Latin markets: broader, deeper, pricier.

Paulistanos like to boast that if you can’t buy it in São Paulo you can’t buy it anywhere. Walk through one of the walls-just-dry shopping centres in the towering suburb cities such as Morumbi and it’s clear that conspicuous consumerism is enjoying a boom. And it’s this consumer-fuelled growth that is getting investors excited for issuance of equity deals in the region, especially in Brazil.

Latin equity issuance markets started the year with a bang, in large part thanks to consumer companies raising funds. By mid-March, Latin equity markets had already generated more than $2.3 billion in new issuance while in 2005, 21 deals worth just under $5 billion came to market. To put that into perspective, a slim $2.16 billion was raised in 2004 and less than $100 million was raised in 2003. Brazil has been the frontrunner, accounting for 10 of the 21 IPOs brought to market in 2005 and close to two thirds of the dollar amounts raised. This deepening of the markets is accompanied by a broadening of the sectors from which these companies are drawn. The real estate, construction and retail markets all featured prominently in 2005.

The upsurge in issuance is being driven by a market that has surged forward over the last three years. In Brazil, the Bovespa index (Ibovespa) was up a hefty 27% in local currency terms last year (compared to a still very healthy 18% in 2004) and nearly 44.8% in dollar terms in 2005. It powered up close to another 20% by late March of this year. That means that it has more than tripled since Lula took office on Jan. 1, 2003.

Still Good Value
At first blush, it might seem that after posting such spectacular performance, the markets must flag soon on the what-goes-up-must-come-down theory. And yet many investors continue to see value in Latin equities. Jules Mort, Latin America fund manager at Threadneedle who manages $1.7 billion, points out that despite the significant re-rating that Brazilian equities have enjoyed, the valuations are still cheap. The Brazilian market Enterprise Value/EBITDA average is 5.5 compared to 9.2 in India and 6.4 in Mexico, for example. That means there is plenty of scope for further rises in equity prices without stretching valuations.

This re-rating is driven by an ongoing re-evaluation of Brazilian risk, which can be gauged through the changing macroeconomic profile. There is a palpable sense that orthodox economic policies would now be extremely hard to reverse and that stability is bedding down. The figures speak for themselves. The Republic posted a trade surplus of some $41 billion in 2005 and has a current account surplus of 2% of GDP. “Until recently, listings in Brazil have been stop-and-go because a stable economic platform has not been in place. Consumers have more confidence now – that they won’t lose their jobs and that inflation rates will stay low,” says Gilberto Nagai, a fund manager at ABN Amro Asset Management in São Paulo who manages $1.5 billion.

The sense that the Brazilian economy is shedding its unpredictability and volatility was confirmed when the pillar of fiscal rectitude Finance Minister Antonio Palocci resigned on March 27. He was smoothly replaced by Guido Mantega. Standard & Poor’s immediately stated that it would not affect its February 28 decision to raise Brazil’s overseas debt ratings to BB (from BB-) two notches below investment grade.

Palocci’s policies have had the desired effect of taming inflation, which has now fallen to 5.5%. Mantega immediately said he will continue the relatively new policy of reducing the benchmark Selic rate from its eye-watering level of 16.5%, one that imposes one of the highest real interest rates anywhere in the world. The country maintained these levels of interest rates to stop consumer confidence getting over-heated and on fears of higher inflation from stronger oil prices. But the policy has come at a high price in terms of Brazil’s economic growth. It has seen GDP growth limp along at some 2.2% in 2005. With Presidential elections slated for October, it is widely anticipated that interest rates will be pruned more rapidly to provide a nice fillip for the economy and to take the wind out of the opposition parties’ sails.

The Consumer Boom
It is this anticipated reduction in interest rates that has made investors calculate that the intensification of consumer spending cannot be far behind. Domestic banks are finally extending more credit and Latin consumers, long highly averse to debt because of economic instability, feel emboldened to spend.

“The region has started to deliver consumer names and there is a frenzy for these kind of companies,” says Nagai. In the consumer sector, the most widely-talked about deal has been Natura, a cosmetics company that raised $243 million through its IPO last year. The deal, listed on the Novo Mercado, seemed quintessentially a Brazilian story: Natura sources its products from the Amazon and the country’s cosmetics industry is a growth story and is now the seventh largest in the world.

Natura helped trigger a make-over through the whole sector. Lojas Renner’s secondary offering has been a rip-roaring success. The mid-range Brazilian chain of clothes-oriented department stores carried out a deal that brought 100% of its free float to public investors, the first time this has ever been done in Brazil. The deal was placed 43% in the US and 35% in Europe with the balance going to domestic investors. The company earned BRL774 million ($350 million) through the offering. And although it’s not big, the shares have performed spectacularly, moving from BRL37 at issuance to BRL 118 in mid March.

