Corruption allegations threaten Brazil's equity bounce

Corruption allegations threaten Brazil's equity bounce

Brazil Equity Economy & Policy Corporate & Sovereign Strategy Features

The third time was the charm for Azul. Following failed attempts in 2014 and 2015, the Brazilian airline listed in April, raising more than $571 million in an initial public offering on the New York Stock Exchange.

“This was the moment when the conditions were right for an IPO,” Wade Angus, a partner at the law firm Jones Day, says of Azul’s listing. “It had been in the works for a long time and, finally, there was a window of opportunity.”

Conditions had indeed ripened. Fund flows into Brazilian equities reached $1.31 billion in the first four months of the year, a turnaround from outflows of $3.3 billion in the same period in 2016, according to data from the Institute of International Finance.

Brazil’s equity market had been stuck in a jam for nearly three years, but the impeachment of former President Dilma Rousseff in August 2016 was viewed as a new dawn. President Michel Temer came to office promising economic reforms that would reignite the economy and create more investment opportunities. His proposals, which include caps on government spending and changes to labor laws and the social security system, have sent fund managers back to Brazil in droves. 

As the investors piled in, more deals appeared. Besides Azul, the car rental company Movida, the water utility Sanepar and two medical services providers — Hermes Pardini and Alliar — have priced IPOs since the impeachment. The listings have revitalized the market, after investors bought just two IPOs in 2014 and 2015. 

“This is the first sign of a government looking to do reforms,” says Angus. "This gave some hope that this is something doable for the future… That is what opened this [market window].”

The energy company Energisa raised 1.54 billion reais ($485 million) from a share sale in July last year that was billed as a "re-IPO" and boosted its free float to 35%.

“We did not have much liquidity in equity and had a lot of recommendations from investors,” says Chyou Pey Tyng, corporate finance manager at Energisa. “We thought it was a good time to tap their resources... A lot of funds had experienced gains with other stocks.”

Energisa was overleveraged but it also wanted to raise money for investments in its power distribution companies. “So we looked at a way to get cost-effective financing,” she says.

Now the state-owned reinsurance company IRB Brasil Re and another medical services provider, Intermédica, have both filed for IPOs. Meanwhile, the French retailer Carrefour is in talks to spin off its local business before the end of this year and the real estate developer BR Properties has told the market of its plans for a share sale.

But not everything has proceeded smoothly. After recordings surfaced in May of Temer purportedly discussing hush-money payments to the former speaker of the lower house, Eduardo Cunha, wary investors responded and sent Brazil’s stock exchange into a tailspin. 

The Bovespa stock index plunged more than 10% on May 18, wiping out almost all the gains it had made since the beginning of the year. But despite the concerns, the shopping center operator BR Malls raised 1.73 billion reais from a follow-on equity offering right after the allegations surfaced.

Temer has denied the charges, but some investors question whether the president can withstand the blow to his already dwindling approval ratings.

“He has lost some of his influence because of the recent news,” says Chuck Knudsen, an emerging markets portfolio specialist at T. Rowe Price. “The political forces that are against him may use this latest incident to try to force him out. At this point, it appears that he will survive, although it is a close call.”

For Peter Taylor, a Latin America senior investment manager at Aberdeen Asset Management, the political environment in Brazil is worse than it was at the end of Rousseff’s administration. “You have to look at politics versus policy, and the politics is more of the same,” he says. “The problem is, the government is now in paralysis, and you question whether they can execute their stated objectives.”


Reforms in question

A critical reform, in the eyes of investors, involves overhauling Brazil's public pension system. Temer's administration has proposed lifting the minimum age to qualify for a state pension from an average of 54, to 65 for men and 62 for women. Such changes are imperative to address the country's fiscal deficit, says Bruno Saraiva, the head of equity capital markets for Brazil at Bank of America Merrill Lynch. 

