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Petrobras Stock Upgraded: What You Need to Know

By Rich Smith - Oct 23, 2018 at 2:30PM

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Elections are only one reason to be optimistic about this stock.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Does Brazilian oil major Petroleo Brasileiro (PBR 2.19%) (PBR.A 1.43%) make for a good investment?

There are a lot of reasons to answer, "No." From 2014 to 2017, Petrobras stock lost money for its shareholders. This $100 billion company carries a $96 billion debt load (admittedly offset somewhat by nearly $19 billion in cash, according to data from S&P Global Market Intelligence). Unusual for an oil major, Petrobras doesn't even pay much of a dividend to its shareholders -- a mere 0.8%, or less than half the average dividend yield on the S&P 500.

And yet, despite losing money as GAAP defines the idea of profitability, Petroleo Brasileiro is now entering its fourth straight year of positive free cash flow production -- and as it turns out, free cash flow is a key reason why one banker is making a big bet on Petrobras stock.

Here's what you need to know.

Brazilian flag superimposed over map of Brazil

With elections looming, Morgan Stanley has Brazil -- and Petrobras stock -- on its mind today. Image source: Getty Images.

Upgrading Petrobras

Analysts at investment bank Morgan Stanley announced they're upgrading shares of Petrobras to overweight and hiking their price target to $21.50, as reported by StreetInsider.com (subscription required) this morning. That's nearly a 60% bump from Morgan Stanley's previous $13.50 price target. It promises as much as a 37% profit to new investors buying in at today's share price of just $15 and change.

As many reasons as there may be to be skeptical of Petrobras stock as an investment, Morgan Stanley sees opportunities for investors to profit from it. For example, Petrobras boasts proven reserves of 8.4 billion barrels of oil, and a further 7.9 trillion cubic feet of proven natural gas reserves, an "oil equivalent." With Brent crude prices around $76 a barrel today, and WTI crude north of $66, Morgan Stanley believes that Petrobras' "asset base is undervalued."

Defusing concerns

Granted, there's still the debt load to worry about, but even that doesn't concern Morgan Stanley overmuch. Pointing to Petrobras' recent history of strong free cash flow generation -- $3.9 billion in cash profits thrown off in 2014, growing to $12.4 billion in 2015, $12.9 billion in 2016, and holding pretty steady at $12.6 billion over the past 12 months -- Morgan Stanley argues that the high price of oil is "taking care of the balance sheet" at Petrobras, and that the company's strong FCF "will lead to rapid deleveraging," enabling Petrobras to pay down its debt in short order.

Helping with that mission, the analyst notes (as summarized by TheFly.com) that Petrobras' refining business is "no longer destroying value." There's even the potential for Petrobras to raise even more cash, potentially accelerating the process of paying down debt by selling off assets -- which should fetch higher prices in the current expensive oil environment.

What it means for investors

Of course, $96 billion in debt won't vanish in a day. This is a process that will take time -- probably a lot of time. Even if Petrobras were to devote every penny of free cash flow that it generates to paying down debt -- $12.6 billion in annual cash generation, for example -- it would require more than 7.5 years to pay off the company's debt in full. (Becoming net debt-free -- with cash levels equaling indebtedness -- could be accomplished in a little over six years, and asset sales could accelerate the process even further.)

Looking at Petrobras as it stands today, though, is the stock a buy? Here's how I look at it.

With $100 billion in market cap, $19 billion in cash, and $96 billion in debt, Petrobras carries an enterprise value of roughly $177 billion. Against that valuation, the company is generating $12.6 billion in free cash flow, resulting in an EV-to-FCF ratio of 14. Analysts who follow the stock expect profits to grow rapidly at the company as oil prices remain high -- as much as 20% annually over the next five years.

If they're right, then paying 14 times FCF for 20% growth seems like a fair price to me. And as Morgan Stanley points out, investors are likely to "shift back" to valuing Brazilian stocks such as Petrobras based on their "fundamentals" after the country has successfully picked a new president next week. Once that happens, I'd expect to see Petrobras shareholders richly rewarded.

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Stocks Mentioned

Petroleo Brasileiro S.A. - Petrobras Stock Quote
Petroleo Brasileiro S.A. - Petrobras
PBR
$15.18 (2.19%) $0.33
Petroleo Brasileiro S.A. - Petrobras Stock Quote
Petroleo Brasileiro S.A. - Petrobras
PBR.A
$13.84 (1.43%) $0.20

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