Opportunity Knocks

This year promises to be one of upheaval in corporate Brazil. Companies are reorganizing themselves trying to bulk up and gain scale to cope with growing international competition. Foreign direct investment is likely to hold up well, signaling more acquisitions of local companies by international competitors. Valuations are recovering after a dismal 2001, the economy is slowly expanding and the international markets should be growing again by the second half of the year as interest rates look set to fall.

Says Luiz Chrysostomo, JP Morgan’s head of investment banking in Brazil, “We think that there will be [continuing] foreign flows of capital to Brazil and that there will be cross-border M&A [transactions] independent of Brazil [risk]. There are good possibilities for selling companies in the retail, food, consumer goods and capital goods industries. In technology, infrastructure, services, concessions and so on.”

Gustavo Marín, president of Citibank in Brazil, says, “If real interest rates fall below 10%, and we expect that to happen, then a lot of projects will become financially viable.”

They are not alone in hoping for the best. Brazil is the busiest market for M&A advisors in Latin America but it has been a feast-to-famine sort of market. Last year was terrible, with volumes down to under $15 billion, two-thirds less than in 2000. This year has got off to a good start, with four acquisitions worth $1.06 billion by Banco Bradesco, Brazil’s biggest private sector bank in January alone (see “Sharks and Minnows,” page 31).

Under Pressure
Many Brazilian companies are under pressure to restructure, either to rebuild their balance sheets, divest unwanted divisions and subsidiaries or buy up assets to gain scale and keep up with giant global competitors. Consolidation is particularly brutal in industries in which Brazil excels such as mining and paper.

Walter Appel, partner at Banco Fator, a São Paulo investment banking boutique, says this process was underway last year when the terrorist attacks in New York and Washington threw the world financial system into confusion. “September 11th froze many operations and raised Brazil risk,” he says. “Now the risk is falling and we are seeing operations being executed.”

Although there are fewer big-ticket privatizations on the horizon, bankers expect to keep busy with the aftermath of the mass state sell-offs of the 1990s. Says Winston Fritsch, president of Dresdner Bank in Brazil, “The big thing in Brazilian M&A is the post-privatization consolidation game, especially in telecoms and electricity.”

The government broke up and then sold off its power and telecommunications monopolies in the second half of the 1990s as fragmented units with strictly controlled territories. It imposed limits on ownership changes for five years. That time is up, and companies in both industries are busily rearranging their assets to gain scale economies and build a national network.

Some of these deals can be large. Last year, Portuguese-owned Telesp Celular Participações paid $1.2 billion for 49% of the voting shares and all the non-voting shares in Global Telecom, a cellphone company operating in southern Brazil, from Brazil’s Inepar, DDI Corporation and ITX Corporation. In another deal, Telecom Américas, a Canadian-Mexican consortium, bought 19.9% of Tess, a São Paulo cellphone company, for $950 million from Brazil’s Algar. It bought 81% of Americel, yet another cellphone operator, for $452 million and 85% of Telet for $463 million. América Móvil, the Mexican-owned cellular operator, bought 41% of Algar Telecom Leste from Williams Communications for $400 million cash.

Some Brazilian companies overextended themselves during the telecoms privatization jamboree. Algar, which controls 20 companies generating annual revenues of R$1.1 billion ($450 million), is revamping its telecoms business, which generates most of its turnover. It hired management consultants Booz Allen&Hamilton to advise on a plan to merge its five telecom units in an effort to reap scale economies and become more focused.

CVRD Springs Loose
The most complex post-privatization deals have taken place in the mining and chemical industries. The government sold Cia. Vale do Rio Doce, the mining company, in 1995 to an unwieldy consortium of local investors that soon began squabbling among themselves. They were divided by conflicts of interest and could not agree on the company’s future. The principal shareholders included Grupo Vicunha, owners of steelmaker CSN that was also an important CVRD customer. Against it were ranged financial investors led by Bradespar, the industrial arm of Banco Bradesco, and Banco do Brasil’s Previ employee retirement fund, the country’s biggest pension fund.

It took bankers from JP Morgan acting for Previ and Bradespar two and a half years to broker an agreement between the groups and split CSN and CVRD apart. JP Morgan put together a deal in which Previ and Bradespar sold their stakes in CSN to Vicunha for $1.18 billion. At the same time, they paid Vicunha $1.31 billion for its CVRD shares.

As soon as CVRD’s shareholders had settled the dispute over control, the company went on an acquisition spree. In April, CVRD bought 50% of Caemi, a private-sector mining group for $280.7 million to share control with Japan’s Mitsui. A week later, it took over Ferteco, another iron ore producer from Thyssen-Krupp Stahl in a $680 million deal.

