Sticking to Their Guns

Roger Wright, a São Paulo financier, sometimes wonders why people bother staying in business in Brazil. “The cost of financing is so great in just about every sector or industry you choose that I don’t understand why people are investing. If they were rational, they’d sell up and invest in US T-bills,” he says. “The reason they don’t is that they believe in what they are doing and where the country is going.” Confidence in Brazil’s future has rarely been tested as much as it has in recent months. Turbulence in the international markets has cut off financing for nearly all businesses and those able to keep borrowing have had to pay higher interest rates and accept shorter maturities. The credit crunch has grown so severe that it is threatening the survival of some companies and forced the Central Bank to provide liquidity to banks on an emergency basis, enabling them to maintain loans to companies.

Of course, companies across Brazil are not going to shut down just because times are tough and likely to get tougher. Brazilians are rightfully celebrated for their business acumen and entrepreneurial spirit. There are many examples of successful business people who have cashed out of one business and gone on to build up new ventures. Take octogenarian Aloysio Faria, martinet and banker, who sold his Banco Real to ABN AMRO for $2 billion in 1998 on the eve of the real’s devaluation in one of the best-timed business deals of recent years. Instead of retiring with his billions, Faria went back into business, setting up an investment bank, expanding a hotel chain he owned already, entering property development and building up a chain of home improvement stores.

The rewards, or at least the promise of rewards, of doing business in a country as large and as complex as Brazil probably explains why capital flight is rarely as serious a problem as elsewhere in the region. Most companies are still erring on the side of caution. Rômulo Dias, director of Bradespar, an industrial holding company controlled by Banco Bradesco, one of Brazil’s biggest banks, says, “We are not investing much in new ventures. We are investing in existing assets. Our shareholders have given us instructions to keep what we have and just make those assets work better.” Wheeling and dealing is only likely to pick up again after the presidential elections are out of the way and the new president has appointed his cabinet and indicated what his policies are.

Capital Handicap
Going forward, companies are likely to face the same challenges they have had to deal with in the recent past, only more so. Financing, its scarcity and high cost, will surely remain a problem for Brazilian companies for years to come. The high cost of capital is probably the single, largest handicap local companies must cope with since their large, well-capitalized transnational competitors can raise money at razor-thin spreads. According to Economática, a São Paulo consultancy, Brazilian companies pay median annual interest rates of 21%, and 70% of their borrowing is in dollars. Furthermore, companies must cope with an onerous tax structure and a fraying infrastructure. The Rio de Janeiro Federation of Industries claims that deficient infrastructure sticks Brazil with over $80 billion a year in added costs. Last year, growth slowed because the country’s power generators could not keep up with demand and the government introduced electricity rationing. While instability and the government’s big budget deficits are the main reasons why interest rates are so high, Brasília has at least done what it can to breathe life into the capital markets.

BNDES, the state-owned development bank, together with the CVM securities regulator and the São Paulo Stock Exchange, have pushed hard to raise corporate governance standards in the belief that this will tempt investors back into the equity market. Only eight companies have launched initial public offerings since 1997, raising $1.61 billion. Legislation last year reforming Brazil’s corporate law has increased minority shareholder rights. The São Paulo Stock Exchange has created a separate market called Novo Mercado that only admits companies that meet corporate governance standards that are more stringent than those required by law. BNDES has tied its concessionary financing to a commitment by companies to go public or meet enhanced corporate governance standards. The CVM, which is now fully independent of the government, requires companies to rotate their firms of auditors every five years. It also requires that those audits be double checked by a second firm once very four years.

Boosting Value
Corporate Brazil has resisted the appeal of the equity markets for years mainly because valuations are so low. The market capitalization of all listed Brazilian companies has now fallen below $100 billion, less than the $102.3 billion market capitalization of Philip Morris, the US food and tobacco company. And family-owned firms so dislike the notion of sharing power with outside shareholders that they tend to sell out rather than take the company public. There are exceptions, such as the Globo media group (see Profile, page 26) but they are still few and far between. Investors have generally preferred higher-yielding and somewhat less risky government bonds than holding corporate debt or shares.

In an analysis of the share prices and corporate governance policies of companies in several emerging markets, two McKinsey consultants found that adhering to higher standards of corporate governance can increase a company’s value considerably. In a recent article in the McKinsey Quarterly, Roberto Newell and Gregory Wilson reported that, “The reward for good corporate governance is large. By moving from worst to best in corporate governance, companies in our sample could expect, on average, to experience roughly a 10% to 12% increase in their market valuation.”

Local institutional investors are growing in power and they too are demanding that companies perform better financially and respect shareholders. Eliane Lustosa, a director at Petros, Brazil’s second biggest pension fund, says, “We are making a big effort in corporate governance through shareholder agreements in some of the companies in which we hold large stakes. If a company is not taking decisions in the interests of the shareholders, that affects my portfolio so we are being very strict.” Petros has considerable clout, with R$14.5 billion ($5.75 billion) in assets under management in May. However, it has only 24% of this portfolio invested in equities.

There is a good chance that corporate Brazil is going to have to resort more to the equity markets in the future or simply sell out, since there are limits to its ability to borrow more money, as leverage ratios move inexorably upwards. Financial markets are less willing to continue lending and even the state development bank BNDES, for decades the sugar daddy of Brazilian industry, no longer has the resources to lend as much money as companies need. The bank increased disbursements in the first half by 30% to R$ 13.7 billion ($5.9 billion) because borrowers could no longer access the international markets. Yet that was still not enough and in August the Central Bank had to pump more liquidity into the banking system.

