is it time to buy brazil?docs.hedgeye.com/he_brazil_feb2014.pdf · because of brazilian...

DARIUS DALE: MACRO TEAM

IS IT TIME TO BUY BRAZIL?

FEBRUARY 27, 2014

HEDGEYE 2

DISCLAIMER Hedgeye Risk Management is a registered investment advisor, registered with the State of Connecticut. Hedgeye Risk Management is not a broker dealer and does not make investment recommendations. This research does not constitute an offer to sell, or a solicitation of an offer to buy any security. This research is presented without regard to individual investment preferences or risk parameters; it is general information and does not constitute specific investment advice. This presentation is based on information from sources believed to be reliable. Hedgeye Risk Management is not responsible for errors, inaccuracies or omissions of information. The opinions and conclusions contained in this report are those of Hedgeye Risk Management, and are intended solely for the use of Hedgeye Risk Management’s clients and subscribers. In reaching these opinions and conclusions, Hedgeye Risk Management and its employees have relied upon research conducted by Hedgeye Risk Management’s employees, which is based upon sources considered credible and reliable within the industry. Hedgeye Risk Management is not responsible for the validity or authenticity of the information upon which it has relied. TERMS OF USE This report is intended solely for the use of its recipient. Re-distribution or republication of this report and its contents are prohibited. For more detail please refer to the appropriate sections of the Hedgeye Services Agreement and the Terms of Use at www.hedgeye.com

LEGAL

HEDGEYE 3

• Slides 4-22: A quick review of our bear case on Brazil (and emerging markets broadly)

• Slides 23-56: Debating the bull case on Brazil

• Slides 57-68: Proprietary valuation work on Vale (VALE) and Petrobras (PBR)

• Slides 69-71: Summary of actionable investment ideas

TABLE OF CONTENTS A Brief Review of our #EmergingOutflows Theme: 4/16/13: 2Q13 Macro Theme: #EmergingOutflows 4/23/13: Presentation: “Emerging Market Crises: Identifying, Contextualizing and Navigating Key Risks in the Next Cycle” 4/29/13: Expert Call w/ Carl E. Walter: “Will China Break?” 6/12/13: Presentation: “Are You Short China [and Other] Emerging Markets Yet?” 7/15/13: 3Q13 Macro Theme: #AsianContagion 8/30/13: Presentation: “Long Weekend Reading Material: 65 Charts To Help You Own the Debate On Emerging Markets” 12/21/13: Presentation: “#EmergingOutflows: More Pain to Come?”

HEDGEYE 4

“Not much else needs to be said other than the fact that it has recently become clear to us that Brazilian policymakers refuse to address the country’s growth/inflation imbalance – which they themselves have perpetuated through currency debasement – with an adequate amount of exchange rate appreciation (we already know Dilma won’t budge on rates). Losing the “war” at home: Brazil is flat-out losing what Finance Minister Guido Mantega dubbed in SEP 2010 as the “Currency War” – mostly because of Brazilian policymakers’ own doing. The ~2yrs of capital controls (which are now slowly being reversed) did little to boost economic growth; 2012 real GDP should come in at roughly +1% YoY – the slowest since 1999 outside of the -0.3% YoY decline in 2009.

Inflation is not growth: The weak BRL did, however, boost inflation, which has exceeded the median central bank’s 4.5% +/- 200bps target for 29 consecutive months! The aforementioned bastardization of international capital also contributed to a drop in investment, which shrank to ~20% of GDP last year (vs. ~48% for China), according to preliminary IMF estimates.

Small measures won’t cut it: Now, in order to combat the now-obvious ramp in CPI that has stemmed from burning the BRL over the past ~2yrs, the Brazilian government has just resorted to scrapping all taxes on the basket of staple foods (after Rousseff herself vetoed a similar measure back in SEP). This latest counter-inflation measure out of the Brazilian government is in addition to their recent use of forceful negotiation tactics with Brazilian utilities in order to drive down energy tariffs for Brazilian consumers and businesses.

Mantega doesn’t get it: The breakdown was confirmed by Mantega’s latest statement on the BRL: “The government is ready to block exaggerated gains in the currency… the exchange rate isn’t an instrument to control prices and a weaker currency helps to protect the domestic industry from foreign competition.”

Pigheadedness ≠ policy: With a hint of arrogance, these comments show Brazilian policymakers haven’t learned anything from the past ~18-24 months of “exaggerated” policy failures.”

“GET OUT OF BRAZIL IF YOU HAVEN’T ALREADY” (2/6/13)

KEY EXCERPTS

SOURCE: HEDGEYE RISK MANAGEMENT

HEDGEYE 5

NEGATIVELY DIVERGING

HEDGEYE 6

STILL BROKEN

DATA SOURCE: BLOOMBERG

15,000

25,000

35,000

45,000

55,000

65,000

75,000

HEDGEYE QUANTITATIVE SETUP: BRAZILIAN EQUITIES Brazil Bovespa Index = 46599.21 TRADE = 47778 TREND = 49802

HEDGEYE 7

IDIOSYNCRATIC HEADWINDS MATTER


50

60

70

80

90

100

110

120

130

140

150

BLOOMBERG CONSENSUS NTM EARNINGS ESTIMATES (INDEXED TO 3Y AGO)