The Brazilian groups that survived the 1990s are now probably fit enough to survive almost any business environment. They lived through hyperinflation, debt moratoria and government freezing of bank accounts. They also had to contend with – and used to their advantage – an atmosphere of constant bureaucratic meddling, interference by politicians and corruption.

The survivors stayed alive by avoiding debt like the plague. High interest rates that oscillated violently killed off many companies. According to UBS Warburg, Brazilian-listed companies are modestly leveraged. They had debt-to-equity ratios of only 26% last year. Three years earlier, the rate was 30%. Few Brazilian companies are in as serious straits as Mexico’s conglomerates, struggling with unsustainable debt loads and a confusing tangle of businesses.

Successful Brazilian companies also concentrated on making fewer, more sophisticated and more profitable products. For instance, Klabin, a 102 year-old family-owned paper company, was heading for the rocks. It was floundering without a clear business strategy, lacked sufficient scale and was sinking in debt. It fell into the red in 1997. Since then, Klabin has shed commodity-type products and focused on high value-added sectors like packaging. The company cut its debt load, which was consuming all its operating income. In the process it closed down or spun off 14 companies to generate annual savings of $100 million. Klabin returned to profit in December 2000 and has recovered steadily since then.

The revival of Klabin was only part of a wider reorganization of the paper and pulp industry. Cia. Suzano de Papel e Celulose acquired 50% of the voting stock and 19% of the non-voting stock in Bahia Sul Celulose, a pulp company, from CVRD for $312.4 million in February 2001. Japan Brazil Paper and Pulp bought 51.5% of Cenibra, another pulp company, owned by CVRD $650 million. Finally, Votorantim Celulose e Papel (VCP) bought 28% of the voting shares in Aracruz Celulose, the pulp exporter, from Anglo American’s Mondi Brazil for $370 million.

However, Klabin and Suzano are both small companies in an international market that is consolidating by the day. They have significant cost advantages, but these are no longer enough to hold their own against big North American and Scandinavian groups.

Unfortunately for the Brazilians, the government is less inclined to support national champions by lavishing public money on a politician’s favorite company or industry. This is a big change from the days when skillful lobbying in Brasília for handouts or protection was more important than developing and marketing new products. Norberto Valdrigue, senior executive director at Banco BMC in São Paulo, comments, “The days are gone when businessmen expected the government to help them. The government is still there, but they are on their own now.” He says executives need to concern themselves less with lobbying and “worry more about things like taxes and interest rates.”

All the same, it is possible that the next government, which is due to take over in January 2003, may be more interventionist than the outgoing administration of President Fernando Henrique Cardoso. Even so, it is scarcely credible that Brazil would ever move back to the protectionist, statist policies that were in force for most of post-World War II period.

Most companies have made the transition to a truly free-market economy as best they could. For instance, Andrade Gutierrez, a construction company that grew fat on public sector contracts, has reinvented itself as a provider of privatized public services. As recently as 1994, the government provided 90% of Andrade Gutierrez’s revenues. Since then, state contracts have fallen to 30% of revenues and the company has diversified into telecoms and privatization concessions. It is the largest Brazilian private-sector shareholder in Telemar, the country’s second-largest telephone company.

Some Struggling
Others are struggling. Many family-owned companies, bitterly divided by succession disputes, suffering from capital depletion or poor management have a difficult future ahead. They will be bought out by stronger local or international groups or will go bust. The finance director of a company struggling with over $1 billion in debt and an 85% debt ratio says, “The problem of this company is that it cannot generate the resources it needs to finance growth. Our level of indebtedness is limited. We need to sell assets to partners and reduce costs across the group, to get a better valuation so we can engage in an IPO process in one to two years’ time.”

Stronger groups not beholden to family interests acted earlier. Three years ago, Embraer, the privatized regional jet maker, sold 20% of its voting stock to a group of French aviation companies. Cia. Brasileira de Distribuição, a family-owned supermarket company that is Brazil’s second-biggest retail chain, also sold a minority stake to Casino, the French retailer. Clearly, it is possible for successful companies to remain under majority family control. There are many examples of healthy companies like Weg, the electric motor company, steel maker Gerdau, Klabin and Suzano. However, these tend to be names that have resolved succession disputes or turned management over to professional executives.

Limited access to capital remains a critical weakness for all Brazilian companies. Rising competition has eroded their profit margins that used to be big enough to generate earnings to finance investments. As a result, companies are beginning to take the equity market more seriously than before as a source of raising capital.

