Suffering Brazilian ethanol sector shows signs of life

Despite all the hullaballoo surrounding ethanol worldwide and the perception that alternative energy is the next big thing, Brazilian ethanol stocks posted dire performances last year. Last year’s results were affected by a glut of money that pushed up asset prices, just as sugar prices tumbled and developed markets failed to open up, even by a crack, to Brazilian ethanol.

Shares in market leader Cosan halved in value last year – down 51.8% -- giving it the dubious honour of being the worst performer on the Brazilian index, although part of the blame can be attributed to questions over its corporate governance (see box). The other two listed ethanol companies saw significant price drops, too. São Martinho, the number two, fell 11.7% and Açúcar Guarani, the number three, more than 20%, compared to the 44% increase in the main Bovespa index.

This year, there are tentative signs of a turn-around for Brazilian ethanol firms, the world’s most efficient producers of the stuff. Their shares have been some of the best performers in a difficult market, driven by a surge in hedge fund buying, signs that the key Indian harvest will be less prolific than forecast and more reasonable, if still not good, fundamentals after last year’s tail-spin. Cosan shares closed at R$26.25 on February 14th, up 21% year-to-date.

How it all went so wrong
The seeds of disaster were partly sown by unrealistic expectations. The ethanol segment was not represented on the Bovespa exchange in Brazil before Cosan’s listing on 18th November 2005, raising R$886 million.

The listing came at a propitious moment. Valuations for Brazilian companies on the exchange were taking off, propelled by economic stability, the launch of the Novo Mercado, with its tighter corporate governance regulations, and pent-up demand after years of sideways movement.

Not only that. Biofuels were all the rage, with talk of global warming upper most in people’s minds. Private equity money was pouring into the industry and the hunch was that soon international markets would open up for Brazil’s cost-effective, sugar-based ethanol, giving the industry a boost of gargantuan proportions. In the IPO, foreign investors represented 72% of the investor base.

“The share price increases didn’t reflect reality. Investors didn’t know the sector, they were not familiar with the business. It was the flavour of the month with [President George] Bush ‘advertising’ biofuels in the US. Investors bought these shares without deep analysis,” according to Cosan CFO Paulo Diniz.

“It came in at a time of a mania for the stock market. It was a completely new industry: if you wanted exposure to ethanol, you had to buy Cosan and many people bought into it,” agrees Antonio Augusto Duva, manager of the soft commodities desk at BNP Paribas in São Paulo.

Initially, shares of Cosan performed spectacularly. Kicking off at R$18.54, they more than tripled in six months, hitting a high of just over R$63 by May. They have never fully recovered since.

It took a while for the success, albeit by now diminished, of the IPO of Cosan to encourage others to market. In 2007, however, there were a further two listings. First up was São Martinho which came to market on February 12th raising R$424 million with 53% sold to foreign investors and then Açúcar Guarani which listed on July 23rd raising R$666 million with foreigners responsible for snapping up 45% of the offer. These shares have struggled to find liquidity, says Duva. Indeed, São Martinho has asked Credit Suisse to investigate ways to stimulate trading, he notes.

And now for the downside
The hangover started when thanks to the fierce competition between investors, particularly foreign ones, prices for land, mill and distilleries skyrocketed. That prompted Cosan to have a thorough-going change of strategy, moving away from an aggressive stance of acquisition-led growth. On April 12, 2007, the company convened a press conference in São Paulo. At that time, the share price was trading at around R$38.

Cosan managers admitted that the future of acquisitions in the sector looked bleak with prices of assets “through the clouds”. That meant expansion would be, at least in part, through organic growth in the centre of Brazil, an area where land prices were lower.

This strategy, however, presented a couple of big problems. Firstly, one of the big bets had been a rapid consolidation of the industry. It had been thought that a few mega players would take over smaller, less efficient producers and bring them up to scratch, with all the economies of scale that industrialization of the process implied. In an industry where the market leader Cosan had just 8.2% of the market and the top five players only 17.4% of the total market, the idea had proved bewitching. Hope for that now lay in tatters, meaning that expansion would take much longer than previously imagined.

Furthermore, there is a significant and real logistics difficulty associated with expansion into the centre of Brazil, outside the traditional sugar growing area of São Paulo state. Brazil’s huge size and neglected road infrastructure makes expansion in the area a costly proposition thanks to high transportation costs.

The real deciding dynamic for the industry, and one that had got lost in all the excited froth and faith in the ethanol industry, was very basic. The cost of sugar was nose-diving, reaching a low of nine cents per pound in autumn last year, down from a high of 19 cents. Naturally, the fate of Brazilian ethanol producers, made from sugar cane, tends to be highly correlated to the price of sugar. Indeed, ethanol producers have the option, up to the last moment, of opting to produce sugar or ethanol and tend to choose between the two on an opportunistic basis.

Part of the blame for the collapse in sugar prices lies with the under-estimation of India’s production. Consensus predictions were for output of 28 million tones, when the reality was some 33 million, according to Eduardo Correa, commercial director, sugar and ethanol, at São Paulo-based Equipav.

