459 million barrels of oil equivalent. Petrobras expects to start pumping oil from this field in the third quarter of 2016 as per the Business and Management Plan.

Recently, the company signed an ultra-deepwater contract with Technip (TKPPY) for the delivery of about 100 kilometers of flexible pipes to support oil production, gas lift and gas injection for the Sapinhoá Norte field and I5 at Lula field in the Santos Basin; along with other equipment required for floating production storage and offloading units. Technip will start production of this equipment during the first quarter of 2014 at its Flexibras Açu facility in Brazil. This contract will help Petrobras to speed up the development of these fields for future production.

Through these projects Petrobras has not only managed to increase its production capacity but also the resources at its disposal that can be harnessed in the future. This gives the company some confidence of an increase in revenues which can affect both long- and short-term returns to the investors through capital appreciation and dividends.

Downsizing

At the end of the 2013 fiscal year, the company sold its 35% stake in Parque das Conchas (block BC-10) to Royal Dutch Shell and ONGC, an Indian energy explorer. Though this sale was initially intended with Sinochem Group, a Chinese conglomerate, for a total of about $1.54 billion, Shell and ONGC used their right of partnership which benefited all parties concerned as the partners increased their stake while Petrobras got around $1.64 billion (more than what Sinochem Group wanted to pay). This will help the company in its plan to spend $237 billion through 2017 to increase production, while also trying to reduce its debt.

Petrobras signed a deal with China National Petroleum Company (CNPC) for the sale of its Peru-based assets for $2.6 billion. The company is divesting its Peruvian subsidiary, Petrobras Energia Peru, which holds three blocks; Block X, Block 57 and Block 58 for a combined production of 200,000 tonnes of oil equivalent annually. The company stated that this sale is part of a divestment program from 2013-2017 and the deal will be closed after regulatory approval and other necessary conditions are met. This cash infusion will help the company to bring down its debt and shift its focus to huge offshore oil fields, leading to an increase in productivity.

Petrobras is planning to cut down its labor force in order to be able to carry on with the investment plan of $237 billion while maintaining financial stability. The company has a present workforce of approx. 62,770 and is planning to lay off as many as 8,500 workers through a voluntary separation incentive plan. This is being done to decrease expenses and increase the profit margin as the company has been suffering due to controlled lower prices of oil in Brazil, which have resulted in huge losses from domestic sales. However, this move has been criticized by union officials who claim that by decreasing the labor force the company will be limiting its expansion, but this claim has been rejected by the Brazilian government.

Adriano Pires, the head of local energy consultants CBIE said, "The company has become almost unmanageable because of the number of people."

Constraints to Growth

At the start of 2014 the company faced a shutdown of production at its Duque de Caxias-based Reduc Refinery's petroleum coke unit as it caught fire. This refinery has a processing capacity of 240,000 barrels of crude oil per day, which is almost 10% of the total refining capacity of Brazil. This was another major hit for the oil giant amidst its topline growth issues. This fire was the fourth such incident at the Reduc Refinery since November 2013 and has created great concerns for the workers' safety who pointed out that the company has increased processing capacity from 85% to 98% without adopting additional safety procedures (although the incident did not result in any injuries). This safety issue can create problems for the company if no measures are taken to address it as it might lead to a fine by the government or labor strikes.

Due to the increasing gap between the domestic and international price of oil and oil products, the company chose the option to raise gasoline and diesel prices with a new pricing formula that will automatically narrow the gap. Although no date has been set for such an increment as President Dilma Rousseff is still reluctant to increase domestic prices. This forced the company to sell imported oil at a loss until the end of November 2013 when it announced a price increase of 4% on gasoline and 8% on diesel. However, this will not automatically fix the gap as President Dilma did not allow the company to execute an automated price adjustment policy as the government wants to keep prices low in order to control inflation. Moreover, the Brazilian government has a majority voting share in the company which gives it more control over its strategic decisions.

(click to enlarge)

Source: Company Website

Valuation

Amounts in ($ Billions)

Market Capital

70

Long term Debt

104

Cash and Cash equivalents

(18)

Enterprise Value

156

Source: Equity Flux calculations

The company's enterprise value is almost $156 billion and it has 6.52 billion shares outstanding. From this we can calculate the EV/share to be closest to $23.9 per share. Currently the share is price at around $11 which shows a room for growth as the stock is undervalued. Furthermore, the dividend yield is less than the industry average indicating that this stock can give better returns to the investor.

Conclusion

Petrobras has been affected by production issues at some of its refineries and also by the price ceiling of gasoline and diesel but its position is starting to improve after an increase in gasoline and diesel prices as the domestic demand for oil products is increasing. Though this increment might not be enough it will give some support to the operating margin, which is what the company really needs as it proceeds with its plan to invest $237 billion through 2017 in order to increase production to 2.75 million barrels per day. Petrobras has a 41.6% stake in the Libra consortium and will be spending $400 million to $500 million in 2014, aimed at attaining the target production for 2017. Looking at the cost cutting and capital spending by Petrobras, it is going to be a very good long-term investment and a must have for 2014.

Source: Petrobras Has Upside Potential On Massive Capital Spending And Cost Cutting

Additional disclosure: Equity Flux is a team of analysts. This article was written by our Basic Material analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.