Investment bank UBS Pactual downgraded Friday shares of Brazilian steel company Gerdau (GGB) to "Neutral" from "Buy" after the company reported a steep year-on-year decline in first-quarter profits.

"Gerdau reported disappointing first-quarter earnings, as high costs and declining volumes continue to take a toll on the company," UBS said in a research report.

A recent run-up in the Gerdau's shares has pushed valuation to a less-attractive level, UBS said. The company's shares were up 41% since the start of March versus a 31% gain for the Ibovespa stocks index.

UBS also noted that since steel prices were unlikely to improve sequentially, the primary driver for profitability would fall on lower costs and higher volumes - which first-quarter earnings results didn't support.

"We are revising our estimates down and we are less confident that they will see positive earnings surprises," UBS said. UBS said it trimmed volume estimates and raised cost assumptions in its model.

While Gerdau remains well-positioned to benefit from a recovery, such a recovery will likely take place at a much slower pace than current market expectations, UBS said.

"While we continue to like Gerdau's long-term strategy and see the operating leverage as attractive, its high debt level remains an issue," UBS said. The investment bank noted that Gerdau may resort to an equity issue to offset debt, although management has said it wasn't under consideration.

Despite the downgrade, UBS raised its target price for Gerdau's locally traded shares to 21 reals ($10.10), up from BRL18.50.

As of 1355 GMT, Gerdau's shares were 2.7% higher at BRL18.39 on the Sao Paulo Stock Exchange, or Bovespa.

-By Jeff Fick, Dow Jones Newswires; 55-21-2586-6085; Jeff.Fick@dowjones.com