Brazilian Tech Bets

Brazil has lately become a hotbed of deal making. Latin America’s largest and possibly most promising new technology market is drawing in foreign companies willing to pay surprisingly high prices for choice assets. In a landmark deal in June, Telecom Italia paid $810 million for a 30% stake in globo.com, valuing the Internet portal owned by Organizações Globo, the country´s largest media group, at $2.7 billion.

This seems a lot even for a country expected to see substantial growth. A survey by the consultants KPMG in São Paulo found that Internet and information technology deals dominated mergers and acquisitions activity in the first quarter of 2000, with 14 transactions. A year earlier, it counted just three information technology-related deals. And the size of deals has been growing all year.

In January, iG, an aggressive free-access portal, raised $100 million from investors for 14% of its equity, which valued the company at $714.3 million. In February, Portugal Telecom paid $365 million for Zipnet, a portal. Since then, the Portuguese have completed a series of Internet deals that raised their investments in Brazil to $515 million. In June, Mexico’s telecom giant Telmex, announced a $3.5 billion alliance with Bell Canada that would include construction of a high-speed Internet network in Brazil.

However, even the finances of Brazil’s better Internet companies do not look any stronger than those in the US or Europe. Universo Online, the country’s largest portal, with over 600,000 subscribers, posted losses of $47 million on revenues of $38 million in the first quarter.

This, plus upheaval on the Nasdaq Stock Market and the São Paulo Stock Exchange is making the outlook for further deals a lot less certain. Private equity investors are thin on the ground. Yet in June, IdeiasNet, an incubator, became the first Latin Internet company to list on a local market, raising $18.4 million in an oversubscribed initial public offering on the São Paulo market. It proved that Brazilian equity investors are ready to back Internet ventures, although the local market hardly seems large enough to accommodate bigger companies. UOL has mulled a listing in São Paulo and on Nasdaq for about a year, but has yet to take the plunge.

On the whole though, Brazil’s comparatively large and sophisticated capital markets have played only a marginal role in the process of building up new industries and recasting traditional ones. Investors are usually willing to buy debentures and corporate debt with maturities of two years or less. New equity issues are almost unheard of these days, although new securities legislation (see box on page 34) may pep up the market.

Instead, Brazilian companies are looking overseas for partners and the capital and the expertise they bring. Mergers and acquisitions increased sharply with 65 deals in the first quarter of 2000, a quarter more than in the same period last year. “I believe 2000 will recover to the same levels as in 1998,” says André Castello Branco, a partner with KPMG. Last year, when Brazil plunged into recession following the real crisis, 309 deals were completed. In 1998, KPMG said 351 deals were completed.

Deals within the fragmented telecommunications industry will be particularly prevalent. Telefónica, the region’s dominant operator, is leading the way with a $20 billion stock repurchase program to delist its Latin American subsidiaries. It will spend most of this in Brazil, where it controls the main fixed line company in the state of São Paulo the country’s wealthiest and most populous region. Portugal Telecom, Telefónica’s minority partner in some operations, is also buying in shares in Telesp Celular, the country´s largest cellular operator, in an operation likely to cost over $700 million.

Anatel, the telecommunications regulator, plans to auction new PCS cellular concessions in the second half of this year, in addition to two existing services and intends to sell licenses for a fourth concession in 2001. Investment bankers say Vodafone, the world’s largest cell phone company, which doesn’t have operations in Latin America, is particularly interested in the new concession.

Anatel has issued new regulations for the cellular system that promises to reshape the market and open the way for consolidation by carving Brazil into only three regions, each to be covered by a single company. This would further increase the pressure on the large number of small companies struggling for survival. Brazil has about 40 fixed line and cellular telephone companies, many of them too small to survive.

However, the action can only start in 2003 when the market is fully liberalized. Several companies such as Globo, are already positioning themselves to enter the telecom market once it is thrown open to full competition. This is why Globo is barging into the cable market: it is paying $870 million for the 90% of Net Sul it does not yet own. Net Sul is Brazil’s second- largest cable television provider, operating mainly in the wealthy southeast.

Meanwhile, Brazil’s banking industry will likely face a defining moment later this year, assuming the government succeeds in privatizing Banespa, the São Paulo state bank. The big three of Brazilian banking – Bradesco, Itaú and Unibanco – are expected to bid, as well as a group of international banks likely to include Citibank, Britain’s HSBC and the two Spanish rivals Banco Bilbao Vizcaya Argentaria and Banco Santander Central Hispano.