Analysts had to make significant adjustments to production forecasts, raising estimates over some 12 months by 25%. As it became clear that India would produce more than thought, sugar prices naturally fell. India indeed proved a major competitor in external markets taking business away from Brazil. There continues to be real difficulty in projecting sugar production out of India, thanks to an antiquated government buying system, Correa notes.

What’s going right
Sugar is once again the main driver behind this year’s price surge for ethanol stocks. Prices have firmed back up and sugar was trading at close to 14 cents per pound by mid-February.

There are two main reasons for this. Hedge funds have been buying heavily in soft commodities, including sugar. They are betting that demand growth out of China and Asia, which has been behind the hard commodities boom, will continue to spread into agricultural products. The signs are there with the sky-high appreciation seen in foodstuffs, such as corn and soya last year, while sugar has remained the Cinderella and the cheapest commodity in the world, says Correa. Furthermore, recent predictions that Indian production will be four or five tons less than the forecast has reduced the risk of massive over-supply.

There’s a risk that investors will get carried away. Supply-demand fundamentals are weak for the industry and although there will be some improvement this year, long-term over-production problems have not gone away, worries Duva. And as for foreigners buying in Brazil: “there continues to be a disconnection with reality in what owners expect to get for their assets,” he believes.

Lessons for the future
There are lessons for the industry from the sticky mess. First is that second guessing trade politics is a fool’s game. Investors in Brazilian ethanol were counting in the possibility of a big increase in exports to one or more of the EU, US and Japan. That never came about. The EU’s focus has been on developing biodiesel, the US has been subsidizing home-grown corn ethanol and Japan has not moved to increase ethanol levels in its fuels, pointed out Marcos Paulo Pereira, an analyst at Banco Fator.

The inability to open markets suggests the industry needs an image make-over. Fernando Reinach, executive director at Votorantim New Energy in São Paulo, said scares in developed markets centred around the possibility that ethanol will lead to deforestation of the Amazon and that its production competes with food. These are unfounded in Brazil because of the large amount of fallow and degraded land that can be used for agriculture. Nevertheless, the wholesome green image Brazilian ethanol had two years ago has been tainted, allowing developed countries to keep the stuff out.

Finally, cash-rich foreign investors need to be aware of how much their buying affects prices of assets. The giddy share and asset price performance in 2006 shows how investors entering a small, highly fragmented industry can decouple price and fundamentals. Cosan was the first ethanol company to list and investors were desperate to buy the shares at any price, says Duva. And in private equity, the money entering the industry led to rapid inflation for land, mills and distilleries.

Ambitious expectations for investment in the sector will be tested in the near future, says Correa. It is not easy to buy and sell mills and that implies that when you buy a company, you are taking a 20 year decision. Most funds intend to invest and then IPO the assets that they have, probably with a two or three year time horizon.

Reinach compares ethanol fever to on-line retailing in the late 90s. The online retail business model did take off as predicted. It just took much longer than anyone thought, he said. He predicted developed counties will be forced to turn to Brazilian ethanol if they want to green their fuels. But that they’ll probably wait til they really have to.

Battered Brazilian ethanol producer succeeds in cash call
Cosan SA, the Brazilian arm of the country’s largest ethanol producer, announced in early February that it had raised R$550m ($315 million) in a fresh capital raising exercise from existing investors. The success of the rights issue took managers by surprise: the firm captured some 10 time more than it anticipated, said Diniz. “We had expected something more like R$50m,” he admitted. Market turbulence, the weak share performance of the company in 2007 and what Cosan sees as misperceptions about the company and its corporate governance within its investor base explain why managers had been more pessimistic, he believes.

The R$550 million is part of a R$1.7 billion capital raising exercise, with the balance of the money transferred from the Bermuda-listed Cosan Limited, a sister company to the Bovespa listed Cosan SA. The injection of capital and the unexpectedly large amount raised from shareholders is allowing the company to re-evaluate plans and should see the development of new greenfield sites. Cosan has 17 plants in Brail and announced last April the construction of three new plants in the central state of Goiás.

Cosan asked existing Brazilian shareholders to dip into their pockets again in December following an extraordinary general meeting in which 70% endorsed plans to boost capital to R$2.94bn from R$1.2b. The additional money was expected to have come almost entirely from the offer of new shares in the US rather than Brazilian shareholders.

Diniz sees the take-up as a sign that Cosan is recovering from its corporate governance difficulties in August. In that month, Cosan created a Bermuda holding company, Cosan Ltd, and listed shares in New York, creating a special class with 10 votes each, most of which are held by controller Rubens Ometto. At the same time, it conferred the right to make and profit from investments overseas, a large part of its embedded value, to Cosan Ltd leaving out the Brazilian subsidiary. Outraged Brazilian investors dumped the stock, which lost more than 8% the day after. At the December extraordinary meeting, Cosan changed tack, offering investors in Cosan SA parity with Cosan Ltd.

Diniz argued that the company’s shares suffered mostly on a misreading of fundamentals and not on its manoeuvres. “Fundamentals were out of touch with reality,” he said. Cosan had warned investors that sugar prices were unsustainable and had predicted poor share price performance in 2007.

Cosan is still waiting for a green light from stock market regulators in Brazil and the US on its plan to offer shareholders in Cosan SA a one for one swap into shares of Cosan Ltd, which is likely to lead to a mass migration to the New York exchange.

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