Brazil Leveraged Names Overview
Disclaimer: The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.
After four years of very high nominal and inflation-adjusted interest rates, the Central Bank of Brazil (BACEN) is preparing to lower the reference rate SELIC. Market expectations are for rates to move from 15% today to around 12% by the end of this year, and 10% by the end of 2027.
This change can present opportunities among equities, many of which are really pressured by the current rate scenario. 15% nominal and 10%+ inflation-adjusted rates constitute a very hard environment for almost any business. There are not that many industries where a 15% return on capital is common, and given that high rates generate a drought of new equity capital, many companies struggle to cover their cost of capital.
This article provides an overview of 10 such businesses. They share similar characteristics: they are struggling to cover interest from operational profits; most of their debt costs are tied to variable-rate BRL debt; and some of them have operational/cyclical leverage to lower rates as well.
Some of them are potentially attractive on a fundamental basis, while others might be attractive vehicles for a speculative trade on bottom-line acceleration or lower-rates as a theme.
Mulher
Você vai gostar
Tô levando uns amigos (muito alavancados) pra conversar
Eles vão com uma fome (de lucro) que nem me contem
Eles vão com uma sede (de capital) de anteontem
Salta cerveja estupidamente gelada prum batalhão
E vamos botar água (liquidez) no feijãoFeijoada Completa - Chico Buarque - 1977 - Additions in italics by me
A more timely note: Olefins and the 2nd Gulf War
Writing about Brazilian leveraged names while the world debates the new Gulf War seems a little out of whack with current events, but it makes a lot of sense, at least in my opinion.
Macro and geopolitical events like this War are volatile and fleeting. It is the War today, two weeks ago was AI replacement and atoms vs bits, one month ago was dedollarization, and in one month it might be something completely different.
We need to abstract from explaining current events and analyze longer-term trends, to have a chance at having an emotional and intellectual framework that is not a prisoner of market sentiment and X feeds. So far, this has paid me good dividends. Some of the things I wrote about became ‘viral’ in the market later.
In this case, related to the war, I was lucky enough to analyze the olefin market late last year. Olefins are extremely affected by the current halt in trade between the Gulf countries and the rest of the world. Based on my analysis of this market, I believe US olefin giants like Exxon, Dow, and LyondellBasell are positioned to benefit substantially from protracted disruptions in Gulf maritime trade.
Following is a small note I wrote about the topic. You can also find much more detailed information in the three-part Primer I wrote about the olefins markets (Part I is currently free to read):
A great deal has been written about how a prolonged conflict in the Middle East could affect global oil and gas markets. Much less attention, however, has been paid to the implications for olefins and polyolefins.
That is surprising, because these are more concentrated industries, with fewer globally relevant players and clearer relative winners and losers. If disruption in the Arabian Peninsula proves persistent, the most obvious beneficiaries are likely to be the large American olefin producers, especially Exxon, LyondellBasell, and Dow.
The logic is fairly straightforward.
The US Gulf Coast producers already occupy one of the lowest-cost positions in the global olefin cost curve thanks to advantaged feedstocks. Their main rival in this respect is the Middle East, particularly Saudi Arabia, Qatar, and the UAE, which also benefits from abundant low-cost feedstock surpluses.
A regional conflict directly undermines the Middle East’s ability to compete. Refining and cracking infrastructure could become vulnerable to attack or operational disruption. Even if plants remain physically intact, exporting products could become more difficult and more expensive due to longer shipping routes, higher insurance costs, and heightened logistical risk. In addition, any decline in regional oil and gas production would reduce the availability of wet feedstocks, further eroding the cost advantage of Middle Eastern producers.
The effects would not be confined to the Gulf. In Europe and China, the other major consuming regions, feedstock costs would likely rise as well. That could happen through several channels: higher crude prices, more expensive and riskier transport, or reduced supply of Middle Eastern hydrocarbons and related feedstocks. In other words, competitors outside the US would face a more inflationary raw material environment at the same time that Middle Eastern producers themselves are impaired.
Finally, the US may experience the opposite dynamic domestically. Higher global oil prices would likely stimulate additional US upstream production, increasing the supply of associated gas and natural gas liquids. That, in turn, could improve the availability of wet feedstocks for Gulf Coast crackers and potentially lower their relative cost base even further.
This matters because the large American olefin producers generate roughly half of their sales and profits from export markets. Those export markets have, until now, been heavily pressured by two forces: low-cost Middle Eastern production and Chinese capacity expansion enabled, directly or indirectly, by relatively cheap feedstocks. A prolonged disruption in the Arabian Peninsula weakens the first force immediately and raises costs across the system more broadly, giving US producers a meaningful relative advantage.