MSCI Brazil Index MSCI Russia Index MSCI India Index MSCI China Index

MSCI South Africa Index MSCI Indonesia Index MSCI Mexico Index

HEDGEYE 8

LONG-TERM UNDERPERFORMANCE

HEDGEYE 9

BRL: PUNISHED


CNY

HKD

INR

IDR

MYR PHP SGD

KRW

TWD THB

CZK

HUF

PLN RON

RUB

TRY

ZAR

ARS

BRL CLP

COP MXN

PEN

y = -0.5794x - 2.9558 R² = 0.5353

-12

-10

-8

-6

-4

-2

0

2

-4 -2 0 2 4 6 8 10 12

x-axis: Absolute YoY Change 1Y Implied Volatility; y-axis: 25 Delta Risk Reversal (1Y)

HEDGEYE 10

… AND EXPECTED TO CONTINUE


CNY

HKD

INR

IDR MYR

PHP SGD

KRW

TWD

THB

CZK

HUF

PLN RON

RUB TRY

ZAR

ARS

BRL

CLP

COP

MXN

PEN

y = 0.1225x + 2.7161 R² = 0.0253

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

-25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0%

x-axis: Forecasted Spot Return EOY '14; y-axis: Forecasted Total Return EOY '14

HEDGEYE 11

HEDGEYE’S EM CRISIS RISK MODEL STILL THE MOST PREDICTIVE MODEL ON THE STREET

DATA SOURCE: BLOOMBERG; WORLD BANK; IMF; BIS.

HEDGEYE 12

HOW THE MODEL WORKS

HISTORICAL CONTEXT Sampling scores of written works that analyzed emerging market crises both at the time of crisis and well after, we carefully indentified ten key economic indicators across four key categories (i.e. “Pillars”).

MATH At the single indicator level, each country is ranked according to its length of standard deviations from the sample average. A higher deviation always indicates greater risk, so for indicators where a higher value is healthy (like a current account balance or budget balance), we inverted the signs. Each country’s deviations are then averaged and multiplied by a constant to produce a composite score at the Pillar level.

ANALYTICAL INSIGHT Certain indicators were given a higher weighting in the average based on both historical precedent and what we viewed as the eminent areas of risk in the current cycle. The aggregate risk score is a arithmetic mean of the four Pillar-level scores .

1

2

3

HEDGEYE 13

CHARTING THOSE IDIOSYNCRASIES


HEDGEYE 14

BRAZIL: THIRD RISKIEST EM ECONOMY


-64 -62 -50

-39 -36 -27 -23 -22

-16 -15 -7 -4

2 6 7 10 11 12 20 23

28 36

42 44 48 51 56

85

-100

-80

-60

-40

-20

0

20

40

60

80

100

HEDGEYE MACRO EM CRISIS RISK INDEX (HIGHER SCORE = MORE RISKY)

AGGREGATED RISK

HEDGEYE 15

DRIVEN BY AWFUL FISCAL POLICY


-128

-102 -95 -82 -77 -76

-56 -44

-29 -28 -14 -12 -11

-1

0 8 13 18 27 34 39 43 45

58 61 65 68

91

145

-150

-100

-50

0

50

100

150


PILLAR II: FISCAL SUSTAINABILITY RISK

HEDGEYE 16

AND BAD SOCIOECONOMIC POLICY


-168 -160

-132

-75 -64 -59

-49 -47 -38 -36 -36 -36 -34 -32 -27 -16

1 4

30 35 52 53

83 94 97 101

122

153 179

-200

-150

-100

-50

0

50

100

150

200


PILLAR IV: POLITICAL & REGULATORY RISK

HEDGEYE 17

A BROAD CARRY TRADE EXPOSED MATH DOESN’T LIE; INVESTMENT FUND PROSPECTUSES DO


-0.90 -0.84 -0.82

-0.57

0.52

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

CRB/BLS Spot Commodity Index

MSCI Emerging Markets Index Gold Spot ($/ozt.) JPMorgan Emerging Markets Currency Index

UST 10Y Yield (%)

EM EQUITIES, EM FX, BONDS, GOLD, COMMODITIES... IT'S ALL THE SAME CARRY TRADE BORN OUT OF SUSTAINED US DOLLAR DEBASEMENT!

Trailing 10Y Correlation to the Trade-Weighted US Dollar Index (Natural Log of Daily Closing Prices)

HEDGEYE 18

THE THREAT OF THE UNWIND REMAINS REMEMBER, THE 2010-12 #EMERGINGINFLOWS WERE HUGE

SOURCE: INSTITUTE OF INTERNATIONAL FINANCE

HEDGEYE 19

AS DOES MATERIAL DRAW-DOWN RISK OUTFLOWS PERPETUATE UNINTENDED CONSEQUENCES


60

70

80

90

100

110

120

130

140

150

160

170

#STRONGDOLLAR ERAS EXPOSE EMERGING MARKETS TO A VARIETY OF RISKS

US Dollar Index

1960s-1970s

Arthur Burns and Richard Nixon team up to debauch the US Dollar by abandoning the Gold Standard and

monetizing US Treasuries

The price of crude oil rips and OPEC "recycled" those USDs into Latin America in the form of USD-

denominated loans

1980s

1982: Mexico defaults

1982-83: Ensuing Latin American Debt Crisis

1983-89: Subsequent

IMF-imposed austerity (prolonged growth

slowdown)

