Petrobras, Brazilian Stocks Recovering From Truckers' Strike

Summary

• Petrobras, the centerpiece of "Lava Jato" and the company most exposed to Brazilian political interference, announced US$4.94B net profit in 1H18 (+226% YoY), its best results since 2011.
• The stock recovered from the May 2018 truckers' strike, but investors feared political interference would return, which led to the CEO's resignation.
• Brazil is set to hold elections on October 2018. Investor response to recent political events indicates high volatility across Brazilian securities is to be expected.
• Investors might find unique buying opportunities at attractive valuations in Brazil's political mess, but should be aware of complexity. The ADRs of Petrobras, Vale, Eletrobras, and Embraer are exposed.

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Brazilian ADRs in the Spotlight - What the Politics Mean to Foreign Investors

Shares of Petrobras (PBR) tumbled ~40% in May 2018, falling as low as US$9.27 following the truckers' strike and closing at US$12.53 on Aug. 3, 2018. The IBOV - Brazil's index of blue-chip stocks - bottomed at 69,814 and closed at 81,435 on Aug. 3, 2018. The recovery of both of these things was driven primarily by investor sentiment on Brazil's politics and, to a lesser extent, the global commodities market.

Having recently moved to Florida following a career in corporate finance in my home country of Brazil, I have often considered writing an article on Brazilian companies - especially after having observed various misconceptions by some of my family members in the U.S. as well as various articles written by foreigners on Brazilian stocks. What ultimately led me into writing this article was realizing how dangerous Brazil's politicians can be to investors' capital - especially foreigners' capital - when I noticed that even a valuation genius such as Aswath Damodaran had a hard time figuring out how to factor Brazilian politics into his valuation. (This can be seen in one of his blog posts where he discussed how he got Vale (VALE) wrong, titled "No Mas, No Mas! The Vale Chronicles (Continued).")

First, let's briefly look at what Brazilian stocks are available to U.S. investors in the form of ADRs listed on the NYSE:

Company	Ticker	Industry
Embraer	ERJ	Aerospace & Defense
Gol Linhas	GOL	Airline
Azul	AZUL	Airline
Banco Bradesco	BBD	Banking
Banco Santander Brasil	BSBR	Banking
Itau Unibanco	ITUB	Banking
Braskem	BAK	Chemicals
Eletrobras	EBR	Energy
COPEL	ELP	Energy
CEMIG	CIG	Energy
CPFL Energia	CPL	Energy
Oi	OIBR	Telecom
TIM Participacoes	TSU	Telecom
Telefonica Brasil	VIV	Telecom
GPA	CBD	Food &Drug Retailers
BRF	BRFS	Food & Beverage
AMBEV	ABEV	Food & Beverage
Fibria Celulose	FBR	Pulp & Paper
SABESP	SBS	Utilities
Ultrapar	UGP	Utilities
CSN	SID	Metals & Mining
Gerdau	GGB	Metals & Mining
Vale	VALE	Metals & Mining
Petrobras	PBR	Oil & Gas
BrasilAgro	LND	Real Estate
Gafisa	GFA	Real Estate

Click to enlarge

Foreign investors generally find Brazilian companies appealing when they want to add some exposure to emerging markets or merely diversify their portfolios. If they do their homework and go through the history of these companies, they realize that most have one thing in common: They were state-owned at some point in their lives. I'll briefly explain the implications of that fact.

Legacy: The Role of Government in Brazil and How We Created Global Players

Brazil, a young country of a little over five centuries in age, has a long history of state intervention in the economy, which includes a policy called "Import Substitution Industrialization" promoted by Getúlio Vargas. In an attempt to reduce its economy's foreign dependency, the Brazilian government created various incentives for local production of industrialized products. In segments deemed strategic for its future, it created and supported a handful of companies. So, basically, Petrobras and Vale are products of our state-led industrialization program.

Petrobras (Petróleo Brasileiro S.A.) was created in 1953 to monopolize the Brazilian oil and gas industry and Companhia Vale do Rio Doce was created in 1942 to explore iron ore and supply our WWII allies, the U.S. Most of these national champions are engaged in commodities and agribusiness - industries that benefit the most from our natural resource abundance, a competitive advantage that compensates for some of our deficiencies (such as a complex tax regime, poor infrastructure, excessive bureaucracy, etc.). Aircraft manufacturer Embraer would eventually become a poster child of this policy, as it embodies Brazil's ambitious venture into a highly sophisticated global industry. For various reasons, some of these players were eventually privatized in the 1990s (such as CSN and Vale) and some acquired by foreign companies such as Oi, Tim Participações and Telefônica Brasil (VIVO), mostly European players in TMT and banking.

