With a stalling economy, low oil prices and the largest corruption investigation in Brazilian history, many investors have turned their backs on Brazil. However, with solid market fundamentals and asset values reduced by a 43% devaluation of the Brazilian Real against the US dollar over the last 18 months, could now be the right time to get into Brazil? In this article we explain why we think it may be, and take a look at some of the opportunities for investors as well as the challenges which exist.
During the last decade there was plenty of good news for Brazilians. Huge oil discoveries were made offshore in what is known as the “Pre-Salt”, leading to rapid growth in Brazil’s oil, gas, shipbuilding and related industries. Brazil’s mining industry grew by 500%, fuelled by demand from China and high prices for minerals such as iron ore. The Brazilian banking system and economy escaped relatively unscathed from the global financial crises and actually grew by 7.5% in 2010 when most other economies were contracting. Brazil’s middle class grew as well, spurred on by a growing economy and consistent macroeconomic policies which successfully reduced poverty and tamed inflation. With the announcements that Brazil was going to host the world’s two biggest sporting events, the World Cup in 2014 and the Olympics in 2016, Brazil was increasingly in the world spotlight and a place foreign companies and investors wanted to be. In fact, in 2013, Brazil was the third most attractive destination for foreign direct investment, behind only the USA and China.
The continuous stream of good news was not, unfortunately, to last. Falling global commodity prices, most notably in oil and iron ore, have made the oil, gas and mining sectors less profitable and this, combined with the launch of Brazil’s largest ever corruption investigation, referred to as ‘The Car Wash’, has had a negative impact on Brazil’s image as a top investment destination. Consequently, foreign investors are having second thoughts before committing to Brazil and many market commentators are predicting a gloomy economic outlook for 2015.
The Car Wash
The ‘Car Wash’ (Lava Jato in Portuguese) is the name given to an investigation launched in March 2014 by the Brazilian Federal Police into bribery and corruption allegations involving state controlled oil company Petrobras and major contractors. It is the largest such investigation in Brazilian history and has exposed a multi-billion-dollar cartel, kickback and money laundering scheme where contractors paid bribes to senior Petrobras executives and other public officials, to secure Petrobras contracts. The implications are far reaching, affecting companies, individuals, politicians and Brazil’s political and economic climate. Nearly two dozen companies, including many of Brazil’s largest construction companies, have been banned from contracting with Petrobras and prevented from participating in Petrobras’ bids. The extent of the corruption has caused public outrage, triggering protests across the country, and causing the Brazilian currency to devalue by 15% since mid-November 2014.
Strong market fundamentals but challenges present requiring patience
In a world of finite resources and increasing demand, however, Brazil’s long term importance cannot be overlooked. The world’s growing population and industry will need greater supplies of food and commodities and world energy demand is predicted to grow by 37% over the next 25 years. Brazil’s continental dimensions and abundance of natural resources will ensure that it has a key role in supporting global economic growth.
The size of its internal market also offers a range of opportunities for companies with the right products and services. The middle class of approximately 100 million people wields considerable spending power and constitutes an important market for everything from cars and technology to improved healthcare and infrastructure. This middle class will continue to grow, with over 17 million households expected to reach a household income of over US$ 35,000 by 2022.
Unlike some other emerging markets, Brazil enjoys economic and political stability, with democratic elections and successive governments largely maintaining the macroeconomic policies of their predecessors, which successfully tamed the hyper-inflation of the 1990’s whilst reducing poverty.
Whatever the challenges of the current economic climate, the above fundamentals remain solid. High profile scandals such as the ‘Car Wash’, whilst uncovering serious levels of corruption, also present a silver lining for international investors. Investigations such as this should make Brazil a fairer and more transparent place in which to do business, by raising awareness and reducing the culture of impunity. The ‘Car Wash’ proceedings represent a golden opportunity to show the international community that, as well as passing new anti-corruption laws last year, Brazil’s judiciary will hold the guilty to account, no matter who they are.
Investing in Brazil does, however, require patience and careful guidance in order to navigate and comply with rules which may be very different to those in an investor’s home country. Newcomers are frequently frustrated by high levels of bureaucracy, the complexity of the tax system and employee-friendly labour laws. Extra care should be taken in conducting legal and financial due diligence to identify problems and assess their impact, prior to taking investment decisions. However, with proper advice these problems can be overcome.