1980s-1990s

Caving in to the demands of the US manufacturing industry -- particularly

automobile producers -- the US Treasury teamed up with its Japanese, German,

French and British counterparts to devalue the USD via the Plaza Accord

The accompanying easing of monetary

conditions once again perpetuated large outflows of US capital into EMEs -- many of which were just starting to turn the corner

economically

1990s-2000s

1994: Mexico's Tequila Crisis

1994-95: Subsequent contagion in Argentina and

Brazil

1997-98: Asian Financial Crisis

1998: Russia defaults

1999: Brazil devalues

2001: Turkish Financial Crisis

2001-02: Argentina defaults

2002: Uruguay Banking Crisis

2000s

Once again facing recession and/or sluggish growth, US policymakers --

particularly Presidents Bush and Obama and Federal Reserve Chairmen

Greenspan and Bernanke -- use a variety of tools to devalue the USD, including record low interest rates

and record-wide budget deficits

Once again, investors looking for respectable return on their capital flocked to EMEs -- which became

increasingly accessible via financial innovation

Chinese demand quintuples amid

record USD liquidity

2010s

2013: Indonesia

India Turkey Brazil

2014:

Argentina Ukraine

Venezuela

HEDGEYE 20

UNDERPERFORMANCE CAN LAST IF WE’VE TURNED THE CORNER ON US GROWTH, THEN…


15.8%

1.4%

10.6%

-5.3%

14.5%

-7.4% -169.2%

272.1%

-55.8%

-200%

-150%

-100%

-50%

0%

50%

100%

150%

200%

250%

300%

-10%

-5%

0%

5%

10%

15%

20%

1995-2001 #StrongDollar Era 2001-2011 #WeakDollar Era 2011-Present #StrongDollar Era

DON'T FIGHT THE TAPE: THE #STRONGDOLLAR ASSET ALLOCATION SHIFT IS UNDERWAY

S&P 500 CAGR MSCI EM Index CAGR Cumulative Relative Performance of MSCI EM (rhs)

HEDGEYE 21

“CHEAP” CAN GET A LOT CHEAPER VALUATIONS APPEAR SUPPORTIVE; THEY DID 3M AGO TOO


70

75

80

85

90

95

100

105

110

115

120

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

MSCI EM Index EV/TTM EBITDA vs. MSCI World Index EV/TTM EBITDA (Ratio)

Historical Mean = 72.5%

+2x Standard Deviations Above the Mean = 105.4%

-2x Standard Deviations Below the Mean = 39.6%

US Dollar Index - Monthly Average (rhs)

HEDGEYE 22

ESPECIALLY AMID AMPLE SPREAD RISK MARKETS CAN MEAN REVERT MUCH FURTHER FROM HERE


65

70

75

80

85

90

95

100

105

110

115

THE EM FX CARRY TRADE IS STILL RIFE WITH SPREAD RISK JPM EM FX Index - Monthly Average Trade-Weighted US Dollar Index - Monthly Average

HEDGEYE 23

SO WHY BUY BRAZIL?


-0.43 -0.40 -0.44

-0.33

-0.56

-0.32

-0.52

0.29 0.23

-0.10

0.06 0.00

-0.03

0.05

0.85

0.10 0.04 0.03 0.01

0.18

0.61 0.68

0.14

0.66 0.67 0.68

0.57

-0.68

0.74 0.73

0.06

-0.54

-0.29

-0.56

0.15

0.55

0.08

-0.81

0.11

0.94

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

Thomson Reuters/Jefferies CRB Commodity

Index

Commodity Research Bureau BLS/US Spot All

Commodities (22)

Commodity Research Bureau

BLS/US Spot Foodstuff

Commodity Research Bureau BLS/US Spot Raw

Industrials

Front-month Brent Crude Oil

Front-month High Grade Copper

Gold Spot ($/ozt.) US Dollar Index (DXY)

US 10Y Yield (%) MSCI Emerging Markets Index

MULTI-DURATION CORRELATIONS TO THE BOVESPA INDEX (IN USD TERMS)

5/20/10-11/4/10 (+25.4%) 8/8/11-3/14/12 (+40.3%) 6/5/12-1/3/13 (+20.6%) 7/3/13-10/22/13 (+25.3%)

HEDGEYE 24

THREE REASONS TO BE BULLISH ON THE BRL

A WIDENING REAL INTEREST RATE SPREAD We believe Brazilian fiscal and monetary policy will remain tight, at the margins, over the intermediate term, while slowing economic growth in the US will cause the Fed to ease – at least rhetorically – at the margins. That should lend support for a relief rally for once-popular EM carry trading strategies.

A LIKELY NARROWING OF THE CURRENT ACCOUNT DEFICIT At the present moment, the threat of social unrest renders the World Cup an underappreciated catalyst for broad macroeconomic improvement in Brazil.

