Brazil : Risks and Opporunities to Consider

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although BRIC nations (Brazil, Russia, India and China) offering staggering growth potential for almost all industries, they also present serious downsides risks. Talking about Brazil, it’s continued high inflation has been a problem for the country, and as a result its currency has declined by 22% over the last year. To curb high inflation, its interest rates have been kept fairly high (7.25% benchmark interest rate,) which in turn has hampered its growth prospects. But investors shouldn’t deter from investing in the country, and should consider both the risks and opportunities present.

Petroleum

Petrol Brasiliero (NYSE: PBR) is one of the largest oil and gas company, with a market cap in excess of $97 billion. But over the past year, its shares have fallen nearly 50%, while its production was flat and oil prices have slid by just 4.6%. Naturally, foreign exchange (forex) losses have reduced its free cash flows by 20%, but the inflating operating costs account for the rest.

Adding to the miseries, the Brazilian oil and gas sector is regulated by its government. This means that companies like Petrobras can’t increase their prices with rising global oil prices. Instead, they book losses and are subsidized by the government. According to Reuters, these losses stood at $5.6 billion for the first half of 2012. But governments too have subsidy budgets, and Petrobras can’t simply increase its production and claim a higher subsidy. This creates a bottleneck situation, which makes it hard for oil companies to stage a turn around.

Moreover, the Brazilian economy is expected to grow at just 3.3% in 2013. This means slightly higher tax revenues for the government, which leaves little room for hikes in oil and gas subsidy budgets. Although Petrobras has huge cash reserves and won’t disappear any time soon, I think investors should stay distant from Petrobras due to massive government intervention.

Meat products

Brasil Foods (NYSE: BRFS) is involved in the raising, production and slaughtering of pork, beef and poultry. The company has a market capitalization in excess of $19 billion and is the 10th largest food company is the world. The company has a presence in over 110 countries, with over 60 manufacturing facilities in Brazil.

A big positive for the meat industry comes from Japan’s policy easing. The country had restricted the slaughter of cattle aged 30 months or younger, but as per the new norms, the slaughter is now restricted for cattle aged 20 months or younger. This in turn should reduce cattle raising costs, and naturally boost exports to the country. Another positive was the drought in North America, due to which crop yields (especially corn) plunged, causing crop prices to surge. This made fodder more expensive, which eventually drove up the costs of raising livestock. Naturally meat products became more expensive, and companies were able to charge higher prices.

Since Brasil Foods is an exporter of meat, it directly benefits from the depreciation of Brazilian Real (forex gains.) As of now, inflation in Brazil is still out of control, which suggests that its currency devaluation may continue. If that happens, Brasil Foods could have a dream run.

Metals and Mining

Gerdau (NYSE: GGB) is one of the largest steel manufacturers in Brazil, and has a market cap in excess of $14 billion. The Brazilian giant has its presence in over 15 countries, and produces nearly 30 million tons of steel per year.

In the most recent earnings release, the management of Gerdau told us that there is a surplus of steel in the market, and this is impacting its profitability by a whopping 26%. Management admitted that its demand forecasts were way too optimistic, and the concerns of a slowing down China decreased the overall steel demand. Although its Q4 results were modest, the management warned investors that the coming quarters could see a downfall in steel demand, which would further strain its margins. To stabilize its revenues, the company would be focusing on its mining operations, which is not its core business. Shares of Gerdau have slid by nearly 20% over the last year, and analysts are not expecting much from the company in FY13.

Conclusion

Shares of Gerdau and Petrobras trade at a forward PE of 7.3x and 5.4x respectively, suggesting that their shares are undervalued. But their coming quarters present a bleak picture, and I think investors should stay distant from both of these stocks. Brasil Foods, however looks attractive, and analysts expect its annual EPS to expand by a whopping 20.39% for the next 5 years. I think Brasil Foods is worth a Buy rating.


PiyushArora has no position in any stocks mentioned. The Motley Fool recommends Petroleo Brasileiro S.A. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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