There is blood on the streets wherever you look in Brazil today, but probably of most interest to the hundreds of US asset managers (the ones managing your mutual funds) is what happens to Petrobras as it remains so widely held. As we noted below, bond prices are collapsing and default risk is soaring, and with the nation’s currency collapsing amid the lower-for-longer oil prices, $90 billion of dollar-denominated debt could soon potentially be too burdensome for the company to repay.
Default Risk is exploding…
S&P recently lowered Brazil’s credit rating to junk status. It later downgraded 60 corporate and infrastructure entities in Brazil, including cutting Petrobras (NYSE:PBR) two notches to “BB.” Petrobras has been reeling from acorruption scandal that reportedly involved Petrobras’ executives and directors awarding suppliers over-inflated contracts in exchange for kickbacks. The scandal has cost the company billions of dollars, and has been a blow to the reputation of Brazil’s President Dilma Rousseff.
PBR is off about 70% over the past year, versus a 50% decline for the Brazilian ETF (NYSEARCA:EWZ) and flat growth for the S&P 500 (NYSEARCA:SPY). Investors should continue to avoid PBR for the following reasons:
Stagnant Revenue And Earnings
When it rains, it pours for Petrobras. In addition to the corruption scandal, a free fall in oil prices has stymied the company’s revenue growth. For the first half of 2015, Petrobras’ revenue was down 27% Y/Y from $71.4 billion to $52.0 billion, while EBITDA growth was flat. EBITDA margin increased to 26% in the first half of 2015 from 19% in the year-earlier period, as the company slashed cost of sales, SG&A expense and R&D.
To stem cash burn, Petrobras slashed its five-year capital spending by 40% and has been canceling drilling contracts with suppliers such as Sete Brasil and Vantage Drilling (NYSEMKT:VTG). These are prudent steps given that oil prices are off 60% from their Q2 2014 peak and the global economy is showing signs of slowing. If sub-$60 oil prices are the new normal, stagnant revenue and earnings growth may be in the cards regardless of the company’s cost-cutting measures.
$90B Dollar-Denominated Debt
Zero interest rates in the U.S. have prompted investors to look to emerging markets for higher yields.Investors have provided dollar-denominated debt to companies like Petrobras at higher rates than U.S. treasuries, but lower than what companies in emerging markets could get locally. Borrowing in dollars and paying in Brazilian real had previously not been a problem.
However, the real has depreciated over 38% against the dollar over the past year, making un-hedged dollar-denominated debt prohibitively expensive.
In Q2, Petrobras had $134 billion in debt load, which equated to about 4.9x run-rate EBITDA – junk levels. About 70% (over $90 billion) of that was dollar-denominated, which means that it will probably take more real for Petrobras to repay its debt going forward.
If China continues to devalue the yuan or if the U.S. raises interest rates, it could spur more capital flight out of Brazil and pressure the real further. Either way, I believe Petrobras’ dollar-denominated debt will appreciate to levels that could potentially become too burdensome for the company to repay.