That performance might suggest the deal was mispriced. But Mort, whose fund is overweighted in consumer discretionary products at 9.1%, does not believe that the underwriters Credit Suisse (global) and Banco Pactual (global and domestic) are to blame. He explains that the performance is in large part because the group’s operations have improved so rapidly. The firm posted gross sales revenue of BRL1.29 billion in 2004, a 22% increase over 2003. And it is not easy to price deals in a difficult market, he says, pointing out that not all deals have been as lucrative for investors as Renner. “Shoemakers Grendene is a warning of what can go wrong with Brazilian retailers,” says Mort. The firm, which makes plastic shoes, debuted at BRL30. By late March, the firm’s shares were trading down at around BRL20. In the case of Grendene, the story was exceptional. Firstly, the firm uses petrochemicals in the manufacturing process so it has seen its input prices go up. And as a highly international distributor, the strength of the real has hurt its international sales.

There is one possible fly in the ointment for pure consumer plays. The arrival of giant discounter such as Wal-Mart in Brazil is forcing local and other foreign-owned supermarkets to shape up. “Wal-Mart is sending shudders down the backs of some Brazilian companies, like Pão de Açucar,” believes Mort. But Chris Palmer, head of Latin America and developing markets for Gartmore Investments, argues that Brazilian companies have some protection. “They have some advantages that are going to be difficult for foreign firms to replicate. For example, many of the Brazilian firms have well established and fragmented value chains. Gap couldn’t just come in with its China model because of tariff protections and the ‘Brazil cost’ such as value added taxes that tend to keep foreigners out.”

Other deals that play on the growing ability of the consumer is the discount airline and travel site Gol which raised $283 million. Gol is directing the proceeds to start a price war with the better established names in the field, Varig and TAM. The essential idea is an upgrade/downgrade: to take market share by poaching customers from other domestic airlines and to convert those that would have taken a bus to upgrade to a flight. In the next wave of companies planning to come to market is the bookstore and legal and educational publisher Saraiva. The stock is already listed but is relatively illiquid.

But, as Nagai points out, even though there are a fair amount of new consumer listings, there are simply not enough to meet investor demand. “Many family owned companies are well capitalised and do not need to raise money,” says Nagai. Palmer adds that: “consumer stocks have held steady at around 20% of the index with a slow diet of new consumer companies. And the new wave of consumer companies coming to market is not making a big impact. Each listing represents a relatively small amount of the index.” Natura, for example, constitutes a measly 0.5% of the MSCI Latin America index. “You’d need to see 10-15 such companies come to market before it had a significant effect on the index,” says Palmer. “There are not enough consumer plays in Brazil,” agrees Mort. “That means that you have to be innovative in tapping the consumer. Banks are a possible way to do this because loan growth has been surprisingly strong at 20-25%,” he adds.

Wannabe Consumer Companies Come to Market
The other effect of the magnetic attraction of investors to consumer companies is that all sorts of companies are selling themselves as retailers, an ugly sister trying to fit into Cinderella’s glass slipper. “What we are seeing now is smaller companies describing themselves as consumer companies to jump on the consumer bandwagon. This is because these firms want to command the kind of multiples that are seen in the consumer area,” notes Nagai. Car rental firm Localiza, which raised some BRL250 million last year, is one example, he says.

Building companies are also capitalising on the booming market levels and are seen as a possibly proxy for consumer growth. Brazilian builders had proved relatively slow to use equity markets to raise capital for expansion. Last September, though, São Paulo-based developer Cyrela raised almost $350 million through an IPO. At the same time, it merged with Brazil Realty, which it already controlled and had a small public float and consolidated operations. This is kicking off wider interest in IPOs from the building sector Rossi Residencial and Gafisa have also tapped equity markets to pay for expansion. That said, the multiples for Brazilian builders are starting to look toppy. Newcomer Rossi is trading at 17 times estimated 07 earnings and that looks high compared to Mexican companies that have longer track records, notes Mort.

And it’s these higher prices that are being commanded that is starting to worry investors. The imbalance in the supply-demand picture with too many investors chasing a small pipeline of consumer companies might point to frothy valuations. And there’s certainly a sense of trepidation that deals are getting priced richly now, according to Nagai. “We are starting to see some investor fears and investor resistance about the higher prices that are being asked for consumer companies at the time of IPOs. Some IPO valuations are starting to look stretched,” he says.

Even Mort who reasons that the longer-term re-rating of Latin equity assets is the main reason for the performance sounds a note of caution. With markets heading northward at this pace, a correction is inevitable at some stage. Still, he sees the correction likely to come much later, possibly in a couple of years.

New Sources of Liquidity?
If markets do continue to perform well in the shorter term, it’s possible that the next wave of equity issuance could be from a relatively new source, believes Palmer, who predicts that 2007 will be the year for infrastructure deals. “There is a huge need for toll roads, bridges, shopping malls, pipelines and electricity grids,” he notes. The pension funds in Brazil have run up big surpluses and could help fund these deals. They will be looking for yield as interest rates fall and government bonds become less attractive. There will also be scope for equity investments as the government will split the deals between equity and debt. “We’ve already seen these deals do phenomenally well in India and some deals getting done in Mexico. Brazil is ripe for them to take off too,” Palmer believes. That really would start to make Latin markets feel wide and deep.

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