An Increasingly Steep Curve

Running a business in Brazil is a constant struggle for survival in which a minor slip can have serious, sometimes even fatal consequences. Executives have to keep an eye on their competition, run marketing campaigns, make investment decisions, keep costs down and develop new products like anywhere else in the world. But they also need to be prepared for the worst: an unexpected leap in interest rates, a sudden rise or fall in the value of the currency or the disappearance overnight of financing. A company that is not ready to boost output at the drop of a hat will lose market share, possibly never to regain it.

The last few years have tested the mettle of senior managers as never before. In 1999, the Brazilian currency crashed by 30% but the economy quickly returned to stability, followed by a year of strong growth. In 2001, with power rationing and the events of September 11th, growth slowed abruptly. This year has been marked by a series of crises that are threatening the solvency of more than a few big companies far beyond Argentina, where all but a handful of companies are rescheduling debt payments and a growing number face collapse.

Designing and maintaining an adequate capital structure for companies has become a question of life or death. In years gone by, most companies could finance industrial expansion with retained profits or bank loans, which kept leverage ratios down and protected them from exchange risk. The trouble is that companies cannot keep this up, because trade liberalization has eroded margins and competition requires them to avoid sacrificing capital expenditure whenever possible. Even very large companies cannot borrow enough money in local currency on reasonable terms and the volumes of concessionary finance from the government’s BNDES development bank are limited. Instead, companies have borrowed in dollars on the international capital markets. As a result, leverage ratios have inched up over the years. Data from Exame, Brazil’s leading business magazine, show how corporate indebtedness has risen steadily over the years while profitability has dropped. Last year, leverage ratios at the country’s 500 largest companies rose to 58%. In 1994, at the start of the Real Plan, leverage was 41%. Last year, their return on equity was a mere 3.2%; in 1994, it was nearly 11%.

Coming Upon A Roadblock
Financing a company in foreign currency is tricky enough at the best of times, but these days it has become extremely hazardous. Companies that failed to refinance debt in the first half of the year will find it almost impossible to renew maturing debts between now and the end of the year, and possibly well into 2003. Foreign loans are available to only a few borrowers – usually exporters – and only then if they issue asset-backed bonds (see Securitization, The Securitization Lifeline). Finance directors at most companies need to choose between paying down debts, compromising their liquidity, or deciding to refinance these debts locally until the international market reopens. However, even the Brazilian market for corporate debt has seized up and banks are increasingly picky when it comes to lending. Even then, bank loans do not come cheap. The cost of real-denominated working capital loans ranges between 25% and 40% a year.

The combination of a collapsing currency, falling sales and rising interest rates makes it very hard for the heavily leveraged to continue as independent companies or avoid default. A growing number of Brazilian companies have either stopped paying their debts or had to restructure their loans. These include companies in depressed industries such as media, energy and telecoms. BCP, which operates São Paulo’s second mobile phone network, in April defaulted on $1.6 billion in debt. BellSouth of the US and Safra Group of Brazil each hold 44.5% of the company. Net, a cable TV operator owned by Rio de Janeiro’s Globo media group, has rescheduled $200 million in debt and raised over $330 million in fresh equity (see Profile, page 26). Ozires Silva has quit as chairman of loss-making airline Varig as it struggles with $1.8 billion in debt. CSN, a steelmill with $2.72 billion in debts, is to merge with European competitor Corus.

According to Dealogic, a capital markets database, Brazilian companies and banks together had $1.25 billion in bonds and $2.5 billion in loans maturing in the third quarter of the year and a further $1.31 billion in bonds and $2.06 billion in loans due in the fourth quarter. Next year’s repayment burden should be easier, with $1.89 billion in bonds and $2.35 billion in loans falling due. In normal times, companies would not have too much trouble refinancing these loans, but the international capital markets have slammed shut. Banks are also pulling back, with fewer and fewer lenders willing to renew lines.

Draining the Coffers
Fernando Exel, president of Economática, a consultancy in São Paulo, says the cost of servicing hard currency indebtedness is sapping the energies of Brazilian companies. He points out that Brazilian companies generate substantial operating profits, before paying interest. However, the rising cost of making hard currency debt service payments severely depresses net income. Exel says the country’s leading companies have interest bills of only $1 billion or so every quarter. However, these charges are magnified by the real’s steady depreciation since he estimates that about 70% of corporate debt is in hard currency, nearly all of it in US dollars. Although interest rates on hard currency debt are much lower than local currency debt, service costs can balloon when the exchange rate depreciates sharply, as it has since early 1999. Companies won a brief respite last December, when the real recovered slightly, cutting their service charges sharply. The median operating profit-to-debt ratios of Brazilian companies are similar to those in Chile and Mexico. Under normal circumstances, they generate more than enough cashflow to service their debts. However, since Brazilian companies are required to show the effects of exchange rate fluctuations on their balance sheets immediately, irrespective of when debt payments are actually due, the effects of currency instability are felt immediately.

Burgeoning Debts
For Cia. Energética de Minas Gerais (Cemig), an electricity generator and distributor, every one percent decline in the value of the real adds R$15 million ($5 million) to the cost of paying its dollar debts of almost $700 million. Like many companies, Cemig has about a quarter of its dollar debt protected against declines in the real through currency swaps. However, hedging a company’s entire debt burden has become prohibitively expensive and treasurers have preferred for some time to limit this to the short-term portions of outstanding loans.

Those lucky few able to refinance in dollars will still find their leverage ratios rising substantially, even if the new loan is for the same amount or is smaller than the original one. This is because devaluation has increased the local currency value of the new debt, while the company’s balance sheet – expressed in reais – remains just the same as before. What’s more, the effort required to service this debt, for non-exporting companies, has also increased. If the real continues slumping, companies’ operating income may no longer be enough to cover their service payments. “Argentine companies were becoming insolvent last year, well before the debt crisis and devaluation,” says Exel. “The margin of Brazilian companies is sufficient, but the [outlook] is bad because of the rising value of the dollar against the real and the rise in international interest rates.”