Growing Weight
Corporate capital structures are sagging under leverage ratios that have been creeping up for years. According to a survey by Exame, a business magazine, leverage at the country’s 500 largest companies was 48% five years ago and now averages 58%, a record. This may seem moderate by the standards in developed countries, but it is an uncomfortably heavy burden in an economy as volatile as Brazil and exposes companies to considerable refinancing and exchange risk. At the end of the first quarter, Brazil’s listed companies had total debts of $180 billion, 30% of which were short-term loans, according to Economática. Some companies have become so leveraged that they have had to sell out, such as privatized steelmill CSN, which in March had $2.72 billion in debt and a leverage ratio of 128%. CSN is to merge with Corus, an Anglo-Dutch steel company in a $1.8 billion deal.

Most CFOs have learned to hedge hard currency loans after many companies flirted with insolvency following the real’s 30% devaluation in 1999. However, the cost of swapping dollar loans into reais has escalated as the real has resumed its fall and it is only practicable to hedge the short-term portion of a company’s total dollar debts or seek a natural hedge by exporting more. Refinancing risk in recent months has grown so severe that only a few companies and banks can raise fresh loans.

Yet companies need to think hard about financing because competition from domestic and international players is unlikely to diminish. Foreign investment in Brazil has risen sharply in the last five years as transnational companies built greenfield plants, acquired local competitors and bought up state-owned enterprises in privatizations. Most foreign companies have invested in Brazil to sell their products in the local market, rather than to export locally manufactured goods. Brazil has attracted $170 billion in foreign direct investment in the last five years alone, and the ownership structure of Brazilian industry has changed markedly. A decade ago, foreign corporations controlled 15% of Brazil’s companies. That figure has increased to 36% today. Locals own 40% of the country’s companies, the same as a decade ago. The government owns the remaining 24%, according to a study by the Federal University of Rio de Janeiro.

Opening Up
Import competition is also likely to intensify as international trade regimes open up. Although Brazil’s corporate elites have traditionally viewed trade liberalization with great suspicion, pressure from the European Union and the US to sign on to free trade agreements is likely to be irresistible. Brazil’s import tariffs have fallen sharply and now average 14%, but import penetration has fallen in recent years as the real has sunk and the economy cooled. All the same, researchers at the Inter-American Development Bank have noted a sharp increase in productivity in industries exposed to import competition. They found that Brazilian industries with little import competition posted a negligible average improvement in productivity of 1.6% per year between 1996 and 1999, whereas companies in industries producing tradable goods saw an average 7.2% increase in productivity in the same period.

Thanks to increased productivity and its low-cost resources, Brazil is a brutally efficient producer of agricultural and industrial commodities like corn and soybeans or steel and petrochemicals. However, companies have struggled to take the next step up the value chain. The high cost of capital, economic uncertainty and a relatively small and unsophisticated domestic market make it hard to justify building large, expensive microchip fabricators or specialty chemical plants. Industry lobbyists are trying to convince the government to overcome these shortcomings by pressing for subsidies to encourage companies to spend more on research and development and training. For instance, São Paulo-based Instituto de Estudos para o Desenvolvimento Industrial wants the next government to design an industrial policy that would support “strategic” sectors like electronics, software development, biotechnology and life sciences.

Although Brazil does have a few centers of scientific excellence such as the University of São Paulo and the University of Campinas, the country is very far from becoming a serious producer of scientific and technological research. Brazil’s output of scientific papers and the number of patents awarded to Brazilians has stagnated in recent years. In 1995, Brazil ranked third among emerging market countries registering patents but last year fell to sixth place behind Asian countries. The government has responded by increasing the budget of the Science and Technology Ministry and is gearing up to offer subsidized loans to encourage research and development spending in industry. Currently nearly all R&D occurs in universities.

Financial markets seem disinclined to support high-tech companies. For example, São Paulo-based Microsiga, a software company, missed the Internet boom and its plans to go public have languished. Private equity investors are also wary of backing technology ventures. (see Private Equity, page 30) Alexandre Saigh, a partner in Patrimônio, a merchant bank that operates some of Brazil’s biggest private equity funds, likens investing in Brazilian tech companies to “putting a stick of dynamite in the oven. If Brazil is risky enough already why am I going to invest in a risky sector? I want a safe business with big margins, solid market shares and growth potential even in the worst scenarios.”

Cutting Capital Costs
Local companies can lower their risk profile by investing outside Brazil. This can be an expensive proposition but if this strategy is properly executed it should cut the cost of capital as long as markets are convinced that a substantial portion of a company’s assets and its cashflow are well beyond Brazilian jurisdiction. While a handful of Mexican companies have succeeded in growing into multinationals, far fewer Brazilian companies have done so. Gerdau, an independent steel producer, is Brazil’s best example of internationalization. Over the years it has discreetly bought up steelmills throughout the Americas, and now has subsidiaries in Canada, the US, Chile and Uruguay that generate over 40% of its revenues. Cutrale, a privately held producer of frozen, concentrated orange juice, has leapfrogged US import barriers by buying up orange groves and production plants in Florida. Bankers say Cutrale’s Florida groves generate 60% of its output, compared with 40% for Brazil. Cia. Vale do Rio Doce, a privatized mining company, has gingerly begun expanding outside Brazil by prospecting for base metals in the Andean countries. Petrobras, the national oil company, and Ambev, Brazil’s leading drinks company, have both bought up Argentine companies. Petrobras agreed in July to pay $1.13 billion for Pecom Energía and in May, AmBev agreed to pay a $346.4 million in cash for 37% of Quilmes, Argentina’s biggest brewery. While these were irresistible opportunities to invest in choice Argentine companies, they do nothing in the short term to improve the Brazilians’ risk profile.