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AmericasFebruary 1 2017

Brazil relishes end of IPO dry season

Brazil’s confounding equity market can rise even when the economy dives and political scandals break. However, 2016 was so chaotic that initial public offerings struggled to launch. Politics permitting, things are about to change, writes Thierry Ogier.
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MB&FBovespa

Heavy tropical rain hit São Paulo, Brazil’s main financial centre, before its Carnival event. Paulistanos seemed to be taken by surprise by the deluge that regularly causes traffic chaos around the Faria Lima financial district at this time of year. Similarly, on the financial scene, investment bankers feel that the dry season is over for the Brazilian initial public offering (IPO) market following a stellar year in the equity markets at the BM&FBovespa stock exchange.

“The drought has come to an end but that does not mean rain is pouring down yet,” says Eduardo Miras, Morgan Stanley co-head of investment banking in Brazil. Healthcare company Alliar re-opened Brazil’s IPO season in October 2016, bringing an end to more than a year of inactivity. At least three companies have since filed for an IPO at the Comissão de Valores Mobiliários, the local security and exchange commission. Several others have announced similar plans, most of them informally, since the beginning of the 2017. But in the meantime, 25 companies have pulled out of BM&FBovespa in the past three years, including 13 that delisted in 2016.

The performance of the Brazilian stock market was one of the greatest paradoxes of last year. Even though economic activity diminished by more than 3% for the second consecutive year and corporate earnings remained under pressure due to mounting debt, the Ibovespa index gained 38% in local currency terms and 63% in US dollars, at 60,227 points.

A new iron age

Investors were encouraged by the change in economic policy following the impeachment of then-president Dilma Rousseff in August and her replacement by the more market-friendly Michel Temer. But political tensions might still spoil the show as the Petrobras scandal rumbles on. Many executives and politicians have signed plea bargain agreements and may implicate government officials, which could cause a resurgence of political instability.

“The impeachment as well as political change and the non-collapse of the Chinese economy that supported commodity prices led to a risk reduction last year,” says Felipe Hirai, Latin America equity strategist at Bank of America Merrill Lynch. There is a strong correlation between commodity prices and the Brazilian stock exchange. The rebound in iron ore prices and Petrobras’ gains (stocks in the state-controlled oil company recovered after the appointment of a new management team and the release of a credible deleveraging programme) also contributed to the Ibovespa’s renaissance.

Prospects for 2017 were further brightened by the cut in the benchmark Selic rate. On January 11, the monetary policy committee of the Brazilian central bank voted in favour of a cut of 75 basis points instead of 25 basis points in the previous meetings. At 13%, the Selic rate is still high and will likely be cut further this year. “The market will react favourably and that should help the market for IPOs and equity offerings in general,” says Roderick Greenlees, head of global investment banking at Itaú BBA.

Mr Hirai adds: “Earnings may also increase in the future because corporate margins are to increase. There has been quite a strong adjustment already, companies have cut costs. As the economy stabilises, we may see companies expand their margins a bit.”

Low returns

But there is plenty of uncertainty on the foreign investment front, mainly regarding the impact of new US president Donald Trump’s policies towards emerging markets. Brazil is less exposed than Mexico, but spillover is unpredictable. “The continuing process of the Federal Reserve’s interest rates hikes may create some volatility,” says Mr Hirai.

“There is also some degree of uncertainty [on the domestic front] regarding the approval of the pension reform that was sent to [the Brazilian] Congress and regarding gross domestic product [GDP] growth in 2017,” he adds. The World Bank has forecast a modest 0.5% GDP growth for Brazil in 2017, while the International Monetary Fund cut its forecast from 0.5% to 0.2% in mid-January. “The main problem with Ibovespa is that we think that the return in dollar terms may not be very high because the exchange rate will continue to depreciate, with the dollar at 3.90 reais by year end,” says Mr Hirai. 

Late in 2016, Crédit Suisse shifted its recommendation to buy Brazilian equities in its Latin American portfolio from 'market weight' to 'underweight'. “Looking ahead, things may become a little bit choppy in terms of market volatility,” says Andrew Campbell, Latin America equity strategist at Crédit Suisse. “The growth environment in Brazil has disappointed, and there is very little evidence of a rebound in the economy. When you are talking to the companies, their fourth quarter has remained very weak.” The bank has forecast zero growth in Brazil this year.    

“The market will require some visibility,” Mr Campbell continues. “The year will break into two segments. Our overall view is that the market will be quite challenging in the first few months of the year to sustain the outperformance that we had last year. In the middle of the year, things will start looking better because the growth and earning expectations would have adjusted downward, some of the moving in terms of US yield will have taken place already, and we should hopefully have some progress in terms of the fiscal agenda here.” As a result, investors will then be able to check whether the recent rally in commodity prices has proven sustainable. 

Only a mild fever

Several bankers have confirmed that the conditions of the equity markets have been supportive. “The performance of equity markets was very good last year, and companies may now take advantage of this window of opportunity to gain access to equity markets,” says Alessandro Zema, co-head of investment banking at Morgan Stanley in São Paulo.