What Does This All Mean for Investors?

Obviously, government plays a big part in any business, be it in Brazil or abroad. However, in Brazil's case, state-ownership has left a significant legacy of bad corporate governance, which often justifies a discount on Brazilian stocks vs. industry peers. Direct government ownership in companies with ADRs currently trading on the NYSE include Petrobras (50.3% of shares), Eletrobras (51.0% of shares), Vale (0.0% of shares but holds golden shares, which empower Brazil's government to mold strategic decisions), Embraer (0.0% of shares but holds golden shares). The Brazilian government also exerts indirect influence through BNDES, its development bank that pumps cheap capital into these companies under the guise of sponsoring development projects, and pension funds. BNDES holds a great amount of shares and convertible debt in these companies.

Some noteworthy examples of political interference in Petrobras and Vale that came to light during "Lava Jato" that definitely hurt investor confidence include former President Dilma Rousseff's approval of the acquisition of a Pasadena refinery by Petrobras when she was chairman of the board of directors, and Aecio Neves', former senator who ran against Dilma in 2014, attempt to manipulate Vale's potential nomination of Aldemir Bendine, an alleged political puppet currently facing corruption charges, as CEO.

Political interference has always accompanied these companies. I would like to point out Brazil's recent memory of local political events triggering spikes in country risk:

Source: Created by author, based on IPEA data.

The financial implications of an event such as the truckers' strike in May 2018 alone could justify a loss in a company's market value. However, given Brazil's history of political interference, investor sentiment on how the government would handle the situation - in other words, government meddling once again in company affairs for the sake of satisfying its political agenda - largely explains how a global company with billions of dollars in assets such as Petrobras lost ~40% in market value in less than one month. In short, a big volume of foreign capital fled Brazil's markets as perceived risk escalated.

What About the Global Commodities Market?

I am aware that many commodities experts expect the market to recover from its drop in 1H14, and that some believe a trade war between the U.S. and China could produce ripple effects, including potentially compromising Vale's and Petrobras' future earnings potential.

Source: Index Mundi

But I would like to emphasize my point in writing this article: You could be a finance genius, be very knowledgeable on commodities, and spend a great amount of time working on your valuation models and still lose money if you don't understand the crazy politics in Brazil.

Opportunities for Those Who Understand Brazil's Politics

So, why should you care about Brazil's politics? Basically, this is probably the primary reason you made or lost money by investing in our ADRs during the "Lava Jato" scandal, and this is likely the reason why you will make/lose money if you are to invest in these stocks in coming months. Expect investor sentiment to produce stock volatility with heavy speculation and big strides by fearful investors pulling out of the market as poll results come out.

Brazil's elections are held in a two-round system (round 1 on Oct. 7 and round 2 on Oct. 28) and campaigning officially kicked off in August 2018. This election will be highly uncertain as ultra popular former leftist workers' party (PT) President Luis Inácio "Lula" da Silva is imprisoned and legally barred from running for president. The market is keeping an eye out for the rise of right-wing candidate Jair Bolsonaro and the probabilities of bigger parties PSDB and PT winning the upcoming presidential election.

In addition to Petrobras, the following stocks have significant exposure to Brazilian politics:

• Vale: A recent improvement in corporate governance announced in February 2017 designed a new shareholders agreement that aims to transform it into a true corporation with reduced government influence by 2020, greatly improving corporate governance. Investors have taken notice and valuation has improved, but political meddling could revert this.
• Eletrobras: Its privatization plan announced in August 2017 is currently in political limbo.
• Embraer: Its merger with Boeing (BA) announced in December 2017 still requires approval by the Brazilian government, and regulators and could run into political opposition.

In Brazil's political mess, investors could find unique buying opportunities at attractive valuations (for example: Petrobras' P/E at 4.9x compares to O&G peers Exxon Mobil (XOM) at 20.9x, Chevron (CVX) at 22.2x, YPF (YPF) at 9.8x, ConocoPhillips (COP) at 26.4x, BP (BP) at 20.5x, Shell (RDS.A) at 13.9x, and Total (TOT) at 16.5x), but should be aware of complexity that could have even the most experienced and knowledgeable local investor on the edge of their seat. Brazilian politics is highly complex and shouldn't be taken lightly when investing in a Brazilian stock. The outcome for investors holding Brazilian securities isn't necessarily negative, but based on recent experience I believe they are in for a wild roller coaster ride.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am also long Bradespar (a holding company for VALE).