Whoever wins Banespa would gain a commanding position in the country’s richest and most populous state. Some of the losers would be forced to sell out to a bigger local or international bank. Brazil has over 200 banks and consolidation at the high end of the market could unleash a series of mergers throughout the banking industry.

The excitement over Brazil’s financial and technology, media and telecom sector does not extend to its old technology companies: slow-growth, capital intensive and highly cyclical businesses such as paper and pulp, steel, petrochemicals and manufacturing. Few of Brazil’s metal-bashers have advanced beyond producing low value-added industrial commodities. Although these companies are often well managed, they are losing the battle for the hearts and minds of investors. Two Brazilian equity issues in the last nine months – an offering by VCP, a paper and pulp company and Ultrapar, a petrochemicals group – fared badly. However, VCP has picked up recently on the strength of rising global prices for its products.

Still, there is plenty of value to be unlocked in the arduous process of restructuring these companies. The largest of them are privatized industrial behemoths linked to each other through complex cross-shareholding structures that have exposed companies to conflicts of interest and impeded efficient management. Brazil’s sprawling petrochemicals industry is especially intertwined.

João Roberto Teixeira, director of corporate finance at Dresdner Kleinwort Benson’s office in Rio de Janeiro, says “privatization was only the beginning of the restructuring of the former state monopolies. In many cases, their shareholder structure is no longer appropriate. These companies need stable equity structures to get appropriate financing for their projects.”

A Rights Revolution
Legislation working its way through Brazil’s Congress would bring drastic and much-needed changes to the country’s out-dated securities law.

A series of acquisitions of Brazilian companies by foreign investors over the last five years forced investors to sell their stock to acquirers on highly unfavorable terms. JC Penney’s acquisition in December 1998 of a Brazilian retailer on particularly harsh terms prompted the country’s first investor revolt and led to the current change in law.

Perhaps the single most important feature of the new legislation is an increase in the rights of non-core shareholders to benefit from takeover premiums, which under existing legislation are appropriated almost entirely by often small groups of controlling shareholders. This is because companies can issue two non-voting preferred shares for every ordinary or voting share, which would enable investors to control a company with little more than 16% of total equity. Still, most of the founding families that control Brazil’s large companies hold a comfortable majority of voting and preferred stock.

In the future, acquirers must buy voting shares through a public tender, which would give non-core investors the same price as the holders of controlling stakes. In addition, the group selling control may, if it wishes, extend these rights to preferred stockholders who would get at least 80% of the price paid to holders of voting shares. Companies must pay higher dividends to holders of preferred shares, or have them converted automatically to voting stock.

Until recently, voting stock was much less liquid than more abundant preferred stock and traded at substantial discounts. Even for highly liquid stocks such as Petrobras, the national oil company that is planning a $4 billion secondary ordinary share offering, ordinary stock traded at a 50% discount to preferred stock. That gap has now fallen to zero as the market becomes convinced that the legislation will pass. Opposition is poorly focused, while Finance Minister Pedro Malan and Armínio Fraga, the central bank president, backed by Brazil’s growing shareholder rights activists are backing the legislation. Political analysts in Brasília say Congress should approve the legislation before the fourth quarter of 2000.

Other proposed changes include a measure that would require companies to issue equal quantities of voting and preferred stock in future equity issues. However an attempt to force listed companies to follow this rule in secondary stock offerings was voted down in committee.

The new legislation also would introduce arbitration of disputes between shareholders, controlling shareholders and management. This would substantially speed up the settlement of disputes currently handled by a slow and unpredictable court system.

Meanwhile, the new rules would also allow investors holding more than 10% of a company to call a shareholders’ general meeting to rule on a conflict of interest. Shareholders who charge that their rights have been violated, can use the voting rights of absent investors. An additional proposal would require greater representation of minority investors on a company’s main board and management board (conselho fiscal).

In addition, the government plans to strengthen the authority of the largely toothless CVM securities regulator. The Brazilian president would appoint the agency head and the Senate would confirm the candidate for a five-year term. The CVM would also become financially independent from the government, and gain greater investigative and enforcement powers. The legislation also criminalizes a series of securities and accounting irregularities, such as insider trading and stock price manipulation.