by Raúl Gallegos

Brazil is the toast of the global oil industry. A string of massive oil discoveries over the past five years and generous capital spending by Petrobras is attracting top oil service companies in droves.

But not all is well in the new oil frontier. Petrobras is missing its production targets and its project execution is falling behind schedule. The delays are hurting suppliers and have left Brazil’s leading oil services company, Lupatech, on the brink of bankruptcy.

Lupatech, an energy valve manufacturer, is the poster child for the dangers of growing too fast and too soon in the Brazilian oil business. Encouraged by Brazil’s large, offshore finds in 2007, the company borrowed heavily and embarked on a string of 17 acquisitions that left it too weak to sustain the 2008 oil price drop and the resulting slowdown.

The company is now undergoing the equivalent of open heart surgery, a capitalization and business overhaul led by the company’s main shareholders, state development bank BNDES and Petros – Petrobras’ worker pension unit – as well as private equity fund GP Investments.

As of early February, these three partners sought to inject as much as 700 million reais ($379.3 million) into the ailing company and merge the business with Brazilian driller San Antonio International, which itself went through a debt restructuring and was acquired by GP Investments in 2007.

What may result from the corporate surgery is still anyone’s guess, but the industry outlook suggests Lupatech can still flounder competing against a host of stronger and more experienced players.

As it stands, Lupatech’s prognosis is grave. The company shouldered a 1.3 billion real debt load as of September, which means equity is almost non-existent and debt holders own 95% of the company’s capital, based on Standard & Poor’s estimates.

Of total debt, 350 million reais is in the form of convertible bonds, most of which are owned by BNDES and whose covenants have been adjusted to keep the company current in the face of its non-existent liquidity.

In the 12 months ended in September, Lupatech saw a negative free cash flow of 100 million reais. Meanwhile, the company is on the hook for $25 million annually in debt service to bondholders and S&P reckons it faces 200 million reais in refinancing needs during the first half of 2012 alone.

“I wouldn’t want to make any assumptions under this kind of scenario. We’ve put the company under review pending the conclusion of the deal,” says Auro Rozenbaum, a Bradesco BBI analyst. “It’s not in the best interests of Petrobras, BNDES or the government to see this company go under.”

Lupatech’s American Depositary Shares rose 19% over the month of January on the back of the capitalization announcement. But in an indication that the market fears the worst, the shares have lost 80% of their value over the last year and were trading at $3.15 per share on February 10.

The company’s 9.875% perpetual bonds, rated Caa2/CCC- by Moody’s and S&P respectively, had climbed back to 74 cents on the dollar, in part due to bondholders’ belief that BNDES won’t let the company flatline. But how long will BNDES and its partners continue to support the company, and how soon can Lupatech generate enough business to walk on its own?

Lupatech is a leading manufacturer of flow control valves for the oil industry, a product typically used in the development and production stages of an offshore oil field, not in the initial oil exploration phase, where most of Petrobras’ projects still stand.

The company has a $2.5 billion backlog of orders from Petrobras, which is partly obtained through the Progredir program. Progredir – designed by Petrobras and financial institutions – allows Petrobras to book services years in advance so small companies can use those unfulfilled orders as collateral to obtain bank financing.

Indeed, Lupatech’s business survival hinges largely on the strength and efficiency of a single customer – Petrobras. Having the world’s fifth largest oil company by market capitalization as a client is not a bad prospect. But having Petrobras as the single most important client is another matter.

Depending on a single customer gives the client all the bargaining power and can ruin a company. If Petrobras is forced to delay its plans, as it has already, Lupatech’s cash flows are squeezed and both its shareholders and bondholders pay the ultimate price. Depending on a sole customer also leaves Lupatech with little power to set prices and negotiate deals to its advantage in the future.

Lupatech’s weak financial health also leaves it at the mercy of its own suppliers. As an upstart likely to continue to struggle with a high level of debt, it is hardly in a position of strength when negotiating prices for the inputs it needs. This also gives Lupatech’s suppliers the upper hand in pricing, which means the valve producer has little control over how high or how quickly its costs can escalate.

Officials at Lupatech declined to discuss the company’s financial health and its competitive outlook, citing its quiet period as it undergoes restructuring. Officials at BNDES also declined to comment.

Those who see a future in Lupatech point to the company’s leadership in the energy valve field as well as the merger with driller San Antonio, a company that itself has $1.5 billion in backlog orders in the oil sector.

Observers expect the new Lupatech to go beyond valves and function as a traditional oil services company such as Baker Hughes, Schlumberger and Halliburton, all three of which are already doing business in Brazil.

Some are betting that Lupatech will be able to leverage Brazil’s local content law, which forces all oil projects to obtain a minimum percentage of their services from domestic suppliers. This requirement opens a broad market for Brazilian companies such as Lupatech, potentially allowing it to grow and thrive.

At this point, however, the local content does not guarantee that Lupatech will necessarily be able to compete with other companies that have more established business models and healthier balance sheets.

“I’m not sure how much of a positive [local content] is over the medium term for Lupatech. If companies like Halliburton or Schlumberger were to buy a local company, they could meet local content requirements,” says Filippe Goossens, head of Latin America corporate ratings for Moody’s.

In the business of energy flow control solutions where Lupatech operates, some valve makers have already set up manufacturing facilities in Brazil by acquiring companies on the ground in anticipation of increased demand from Petrobras when it seeks offshore services in the future.

For instance, Oklahoma City-based Circor International, an energy industry valve producer, has set up a production facility in the state of São Paulo. Circor entered Brazil a year ago through the acquisition of Brazilian company Valvulas SF Industria e Comercio, a company with $20 million in sales at the time.

Meanwhile, global engineering company The Weir Group, another important valve-maker, already has established operations for its valve unit in Macaé in the state of Rio de Janeiro, the center of Brazil’s offshore oil industry.

In drilling and oil services, a line of business that Lupatech is seeking to enter, global companies such as Halliburton, and Schlumberger and drillers Baker Hughes and Transocean, already have established operations in the new oil rich country.

Baker Hughes, a company that already serves Petrobras, has created a deep water technology research center in Rio de Janeiro. Schlumberger has done the same, while US driller Transocean has set up training facilities in Macaé.

If Petrobras continues to delay its standing work orders, many of these competitors may have already built their operations by the time Lupatech starts to execute the long-awaited Petrobras work orders in one or two years time. With such an outlook, it would appear Lupatech has much more to worry about than a financial lifeline. LF