UNDERVALUED WITH A POLITICAL CATALYST: REFORM Our proprietary valuation models show that the BRL is anywhere from 12% to 30% undervalued vs. the USD. Our analysis suggests the OCT 5th election will be much closer than investors think. The potential for opposition parties to gain material traction is not at all insignificant. Political gridlock would be very positive to slow the pace of fiscal deterioration; new leadership would be even better in terms of promoting economic reforms.

1

2

3

HEDGEYE 25

US GROWTH IS SLOWING

HEDGEYE 26

BECAUSE INFLATION SLOWS GROWTH

HEDGEYE 27

HOUSING MARKET MOMENTUM: GONE

HEDGEYE 28

OLD FORMAT = $800/SQUARE FT NEW FORMAT = $1,300 SQ FT

DOLLAR DOWN + RATES DOWN = EM RELIEF RALLY?


79

80

81

82

83

84

85

HEDGEYE QUANTITATIVE SETUP: US DOLLAR INDEX

US DOLLAR INDEX TREND = 81.12 TAIL = 81.04

1.50

1.70

1.90

2.10

2.30

2.50

2.70

2.90

3.10

3.30

HEDGEYE QUANTITATIVE SETUP: UST 10Y YIELD

UST 10Y YIELD (%) TREND = 2.80 TAIL = 2.54

HEDGEYE 29

THAT WOULD BE POSITIVE FOR BRAZIL


72

74

76

78

80

82

84

86

88

90

92

-$20,000

-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

GLOBALIZATION AND DIVERSIFICATION HAVE MADE THE USD A KEY FACTOR IN DETERMINING CROSS-BORDER INVESTMENT IN BRAZILIAN FINANCIAL ASSETS

Brazil Net Portfolio Investment QTD Sum ($M) US Dollar Index (rhs)

HEDGEYE 30

ESPECIALLY BRAZILIAN EQUITIES


68

70

72

74

76

78

80

82

84

-R$5,000

-R$4,000

-R$3,000

-R$2,000

-R$1,000

R$0

R$1,000

R$2,000

R$3,000

R$4,000

HISTORICALLY, THE BOVESPA HAS ESPECIALLY FAVORED A WEAKER USD

BMF Bovespa Exchange MTD Net Inflows (BRL millions); SMAVG(6) Trade-Weighted US Dollar Index (rhs)

HEDGEYE 31

IS THE EM CARRY TRADE BACK “ON”?


ARGENTINA

BRAZIL

CHILE CHINA

CZECH REPUBLIC

EGYPT

HUNGARY

INDIA

INDONESIA

MALAYSIA

MEXICO PHILIPPINES

POLAND

RUSSIA SOUTH AFRICA

SOUTH KOREA

TAIWAN

THAILAND

TURKEY

y = -0.4093x - 0.9546 R² = 0.0928

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0%

x-axis: Real 3M Deposit Rate; y-axis: Real Dividend Yield Linear (x-axis: Real 3M Deposit Rate; y-axis: Real Dividend Yield)

HEDGEYE 32

THE BCB'S HAWKISHNESS IS HELPING


7%

8%

9%

10%

11%

12%

13%

WILL ROUSSEFF AND MANTEGA CONTINUE TO ALLOW TOMBINI TO REMAIN VIGILANT ON INFLATION?

BCB Overnight Interest Rate (SELIC)

HEDGEYE 33

THEY WILL NEED TO DO MORE


-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

WHOLESALE PRICES, WHICH TYPICALLY LEAD CONSUMER PRICES BY 4-6M IN BRAZIL, HAVE INFLECTED AND ARE NOW ACCELERATING WELL IN ADVANCE OF BCB'S TARGET BEING MET

FGV Brazil General Prices IGP-M YoY SMAVG(3)

Brazil CPI IPCA YoY SMAVG(3)

Median of Central Bank's Target Range = +4.5% YoY

HEDGEYE 34

INFLATION WILL REMAIN STICKY


HEDGEYE 35

A TIGHT LABOR MARKET EQUALS…


4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

A HUMAN CAPITAL DEFICIENCY AND A LARGE BLACK MARKET ARE THE ROOT CAUSE FOR BRAZIL'S TIGHT LABOR MARKET -- NOT ECONOMIC GROWTH

IBGE Brazil Unemployment Rate Region 30 Days New Methodology NSA SMAVG(12)

HEDGEYE 36

UNCHECKED WAGE INFLATION


-1.4%

5.4%

11.3%

7.4% 7.0%

10.4%

4.8%

12.7%

8.9% 9.4% 9.0%

20.0%

8.3%

15.4%

16.7%

8.6% 9.2%

12.0%

9.7%

6.9%

14.1%

9.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

WAGE GROWTH IN BRAZIL HAS AVERAGED +9-10% Y/Y OVER THE PAST 3Y, HELPING BOOST NOMINAL GDP GROWTH TO A SIMILAR AVERAGE. MEANWHILE, REAL GDP GROWTH HAS