“Every year, the social security deficit has been in the billions and it has been increasing,” he says. “The Brazilian structure is old. People now live longer, so we need to adjust.”

Now, investors worry that the latest bribery allegations could postpone the process. A Senate committee rejected the reform bill in mid-May, raising the specter that the proposals could stall in Congress.

Some argue that the market dip and prospect of better growth will combine to spur lawmakers into action. Knudsen argues that the country’s leaders have “no choice” but to pass the reforms if they want economic growth to continue. The stock market sell-off in May, he says, “put pressure on the politicians. You must pass these reforms or you are going to see a continued sell-off.”

With presidential elections scheduled next year, politicians will be keen to get the economy moving, he adds. “If the stock market craters again, interest rates will have to go back up, putting more pressure on the economy,” Knudsen says.


Taking advantage of momentum

Despite the snarl-ups in the administration, the rise in the equity market, lower interest rates and good first-quarter earnings reports have managed to keep investors fairly optimistic, BAML’s Saraiva says.

Azul, for example, posted net revenues of 1.87 billion reais in the first quarter this year, up 12.3% on the same quarter last year. The retail chain Lojas Renner also registered a strong first quarter, with net revenues from merchandise sales reaching 1.24 billion reais, up 14.7% year-on-year.

“There is earnings momentum in Brazil,” Saraiva says. “The momentum comes on the back of reduced interest rates and it has brought earnings power to companies in Brazil.”

Knudsen says stock buyers can find good opportunities in sectors such as real estate, retail, consumer goods and financial institutions. “Lojas Renner and Raia Drogasil, for example, have been able to take on market share,” he says. “These are companies that can weather the tough times.” 

And despite the latest allegations, conditions are still solid, say some. 

“Even after the sell-off [in May], the market went from probably overpriced to fair value,” says Taylor at Aberdeen. 

“If I am a company owner, or a banker advising them, I’m telling them it would have been even better to come to market [before the Temer recordings]. But right now is not bad timing either.” 

BAML's Saraiva expects some companies to capitalize on the open market window, rather than face potentially further political uncertainty next year. "All those companies that have capex plans or M&A opportunities see the inflows and want to get ready,” he says. “Some don’t want to wait until 2018 and are trying to anticipate their new investment plans.”

The same is true for shareholders wanting to divest. Qatar Investment Authority, for example, sold shares in Santander Brasil in April, reducing its stake to 3.4% from 5.5% and raising 2 billion reais in the process. The sovereign wealth fund capitalized on a rally in the bank’s American depositary shares, which had climbed from as low as $5.06 in June 2016 to peak at $11.61 in February.  

Roderick Greenlees, the global head of investment banking at Itaú BBA, says liquidity was buoyed by financial sponsors that had invested in companies years ago. "It was time for them to monetize, at least in part," he says.


Fair value

The rebound in corporate earnings, lower interest rates and the all-important reforms drove Brazilian stock prices above where they should have been earlier this year, given the uncertainty ahead, argues Taylor. 

“If you believe in these pillars, then you would think the valuations are now fair,” he says. “If any of those pillars fall away, then equities are certainly not cheap here.” 

The surge in stock prices earlier in the year came as fund managers shifted their weightings on the country, moving from underweight allocations to more bullish stances, says Greenlees. Now, growth expectations alone are "more than enough" reason reconsider Brazilian stocks, he says. “The markets have been responsive and we should have a busy second half of 2017.”

Lawmakers' progress at pushing through reforms will likely determine how busy Brazil's equity market is for the rest of the year and into next. Investors understand that the changes may not take effect until 2018 — but progress on implementation alone can fuel fund inflows and spur demand for new transactions. 

“You have a country that is marching towards better economic policies,” says Knudsen from T. Rowe Price. “The end goal does not change. The reforms must get passed, maybe in 2019, maybe sooner.” But Brazil, he says, is exhibiting a welcome political will “to keep the momentum going”. LF