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Tickers in this Article: PBR, XOM
Following Petroleo Brasileiro S.A., or Petrobras' (PBR) dismal second quarter showing, we have downgraded the Brazilian state-run energy giant to Underperform from Neutral.

Headquartered in Rio de Janeiro, Petrobras is the largest integrated energy firm in Brazil. The company's activities include: the exploration, exploitation and production of oil from reservoir wells, shale and other rocks, and in the refining, processing, trade and transport of oil and oil products, natural gas and other fluid hydrocarbons, in addition to other energy-related activities.

Petrobras recently posted its first quarterly loss in 13 years on the back of a weak domestic currency, rising costs and heavy fuel imports. Loss per ADR came in at 10 cents (1 ADR = 2 shares), contrary to the Zacks Consensus Estimate of 33 cents in profit. During the corresponding period last year, Petrobras earned $1.06 per ADR. Petrobras' net operating revenues of $34.7 billion were down 9.4% from the second quarter 2011 level.

Petrobras - which aims to surpass Exxon Mobil Corporation (XOM) by 2020 to become the world's largest oil producer - has embarked on an ambitious investment program for the 2012-2016 period, totaling a massive $236.5 billion. This is expected to substantially increase the company's leverage and deteriorate its credit metrics during the current downturn in the economic cycle. Additionally, the increasing capital intensity of its operations may result in reduced returns going forward.

In September 2010, Petrobras raised R$120.4 billion ($70 billion) in the biggest global share issue in history. Following the share sale, the Brazilian government boosted its stake in Petrobras, now controlling approximately 63% of the voting power. This has led to investor skepticism regarding heightened state interference in the company.

Finally, Petrobras is expected to suffer from its inability to shift the burden of rising oil costs to its consumers, as mandated by the state policy of keeping a lid on gasoline and diesel prices.

Given these concerns, we expect Petrobras to perform below its peers and industry levels in the coming months. Our long-term Underperform recommendation is supported by a Zacks #5 Rank (short-term Strong Sell rating).

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