AVERAGED A MEASLY +2.3% OVER THAT TIME FRAME. WHAT GIVES?: INFLATION

Brazil Usually Earned Nominal Total Income YoY Brazil Minimum Wage YoY

HEDGEYE 37

PLUS, CPI COMPARES GET EASY


0.8x

1.4x

1.1x

0.9x 0.9x

0.5x

-0.6x

-0.1x

1.2x

1.9x

1.7x 1.7x

1.1x

0.8x

1.3x

1.1x

0.8x

0.1x

-0.3x

-0.9x

5.2% 5.4% 5.3% 5.2% 5.3%

5.1%

4.5%

4.9%

5.5%

5.8% 5.9% 6.1%

5.9% 5.8%

6.2% 6.2% 6.1%

5.8% 5.7% 5.7%

0%

1%

2%

3%

4%

5%

6%

7%

-1.5x

-1.0x

-0.5x

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

Z-SCORE (TRAILING 3Y) OF SELECTED COMPARATIVE BASE (2Y COMP) FOR THE RESPECTIVE CPI REPORTING PERIOD

BRAZIL 2Y COMP (rhs)

HEDGEYE 38

AMID ANNUALIZED FX WEAKNESS


8.0%

12.4%

7.2%

-5.8% -5.7%

-18.6% -19.5%

-12.5% -11.5%

-5.1%

-11.3%

-9.5%

-16.2%

-13.4%

-4.1% -4.6%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

BRL-USD X-RATE Quarterly Average, YoY % Change

Forecasts assume no change in prices from current levels.

HEDGEYE 39

ECONOMISTS GET IT


6.11%

5.2%

5.4%

5.6%

5.8%

6.0%

6.2%

6.4%

INFLATION EXPECTATIONS HAVE INFLECTED RECENTLY

Brazil Central Bank Market Survey of NTM YoY CPI

HEDGEYE 40

WHILE TRADERS OVERREACT


0bps

20bps

40bps

60bps

80bps

100bps

120bps

140bps

160bps

180bps

200bps

EXPECTATIONS FOR BCB MONETARY POLICY HAVE INFLECTED RECENTLY... IS THAT A GOOD OR A BAD THING?

Brazil NTM OIS less Benchmark SELIC Rate (bps) Brazil 1Y Nominal Sovereign Debt Yield less Benchmark SELIC Rate (bps)

HEDGEYE 41

FISCAL POLICY MARGINALLY SUPPORTIVE


-6.0%

-5.5%

-5.0%

-4.5%

-4.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

BRAZIL BUDGET BALANCE/GDP RATIO = -3.2% TTM AVERAGE = -3%

HEDGEYE 42

GDP COMPS NO LONGER A TAILWIND


-1.8x

-1.5x

-1.0x

-0.8x

-0.6x -0.6x -0.7x

0.8x

1.6x

1.2x

0.5x

-0.2x

-0.9x

-1.2x -1.3x

-1.1x -1.1x

-0.7x -0.8x

-0.5x

1.8% 2.0%

2.8% 3.1%

3.3% 3.2%

2.7%

5.3%

6.8%

6.0%

4.5%

3.4%

2.5%

1.9%

1.5% 1.6% 1.3%

1.9% 1.6%

1.9%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

-2.5x

-2.0x

-1.5x

-1.0x

-0.5x

0.0x

0.5x

1.0x

1.5x

2.0x

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

Z-SCORE (TRAILING 3Y) OF SELECTED COMPARATIVE BASE (2Y COMP) FOR THE RESPECTIVE GDP REPORTING PERIOD

BRAZIL 2Y COMP (rhs)

HEDGEYE 43

RETAIL SALES TRENDS STILL POSITIVE


-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

BRAZIL RETAIL SALES YoY % CHANGE = 4% SMAVG(3) = 5.5% SMAVG(6) = 5.5%

HEDGEYE 44

BUT PRODUCTION IS CRASHING


-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

BRAZIL INDUSTRIAL PRODUCTION YoY % CHANGE = -2.3% SMAVG(3) = -0.4% SMAVG(6) = 0.3%

HEDGEYE 45

AS IS THE CURRENT ACCOUNT BALANCE


-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

BRAZIL CURRENT ACCOUNT BALANCE/GDP RATIO = -3.6% TTM AVERAGE = -3.1%

HEDGEYE 46

Hydropower, which generates 80% of electricity in Brazil is being constrained by an unusually dry rainy season… JAN ’14 was the second driest in 80 years

In early FEB, water levels in the southeast and central western regions – home to 70% of the country’s reservoirs and half of the population – dipped to 37% of capacity, the lowest since 2001

Meanwhile, electricity usage is running up +10% Y/Y (JAN) and peak demand reached an all-time high of 86GW in early-FEB… that compares to a YTD average of 66.8GW

Total installed energy capacity is a robust 126.7GW, but assured energy capacity is around 63GW – i.e. below average demand… peak demand should cool from here, but there is rising risk of brownouts

To fill the gap, utilities must burn fossil fuels, etc… that is costly in the context of 2012’s energy price cuts, forcing the government to set aside a total of R$9B to plug operating holes… ratings agencies believe another R$5.6B will be needed – unless a +4.6% price increase is implemented (Fitch)

“BROWNOUTS”: BAD FOR GROWTH WILL ENERGY BILLS RISE BY +4.6% Y/Y IN 2014?