A selection of potential opportunities
Contracts with Petrobras
A consequence of the ‘Car Wash’ is that 28 companies, including some of Brazil’s biggest EPC contractors, have been banned from contracting with Petrobras, with more being investigated. As this list develops, local content rules requiring Petrobras to contract with Brazilian companies will increasingly become an obstacle to Petrobras achieving its production targets. Petrobras has indicated that its local content requirements may be relaxed, to enable greater participation in projects by international companies, which may be needed to fill the void. A number of Petrobras projects have been delayed while investigations continue, but there are some signs that new international tenders are being prepared including for two FPSOs (floating production storage and offloading vessels).
A long-term drought and low reservoir levels have highlighted Brazil’s over-reliance on hydropower, and the need for investment in the energy sector. Recent power auctions have attracted major investment in wind and solar energy, while the Government has just improved the terms for upcoming transmission tenders. Major investments by EDF, State Grid, Tractebel and others demonstrate that foreign players see the potential in this expanding market.
Infrastructure is another sector that requires significant capital projects to make-up for years of under- investment. The Government is continuing with plans to attract private money into road, rail, ports, airports, sanitation, health and other infrastructure. Foreign companies found it difficult to compete with local infrastructure groups in the past, but many of these are weakened by ‘Car Wash’ allegations and divesting rather than expanding. Project financing opportunities may also open-up as the Brazilian Development Bank (BNDES) and other state banks, which long dominated the market, are forced to accept a reduced rate, given current budgeting restraints.
There are a number of Brazilian companies in oil & gas, shipbuilding and related industries suffering financial hardship as a consequence of both low oil prices and Petrobras-related problems. Brazil has modern bankruptcy laws, which since 2005, allows the separation of assets from liabilities when an investor purchases a distressed asset. This therefore facilitates the acquisition of struggling Brazilian companies. Negative market sentiment and currency depreciation have combined to dramatically reduce asset values. Infrastructure conglomerates involved in the ‘Car Wash’ investigations are being forced to de-leverage by selling off subsidiaries and assets in a buyers’ market. There are bargains to be had.
Companies in the USD 20m to USD 200m turnover range
Many mid-sized companies are currently considered by the private equity industry to represent good value and are being earmarked for investment by funds. While there may be risk of devaluation in the short term, this is not likely to be an issue for investors wishing to increase the value of their portfolio long term. A study of 239 Brazilian mid-sized businesses quoted in Brazil’s Valor Economico newspaper revealed that between 1994 and 2010 the average performance of these companies exceeded international stock market indices.
Performance of investments made by funds in Brazil have often proven to depend on the exchange rate of the Brazilian real at the time of purchase compared to the rate at the time of sale. Fluctuations in exchange rates sometimes make an even greater difference to profitability than the ordinary rate of return in local currency over the investment period. With the Brazilian real currently at its lowest value in over a decade, companies or funds looking to invest in Brazil are currently afforded excellent value compared with a few years ago.
Other growing sectors
There are also a number of other growing sectors in the Brazilian economy representing opportunities for overseas investors. Key growth sectors for foreign investment have been identified by both ‘UK Trade & Investment’ (UKTI) and ‘Apex’ (Brazilian Trade and Investment Promoting Agency) as including Agriculture, Automotive/Aerospace, Infrastructure, Mining and TMC. The OECD-FAO Agricultural Outlook for 2010-2019 identified Brazil as the “fastest growing agricultural sector by far, growing by over 40% up to 2019, when compared to the 2007-09 base period.”
The potential for growth in the TMC sector is also vast; there are 100 million people who still require access to the internet. Telefonica’s recent agreement to acquire Global Village Telecom from Vivendi for US$ 7.9bn shows that foreign companies are taking notice.
Although the Brazilian economy clearly faces a number of challenges, it also presents long-term growth potential. Gains made in the fight against corruption, allied with strong market fundamentals and an array of opportunities across sectors should arouse the interest of many foreign companies. The fact that the currency has devalued and some good Brazilian companies now find themselves in difficulties, means that some acquisition targets represent good value for money and investors should keep an eye out for bargains!