Petrobras scandal signals ‘hold’ for Brazil investors

This is absolutely not the time to invest in Brazilian stocks.

The Petrobras scandal taints Brazil's investment appeal.

WASHINGTON, June 22, 2015 – More than a year after the Petrobras scandal opened Brazil’s corruption-riddled economy to the world, the country remains mired in mess, and its stocks are off-limits to smart investors.

Brazil samba-ed into investors’ consciousness as the fast-growing, fun and easy B of BRIC fame. The market was undervalued, people said, the oil company Petrobras is a dream, they said. Invest, they said.

With the successful World Cup behind them and the 2016 Rio Olympics on the horizon, Brazil was primping for international attention.

Unfortunately for Brazil, that bubble burst in spectacular carnival-like fashion. The international community was already skeptical about the economy, thanks to state intervention in the name of “national interest,” and those concerns multiplied after Petrobras was exposed for corruption. The national investigation revealed an ugly underbelly of Brazilian business that has touched every sector, and its reach isn’t over yet.

Last week, the government arrested the owners of two construction giants, Odebrect SA and Andrade Gutierrez SA. The companies were long thought to be untouchable, like that crowning glory of petroleum exploration, Petrobras.

Brazil is on the brink of economic disaster. With a recession looming, expanding questions surrounding Petrobras, political volatility and public discontent with austerity, there are few good investment options in the country.

As Brazilian stocks spiral downward, some investors are starting to sniff around for bargains. Fair warning, fellow investors, just because something is cheap does not mean it is a good deal. More words of wisdom: Things are bad in Brazil, but they have not yet hit bottom. Never underestimate the potential for a corruption-infused economy to go even lower.

The tentacles of the massive corruption scheme just keep getting longer. The scandal has left the company not only weak, but also humiliated. It has also spread through the private sector, touching banks and major infrastructure companies and the political sector. And it isn’t done yet.

In Brazil, the bandwagon is immensely jumpable. Watch for the taint to spread. And spread. And spread.

The scandal involves a complex series of kickbacks, where construction companies bidding on Petrobras contracts paid bribes to Petrobras executives. Those Petrobras executives then paid a portion of the bribes to members of Dilma Rousseff’s Workers’ Party.

Although Rousseff has not yet been named in the investigation, the accusations are nipping at her heels. Rousseff was chairwoman of Petrobras from 2003 to 2010, when the kickback scheme reportedly was in place.

Members of congress and private sector executives have already lost their jobs over the scandal. Petrobras executives, including CEO Maria Gracas Foster, have resigned.

Petrobras has had to delay earnings announcements while it figures out just how much it lost in the scheme. Auditors are struggling to identify the total amount of kickbacks, since many of them went through Swiss bank accounts and alias account holders. Analysts now estimate the total amount to be approximately $10 billion.

There is significant skepticism about its financials, and ratings agencies are unimpressed with what they have seen so far. Moody’s downgraded the company to junk status in February, and in late March reduced it from Baa3 to Ba2. Moreover, after the most recent downgrade, Moody’s noted that the problems at the company could last “for years,” and that it continues to review the company for more downgrades. Standard & Poor’s also downgraded the company.

Meanwhile, the scandal has sparked three class action suits against Petrobras and 15 of Brazil’s investment banks. The plaintiffs say that several Brazilian investment banks over-inflated the underlying value of Petrobras’s assets, distorting the risk. The defendants argue that they had no idea Petrobras was over-inflating its assets and that they were not aware of the kickback scheme.

Sure, JP Morgan upgraded the stock this week to “overweight” from “neutral,” citing “efforts” by Petrobras to restore confidence, but there will be more hits to come that will send the stock lower. Guaranteed.

And as goes Petrobras, at least in this convoluted, complex and far-reaching scandal, so goes Brazil.

All this means that there is very little to love in Brazilian ADRs at the moment, even at their low prices. Unless you are specifically looking for exposure to Brazil – and right now, why would you? – there are few reasons to buy any of the 25 Brazilian ADRs listed on US exchanges.

We’ve already discussed Petrobras, which would be a disaster investment right now. The investigation could last years, and we can’t yet see the depth of the fallout. Even the latest oil discoveries are not enough to counter the negative developments at the company.

Sources at two major investment banks tell me they are in the process of re-rating the company and lowering their expectations. Last year, the company traded in the low 20s and it is now at around $6. Investors jumped on the company when it was around $10, thinking the price was low, but at $6, investors are skittish and worried that the corruption investigation will have major ramifications. They are right.

Embraer and Telefonica Brazil both have recently posted negative earnings revisions. The Brazilian banks are being dragged into the Petrobras scandal, making them difficult investments at best.

Even relatively positive companies like Companhia Brasileira de Distribuicao or Gol are not compelling enough to justify their purchase. Neutral is about as good as it gets for these names.

All that said, Brazil should settle in around the end of 2016. By then, we will know the full scope of the Petrobras fall-out, and both Petrobras and the other companies tainted by the scandal will start to rebuild. Higher oil prices will also help revive international interest in Brazil, and the hope of a new government, or at least a revitalized Rousseff government, will accelerate interest.

Long term, the economic, political and corruption confluence could actually bring good things to Brazil. Like an addict that has to hit rock bottom before looking for help, Brazil is starting to realize that Rousseff’s emasculation of capitalism has helped create this crisis, and that the country must change to succeed.

Rousseff even knows it. Her finance minister, Joaquim Levy, told business leaders, “State capitalism doesn’t work very well in a democracy,” suggesting that maybe, perhaps, Rousseff’s next term will back away from state intervention in the economy in the name of “public interest.”

But be patient. Brazil is faltering now, and will fall flat on its face before it starts clawing back. Investors should mark their calendars to take a look at Brazil again around the end of 2015 or beginning of 2016.

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Lisa M. Ruth
Lisa M. Ruth is Editor-in-Chief of CDN. In addition to her editing and leadership duties, she also writes on international events, intelligence, and other topics. She has worked with CDN as a journalist since 2009. Lisa is also President of CTC International Group, Inc., a research and analysis firm in South Florida, providing actionable intelligence to decisionmakers. She started her career at the CIA, where she won several distinguished awards for her service. She holds an MA in international relations from the University of Virginia, and a BA in international relations from George Mason University. She also serves as Chairman of the Board of Horses Healing Hearts, and is involved with several other charitable organizations, including Habitat for Humanity, The Boys and Girls Clubs of America, and AYSO.