SOURCE: THE ECONOMIST (FEBRUARY 15TH, 2014)

HEDGEYE 47

WORLD CUP: GOOD FOR GROWTH


120bps

320bps

-8bps

300bps

158bps

193bps 183bps

-50bps

0bps

50bps

100bps

150bps

200bps

250bps

300bps

350bps

France (1998) South Korea (2002) Japan (2002) Germany (2006) South Africa (2010) Trailing Three World Cup Average

Trailing Three World Cup Average ex-SA (for GFC recovery)

Real GDP Growth, bps Delta From Previous Year

HEDGEYE 48

AND THE CURRENT ACCOUNT


-61bps

72bps

120bps

210bps

85bps

-100bps

-50bps

0bps

50bps

100bps

150bps

200bps

250bps

South Korea (2002) Japan (2002) Germany (2006) South Africa (2010) Trailing Three World Cup Average

Current Account Balance as a % of GDP, bps Delta From Previous Year

HEDGEYE 49

WILL BRAZIL PULL AN INDONESIA?


-3.6%

-2.5%

-4.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

2013E 2014E

DECENT IMPROVEMENT IN THE SERVICES SECTOR DEFICIT COULD NARROW THE BROADER CURRENT ACCOUNT DEFICIT BY ~100 BASIS POINTS

Brazil Current Account Balance as a % of GDP

HEDGEYE 50


POLITICAL REFORM AHEAD?

Poor institutions and a lack of adequate infrastructure remain key headwinds to Brazil’s structural economic growth outlook.

As our EM Crisis Risk Model highlights, the biggest risks to investing in Brazil are generally associated with the inefficient and overbearing government sector.

SOURCE: WORLD ECONOMIC FORUM 2013-14 GLOBAL COMPETITIVENESS INDEX

HEDGEYE 51

CONSUMER CONFIDENCE SAYS, “YES”


105

110

115

120

125

130

Brazil FGV Consumer Confidence SA = 107.1 SMAVG(3) = 109.1 SMAVG(3) = 110.9

HEDGEYE 52

SO DOES INDUSTRIAL CONFIDENCE


48

50

52

54

56

58

60

62

CNI Brazil Industrial Confidence General = 52.4 SMAVG(3) = 53.3 SMAVG(3) = 53.7

HEDGEYE 53

BRL REER VALUATION


y = -0.0244x + 4.1693 R² = 0.8737

1.25

1.45

1.65

1.85

2.05

2.25

2.45

80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 110 112

x-axis: Brazil Real Effective Exchange Rate Broad; y-axis: Brazilian Real Spot (Monthly Averages)

Red dot indicates current reading. Trailing 10yrs of data.

HEDGEYE 54

BRL REAL INTEREST RATE VALUATION


y = -0.0007x + 2.2952 R² = 0.3946

1.45

1.55

1.65

1.75

1.85

1.95

2.05

2.15

2.25

2.35

2.45

200bps 300bps 400bps 500bps 600bps 700bps 800bps 900bps 1000bps

x-axis: BRL Real 12M Sovereign Yield, bps Spread vs. USD; y-axis: Brazilian Real Spot (Monthly Average)

Red dot indicates current reading. Trailing 5yrs of data.

HEDGEYE 55

CONSENSUS DOESN’T CARE


2.05 2.08

2.05

2.47

2.55

2.00

1.75

1.85

1.95

2.05

2.15

2.25

2.35

2.45

2.55

2.65

2.75

2014E 2015E 2016E

USD/BRL SPOT Bloomberg Consensus Forecast - 1Y Ago Bloomberg Consensus Forecast - Latest

HEDGEYE 56

NEITHER DO INVESTORS


2.21

2.35

2.48 2.53

2.78

3.04

2.00

2.20

2.40

2.60

2.80

3.00

3.20

EOY '14 EOY '15 EOY '16

USD/BRL SPOT Implied Forward Rate - 1Y Ago Implied Forward Rate - Latest

HEDGEYE 57

THE “BRAZIL DISCOUNT”


-62% -59%

-52%

-47%

-33% -33% -29%

-27%

-19%

-15%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

Teck Resources Ltd

Vale SA Anglo American PLC

Kumba Iron Ore Ltd

Mitsubishi Corp

BHP Billiton Ltd

Rio Tinto Ltd Fortescue Metals Group

Ltd

Mitsui & Co Ltd Wesfarmers Ltd

THE "BRAZIL DISCOUNT" HAS NEGATIVELY IMPACTED VALE Peak-To-Present Decline in Market Cap (USD); Trailing 3Y

HEDGEYE 58

EVEN WORSE HERE


-70%

-34%

-19% -18%

-11% -11%

-5% -2%

0% 0%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

Petroleo Brasileiro SA

PetroChina Co Ltd

Eni SpA China Petroleum &

Chemical Corp

Chevron Corp Statoil ASA Exxon Mobil Corp

Royal Dutch Shell PLC

Total SA BP PLC

THE "BRAZIL DISCOUNT" HAS CRUSHED PBR Peak-To-Present Decline in Market Cap (USD); Trailing 3Y

HEDGEYE 59


MARKET SHARE VALUATION

VALE Not particularly cheap or expensive.

PBR Not particularly cheap or expensive.