Odebrecht Oleo e Gas, the energy arm of the Odebrecht Group, mandated Dresdner Kleinwort Wasserstein to mount either an IPO or locate a strategic investor. This is part of a plan for Odebrecht’s operating companies to raise financing from debt or equity markets, rather than relying on support from the parent company. CCR, a highway concession operator, went public in January by floating 20% of its equity on the São Paulo Stock Exchange, the first IPO in Brazil since May 2000. The market’s Ibovespa index has fallen by nearly half and volumes have shrunk by over 70% in dollar terms in the last two years.

Financial Constraints
Capital starvation affects the largest and smallest companies in Brazil. Small companies rarely grow into larger ones simply because they cannot raise enough debt or equity capital to expand. They have no access to the capital markets and bank loans are prohibitively expensive, even when banks agree to lend. Banco Fator’s Walter Appel says small companies are stuck in a financial Catch 22. “Brazilian companies can only grow if they are capitalized and they can’t grow with debt. There is no access to the capital market. It is hell being a small Brazilian company.”

Brazil is fortunate that is has an organization like Banco Nacional de Desenvolvimento Economico e Social (BNDES), the government-owned development bank. It lends at about 12% a year in reais to companies that qualify for support. Although BNDES provides $12 billion annually in financing in loans or through capital market operations, its resources are limited (see Capital Markets section, pages 16 through 25).

Even big companies have trouble raising finance at reasonable interest rates. João Batista Nogueira, chief financial officer at state-controlled oil producer Petrobras, which is also the biggest company in Brazil, says his dream is to become a “frequent issuer of plain vanilla bonds” (see “Across-the-Board Issuing.” page 30). At the moment, it raises money through project finance deals and by issuing asset-backed bonds or bonds backed by political risk insurance. This will only ever happen when Petrobras wins an investment-grade rating, although Moody’s does rate the company Ba1, above the sovereign’s B1 grade.

Petrobras, which has annual revenues of $30 billion, needs to continue improving its financial profile. Although its market value has increased strongly in the last three years to $22.5 billion, it still trades at discounts to companies of a similar size in the US or Western Europe. This is why Petrobras is carefully extending its international presence by buying up properties or operating companies in developed countries to diversify its risk profile. It will be following in the footsteps of Grupo Gerdau, which has grown into Brazil’s largest steel company through a judicious balance of organic growth and acquisitions at home and abroad. It now gets about 40% of its revenues from outside Brazil.

In December, it bought 18% of the voting stock of Açominas for $175 million from the failed Banco Econômico. In January, Gerdau offered to pay Singapore’s NatSteel $209 million for 25% of Acominas, to raise its stake in Açominas to 56%. Earlier in January, Gerdau paid Birmingham Southeast, the fifth steel maker in the US, $48.8 million for its Cartersville steel mill. The acquisition increases Gerdau’s North American capacity by 17%. Family-controlled Gerdau owns nine mills in Brazil and has subsidiaries in Argentina, Uruguay, Chile, Canada and the US.

But few Brazilian companies have ventured abroad, unlike Mexican groups such as cement company Cemex, Telmex, the dominant telephone operator or Grupo México, the mining group. Many Brazilian companies have built up close relationships in Argentina since the creation of the Mercosur customs union. They may be tempted to convert uncollectable debts from their clients into equity stakes, or take over weaker Argentine competitors. Although the scene in Argentina is still very confusing, asset prices are falling by the day. One Rio banker says, “Exporters should use the crisis in Argentina to take over the market. This would be a good time to buy their competition.”

Regional Push?
So far, few Brazilian companies have invested in Argentina. Banco Itaú, Brazil’s most profitable bank, bought up Banco del Buen Ayre, a small local retail bank for $213.5 million in 1998, an investment that is now in tatters. Itaú is growing in the Brazilian market organically and through acquisitions. Yet it is also mulling expansion into regional markets. In December, it paid $1.6 billion for Banco Sudameris, the Italian-owned regional bank. With the deal Itaú got the Brazilian, Chilean and Peruvian assets of Sudameris as well as a collection of branches in Europe.

Itaú has built up a faithful following among equity investors at home and on Wall Street with its steadily rising earnings and a high degree of disclosure. Itaú’s bosses have hinted that the bank has enough backing on the capital markets to be able to raise a substantial amount of money to finance a major acquisition when the time is right.

Fritsch and many other Brazilian bankers speculate that foreign companies and banks could begin packing up and leaving Brazil. “They expected more growth in Latin America and now they need to sell or cut back their situation and retrench,” says Fritsch. Last year, two Portuguese banks sold their recently acquired Brazilian subsidiaries to Unibanco and Bradesco. Naturally, no bank or company is admitting to talks on exiting Brazil, but rumors are rife. According to one account, Banco Bilbao Vizcaya Argentaria (BBVA) has held talks on merging with Unibanco, the fourth-ranking private sector bank – a house that has been given up for dead more than once.