Meanwhile, Brazilian business newspapers are once again full of IPO announcements. Investors are looking forward to a strong year of 10 or maybe as many as 20 offerings. But there is no sense of euphoria.  

“We are cautiously optimistic,” says Morgan Stanley’s Mr Miras. “However, the moment is far from ideal. The comparison base is very low. We have been going through a period of severe drought, with only a few transactions in recent years. So naturally there is a reasonable number of good companies that have been held back in the pipeline.”

In 2016, only one IPO was completed, and another failed. Even Alliar, the medical diagnostics company that ended the drought, saw its stock price fall 25% a few weeks after its IPO because its price was believed to have been incorrectly set.

Moreover, Tenda, a low-cost subsidiary of real estate company Gafisa, cancelled its IPO in mid-December due to lack of investor demand.

“Tenda did not materialise,” says Kenneth Ferreira, a capital markets partner at São Paulo law firm TozziniFreire. “There is a lot of unmet demand in the market. There is also an influence from the international market, [such as] the Trump issue. There are a lot of factors in play, but the fact is that there are a lot of companies getting prepared for this, and they are waiting for a window of opportunity.”

Opening windows

At least three companies have filed for IPOs and are heading for the starting blocks. They include car rental companies Unidas and Movida, which are trying to resist the local market leader, Localiza, which recently acquired the Brazilian subsidiary of Hertz. Another healthcare company, Hermes Pardini, also intends to go to market. But there may be more: food company BRF may launch an IPO for its subsidiary OneFoods, which specialises in products that comply with Islamic requirements, and investment firm XP Investimentos has said it intends to be ready for an IPO by the end of June.  

“It is going to a be a year of opportunities. No doubt about it,” says Mr Miras. “There is going to be a lot of volatility due to domestic factors and windows for companies to go public are going to open and close quite rapidly.”   

Some of these deals may materialise as early as February, according Itaú BBA’s Mr Greenlees. “There is a window that ends in the second week of February. After that, companies may come to market after their year-end results are issued, possibly in April or May. And then after that, [there is] a third window which goes on until late July, with the results of the first quarter of 2017,” he says. “By July, we could have between five and 10 IPOs. If we are very lucky and the market really engages, if we have a very strong second quarter, maybe as many as 10.”

Morgan Stanley’s Mr Zema adds: “We will not go back to the period when the window was left open practically all the time so soon, which was around 2007-08. We are going back to the period of specific windows for companies to go public.” 

Mr Miras says: “There are a lot of companies in Brazil that are in the process of hiring a bank. It is reasonable to expect a double-digit number of IPO transactions in 2017.” Morgan Stanley expects between 10 and 15 IPOs this year, while another investment bank expects as many as 25 if the climate of reforms, aggressive cuts in interest rates and a return to political stability prevails.   

Washing the car

Nevertheless, it is not going to be a free for all. “Investors are going to be very careful in terms of what story they are buying into,” says Bruno Constantino, head of capital markets at XP Investimentos. Marcelo Millen, director of equity capital markets at Crédit Suisse, adds that companies with “rather defensive stories” that can show resilience in a low-growth environment will be in a better position.  

Meanwhile, the political crisis is far from over. So far, the president has approved a record number of reforms since August, including a cap on public spending, but the corruption investigation known as lava jato – ‘car wash’ in Portuguese – could still destabilise the ruling coalition. The supreme electoral court will also investigate whether Mr Temer’s campaign when he was Dilma Rousseff’s running mate in the 2014 presidential elections received some undeclared funds from corrupt companies.

“Just to put things in perspective: at the beginning of last year, we had a lot of political uncertainty, which actually translated into facts. But we now have much more positive expectations than last year, with less uncertainty on the horizon than before, in spite of the turmoil that Brazil is going through,” says Mr Zema.

Despite all the question marks, the mood is generally positive. Nevertheless, moods can change very quickly if political volatility is reignited.

“Brazil is recovering, but we still have a lot of challenges ahead,” says XP’s Mr Constantino. “We need to pass [structural] reforms. There is going to be a lot of noise in the markets. Usually, we do not go along this path without noise and setbacks. I do not expect calm weather in the market.”    

Itaú BBA’s Mr Greenlees adds: “If things settle on the political front I would definitely [expect to] see a much stronger environment for equity towards the second quarter of the year.”

Meanwhile, a lot of things could still go wrong. According to Mr Zema, the main threat is “Congress paralysis due to lava jato, which would in turn prevent reform approval. This would create a great uncertainty from the macro point of view, and even a greater one for investors towards Brazil. The government has managed to approve an important micro- and macro-reform agenda in recent months, but there is lot more to do. If investigations lead to Congress paralysis, good will tends to decline.” 

Mr Miras adds: “Brazil can only find the path to sustainable growth again if reforms are approved by Congress. If they are not, conditions will probably not be met for the kind of decline in interest rates that the market expects, and for the strength of economic recovery that the market expects.”

Once again, politics and the fallout of lava jato may yet frustrate expectations for a better IPO market after several years of disappointing performance.

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