BHP Billiton Ltd

Rio Tinto Ltd

Vale SA

Wesfarmers Ltd Anglo American PLC Mitsubishi Corp Mitsui & Co Ltd

Fortescue Metals Group

Ltd Kumba Iron Ore

Ltd Teck Resources

Ltd

y = 1.1388x + 6692.5 R² = 0.307

$-

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

$200,000

$- $20,000 $40,000 $60,000 $80,000

x-axis: TTM Net Sales ($M); y-axis: Market Cap ($M) Exxon Mobil

Corp

Royal Dutch Shell PLC PetroChina Co

Ltd Chevron Corp

BP PLC Total SA

China Petroleum & Chemical Corp Eni SpA Statoil ASA


y = 0.4322x + 51548 R² = 0.2888

$-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$- $100,000 $200,000 $300,000 $400,000 $500,000

x-axis: TTM Net Sales ($M); y-axis: Market Cap ($M)

HEDGEYE 60


PRICE/BOOK VALUATION

VALE The market is not paying for VALE’s book value growth.

PBR “What even is book value in this space?”, says the market.


BHP Billiton Ltd Rio Tinto Ltd

Vale SA

Wesfarmers Ltd

Anglo American PLC Mitsubishi Corp Mitsui & Co Ltd

Kumba Iron Ore Ltd

Teck Resources Ltd

y = 2.5448x + 6.4248 R² = 0.4284

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0.0 2.0 4.0 6.0 8.0

x-axis: Price/Book Ratio; y-axis: Book Value 5Y CAGR


PetroChina Co Ltd

Chevron Corp

BP PLC Total SA

China Petroleum & Chemical Corp

Eni SpA

Statoil ASA Petroleo Brasileiro SA

y = -0.0958x + 8.8148 R² = 0.0002

0

2

4

6

8

10

12

14

0 0.5 1 1.5 2

x-axis: Price/Book Ratio; y-axis: Book Value 5Y CAGR

HEDGEYE 61


EV/EBITDA VALUATION

VALE Appropriately valued on cash flows.

PBR Slightly overvalued on cash flows.


BHP Billiton Ltd

Rio Tinto Ltd

Vale SA

Wesfarmers Ltd

Anglo American PLC

Mitsubishi Corp

Mitsui & Co Ltd

Kumba Iron Ore Ltd

Teck Resources Ltd

y = -0.9683x + 9.3063 R² = 0.1771

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

0.0 5.0 10.0 15.0 20.0

x-axis: EV/NTM EBITDA Ratio; y-axis: EBITDA 5Y CAGR

Exxon Mobil Corp


PetroChina Co Ltd

Chevron Corp

BP PLC

Total SA


Eni SpA

Statoil ASA


y = 1.4133x - 6.8631 R² = 0.093

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

0.0 1.0 2.0 3.0 4.0 5.0 6.0

x-axis: EV/NTM EBITDA Ratio; y-axis: EBITDA 5Y CAGR

HEDGEYE 62


P/E VALUATION

VALE Appropriately valued on earnings.

PBR Appropriately valued on earnings.


BHP Billiton Ltd

Rio Tinto Ltd

Vale SA

Wesfarmers Ltd

Mitsubishi Corp Mitsui & Co Ltd

Kumba Iron Ore Ltd

Teck Resources Ltd

y = 1.4775x - 17.255 R² = 0.3485

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

0.0 5.0 10.0 15.0 20.0

x-axis: Price/NTM Earnings Ratio; y-axis: Adjusted EPS 5Y CAGR

Exxon Mobil Corp


PetroChina Co Ltd

Chevron Corp

BP PLC

Total SA


Eni SpA

Statoil ASA


y = 0.8433x - 12.515 R² = 0.0835

-16.0%

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0

x-axis: Price/NTM Earnings Ratio; y-axis: Adjusted EPS 5Y CAGR

HEDGEYE 63


YIELD VALUATION

VALE Decent yield support.

PBR Very high-yielding. An appropriate target for a carry trade.


BHP Billiton Ltd

Rio Tinto Ltd

Vale SA

Wesfarmers Ltd

Anglo American PLC

Mitsubishi Corp Mitsui & Co Ltd Fortescue

Metals Group Ltd

Kumba Iron Ore Ltd

Teck Resources Ltd

y = -0.0906x + 5.2152 R² = 0.1142

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

-5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

x-axis: TTM Earnings Yield; y-axis: TTM Dividend Yield

Exxon Mobil Corp


PetroChina Co Ltd

Chevron Corp

BP PLC Total SA China Petroleum & Chemical Corp

Eni SpA

Statoil ASA


y = 0.1085x + 3.6859 R² = 0.0674

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

x-axis: TTM Earnings Yield; y-axis: TTM Dividend Yield

HEDGEYE 64


DRIVERS

VALE Vale needs China. Even if China doesn’t blow up, its

structural rebalancing agenda and capacity reduction across materials-intensive industries bodes poorly for VALE’s future.

PBR Petrobras needs a stronger BRL – especially with the

government forcing them to eat the cost of subsidies for refined products. PBR doesn’t have enough upgrading

capacity domestically, so it’s often forced to import refined products or light sweet crude at huge operating losses.