Over the longer term, however, the picture becomes more complicated. One plausible consequence of sustained geopolitical instability is that China accelerates its push for energy self-sufficiency and strategic resilience. That could mean faster electrification of transport, lower domestic fuel consumption, and greater efforts to shift refining systems toward chemicals production. If so, the medium-term effect could be to increase chemical output and place renewed pressure on global olefin supply. I explore that dynamic in much greater detail in my second article on olefins.
Index of the main article
The context of lower rates
The method for finding opportunities leveraged to lower rates
Company 1 - industrials
Company 2- retail
Company 3 - retail
Company 4 - insurance
Company 5, 6, 7, 8 - industrials
Company 9 - commodities
Company 10 - infrastructure
Annex: Derivatives accounting and the upcoming IPCA swap revaluation
The context of lower rates
Brazil has maintained four years of very high inflation-adjusted rates. Brazilian inflation peaked at 12% YoY in April 2022 and has been below 6% since November 2022. Compared with this, the SELIC reference rate has hovered around 14% on average over this period, implying inflation-adjusted rates above 10% at times.
The Central Bank’s justification for such a monetary stance is that inflation has almost consistently remained above target (3%) and above the tolerance upper limit (4.5%). Further, after an initial period of rate cuts between 2H23 and 1H24, inflation reaccelerated, prompting the BACEN to return to a hawkish stance.
I have been fairly critical of the instrumentality of high rates in Brazil. Rates might be the only instruments at hand, given that fiscal policy is very rigid because of mandated expenses and indexes, but they are very imperfect. They generate a positive wealth effect among the richer strata of society (who earn 10% above inflation for having money in the bank); widen the consolidated deficit of the state; stifle investment that could improve productivity and resolve the inflation problem long-term; and may not even really reduce credit availability. I wrote more extensively about the fiscal and monetary problems in Brazil in the two articles linked below:
Independent of my opinions on high-rate policy, inflation is expected to decrease to 3/4%, that is, within the tolerated policy range, and the BACEN has already signalled its intent on reducing rates. The FOCUS expectations survey, a key policy-determination survey carried out by the BACEN, expects rates to decline to 12% this year and to 10% in 2027.
For a lot of businesses, 15% to 12.5% to 10% is the difference between life and death. There are not that many businesses that can earn a 15% return on capital, not even with 4/5% inflation. These businesses cannot earn their cost of capital at 15% rates. To this, we have to add the challenging consumer cycle in many domestic industries in the post-pandemic period. Finally, the complete drought in equity markets in Brazil (who would buy equity when the bank pays you 15% for holding cash equivalents?).
Further, most companies in Brazil issue variable-rate debt in BRL, meaning they are exposed to a decrease in rates. Of course, not all to the same degree.
It is in this context that sifting through ideas in Brazilian equity markets becomes attractive.
The method for finding opportunities leveraged to lower rates
The ideal company to benefit from lower rates is one that has the following characteristics:
Currently fairly leveraged, and either not able or barely able to cover interest costs, using different metrics depending on the case (EBIT, EBITDA, EBITDA - CAPEX).
Most of the interest expense is tied to BRL variable-rate debt. This does not mean that most debt is BRL, but rather that most of the cost is tied to BRL debt.
Bonus: its operations present additional leverage to lower interest rates. Examples include downstream industry cycles (more construction) or consumer dynamics (higher availability or lower cost of installment credit).
If the company matches these characteristics, we can then analyze its income statement in more detail with a simple napkin model:
Adjust operating income (or whatever operating profitability metric we are using) based on expected cyclical changes because of rates, if any.
Adjust net financing expenses based on the current capital stack (BRL debt, leases, BRL securities).
With these, we can find the expected change in pre- and post-tax income for the company.
Finally, a company might be an opportunity from a fundamental or a speculative basis:
It is attractive on a fundamental basis if its market cap offers an interesting discount to our expected lower-rate earnings. For example, the company now makes R$200 million net; we expect it to make R$500 million with lower rates, and it trades for R$3 billion. What is attractive in this case depends on each person, but the source of returns is either earnings or a repricing triggered by what we believe is a fair multiple.
It is attractive on a speculative basis if we expect the lower rates to trigger a repricing, even if its current market cap is overvalued in our understanding. This could happen because earnings improve, or because leveraged plays become a theme.
Each company in this overview meets the first two criteria above. In each segment, I introduce the company and its operational aspects (economics, cycle) succinctly, and then provide a ‘napkin model’ for lower rates (both 12% and 10% reference expectations).