1.3

1.5

1.7

1.9

2.1

2.3

2.5 $10

$15

$20

$25

$30

$35

$40

$45

$50

$55 Petroleo Brasileiro SA (PBR) USD/BRL Spot (rhs; inverted)

0

50

100

150

200

250

$0

$5

$10

$15

$20

$25

$30

$35

$40

Vale SA (VALE)

China Iron Ore Import Prices 62% Fe Spot (rhs)

HEDGEYE 65

OPERATING TRENDS ON THE MEND?


0%

10%

20%

30%

40%

50%

60%

-100%

-50%

0%

50%

100%

150%

200%

250%

300%

350%

400%

VALE SA (VALE) Revenue ($M) YoY 2Y Average TTM Operating Margin (rhs)

HEDGEYE 66

EASY COMPS IMPLY, “YES”


-2.2x

-2.0x

-1.0x -1.1x

-0.8x

2.1x

0.2x

0.7x 0.7x

2.3x

0.4x 0.4x

-0.2x

-0.7x

-1.1x -1.0x -1.1x -1.0x -0.8x

-13.0%

-27.8%

2.9%

-11.8%

-1.6%

127.1%

38.0%

64.7% 60.1%

188.5%

65.4%

75.4%

38.4%

14.6%

-9.9% -4.9%

-9.0% -14.0% -10.9%

-50%

0%

50%

100%

150%

200%

-2.5x

-2.0x

-1.5x

-1.0x

-0.5x

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13E 1Q14E 2Q14E 3Q14E

VALE SA (VALE) Z-Score (3Y) of 2Y Top Line Comp for Respective Reporting Period Actual 2Y Top Line Comp for Respective Reporting Period

HEDGEYE 67

STILL A DOG – THANKS TO PILLAR IV


5%

10%

15%

20%

25%

30%

35%

-40%

-20%

0%

20%

40%

60%

80%

PETROLEO BRASILEIRO SA (PBR) Revenue ($M) YoY 2Y Average TTM Operating Margin (rhs)

HEDGEYE 68

BAKE IN A BACK HALF RECOVERY?


7.2%

10.8%

13.5%

7.3%

10.1%

2.2%

-3.6%

24.5%

34.2% 33.4%

23.9%

13.8%

15.6%

9.3% 9.1%

7.0% 5.9%

-3.3%

-7.1% -1.8x

-1.2x

-0.9x

-1.2x

-0.8x

-1.2x

-1.4x

0.7x

1.3x 1.4x

0.8x

-0.1x 0.0x

-0.5x -0.5x

-0.7x -0.7x

-1.4x

-1.6x

-200%

-150%

-100%

-50%

0%

50%

100%

150%

200%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14E 2Q14E 3Q14E 4Q14E

PETROLEO BRASILEIRO SA (PBR) Z-Score (3Y) of 2Y Top Line Comp for Respective Reporting Period Actual 2Y Top Line Comp for Respective Reporting Period

HEDGEYE 69

BEST IDEA: LONG BZF LOTS OF UPSIDE IF YELLEN BECOMES HERSELF IN 3-6M


$16

$18

$20

$22

$24

$26

$28

$30

HEDGEYE QUANTITATIVE SETUP: BRAZILIAN REAL (BZF) WisdomTree Brazilian Real Strategy Fund (BZF) = 17.76 TRADE = 17.46 TREND = 17.36

HEDGEYE 70

BEST-IDEA-IN-WAITING: LONG PBR BUY IT ON A BREAKOUT ABOVE THE TREND LINE


0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

HEDGEYE QUANTITATIVE SETUP: PETROBRAS (PBR) Petrobras (PBR) = 11.07 TRADE = 11.39 TREND = 13.13

HEDGEYE 71

BEAR CASE

• Its current 3M decline of -37% is the steepest 3M selloff since 2008 and the stock remains broken on our quantitative signals

• Worst FCF generation of all 113 oil & gas producers tracked by Bloomberg over the TTM ($15.4B loss)

• Its refining division has lost $35B since 2011, when the gov’t forced it to start subsidizing domestic fuel prices by selling imported gasoline and diesel at a loss – often at a ~20% discount to international prices

BULL CASE

• If nothing else, it’s an optically cheap way to play our #InflationAccelerating theme: PBR’s market cap is less than half of what it was before it began exploring its pre-salt reserves ($149B for the SEP ‘10 IPO; $225B in APR ’11; and $71B currently)

• The planned introduction of six new platforms should boost production capacity by +680k barrels per day by EOY ‘14 (on a base of 2.54 mbpd)

• That would be very positive after 2Y of negative production growth… as would a policy to raise domestic fuel prices (is the OCT ‘14 election a catalyst?)

• Over the past five years, it’s registered a negative correlation of -0.70 to the USD/BRL spot rate, meaning that as the BRL strengthens, PBR’s stock price also tends to increase in value

ULTIMATE BEARISH SENTIMENT; VALUATIONS AT EXTREMES

LONG PBR JANUARY 2015 OTM CALLS?

Falling prices are giving us an opportunity to do more work here, but preliminary indications suggest a decent appreciation of the BRL vis-à-vis the USD would provide a much needed boon to PBR’s cash flow dynamics.


FOR MORE INFORMATION CONTACT:

[email protected] 203.562.6500

mailto:[email protected]�

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