Emerging Markets Insights

Making the Case for Latin America Has Historically Revolved around the Region’s Untapped Growth Potential

Making the case for resources has long been a challenge for emerging markets executives—while emerging markets represent tremendous growth opportunities, they have historically been viewed as risky, volatile, and fragmented, undermining corporate willingness to commit large amounts of resources. On a regional level, many of the Latin America executives we work with have expressed frustration at having to defend the region’s potential when top-line growth has been higher elsewhere in the world, particularly in Asia.

At Frontier Strategy Group, we have long strived to help our clients overcome such skepticism and communicate upwards effectively by emphasizing the region’s hard-won macroeconomic stability, relatively under-penetrated markets, and growing middle class. While these drivers remain in place and multinationals’ growth targets for Latin America are now on par with those seen in Asia, sluggish global growth has raised the stakes, and emerging markets are increasingly expected to deliver both top- and bottom-line growth.

However, Sluggish Global Growth & Underperformance in 2012 Have Undermined Confidence in Latin America

In the wake of Venezuela’s recent devaluation and the death of President Hugo Chávez, as Argentina continues to impose heterodox capital and import controls and Brazil edges towards stagflation, it is easy to understand why multinational executives face growing skepticism from risk-averse corporate centers as they strive to make the case for resources in Latin America.

Fortunately, Executives Compelled to Reassess the Region’s Potential Can Walk Away Reassured

While we certainly acknowledge the endogenous and exogenous factors undermining Latin America’s near-term outlook, we remain bullish about the region’s potential over the medium-to-long term, and our optimism is grounded in a demonstrable belief that the region’s core advantages have in fact remained intact, and will be reinforced by positive secular trends.

Not Only Do Latin America’s Core Advantages Remain Intact…

Latin America’s core advantages can be divided into four buckets, including profitability, relative growth, stability, and concentrated financial resources. Of these four advantages, profitability stands out as the most salient given the pivot to profitability that emerging markets executives are experiencing. As growth remains stalled in developed economies and corporate places increasing pressure on emerging markets, 73% of FSG clients in Latin America have experienced or expect to experience a shift in corporate emphasis towards bottom-line growth over the near-term. With this in mind, it is certainly reassuring to consider that available data on publicly traded companies indicate that average operating margins in Latin America are 55% higher than in the BRICs excluding Brazil.

At present, Latin America derives its profitability advantage vis-à-vis other emerging market regions primarily from a host of demand-side factors which allow multinationals to sell at higher margins and maximize the gains associated with realizing economies of scale. However, these advantages have the potential to diminish over time as competition within the region increases, meaning the time to build market share and brand loyalty is now.

When it comes to GDP growth, while the pace of growth in other emerging markets is expected to decelerate in comparison with pre-crisis rates, LATAM has remained relatively resilient and will accelerate in the coming years.

If you’re tempted to dismiss growth and profitability out of fear of resurgent instability, think again. More conservative corporate centers have historically associated Latin America with hyperinflation, uneven growth, and overexposure to commodity boom-and-bust cycles. Part of the story we’re striving to help our clients communicate is that while these sorts of risks persist in specific markets, the region as a whole has progressed tremendously thanks to orthodox macroeconomic reforms.

Inflation targeting regimes, reduced deficit spending, and the liberalization of trade and capital flows have brought down inflation, empowered consumers and provided the stability necessary for sustained growth. Latin America also remains well-positioned to ride out any future global downturn, as its economy is less dependent on trade than APAC, and less integrated into the global financial system, reducing the risk of Eurozone contagion. Concentrated financial resources also bode well for B2C and B2B multinationals—per capita private consumption spending and government expenditure in LATAM outpace other EM markets including India and EMEA, and are on par with China.

But investment and reform are positioning the region to build on these strengths moving forwards, unlocking new opportunities for multinationals:

Most importantly, Latin America is well-positioned to build on these core advantages, and secular trends are already yielding proof points. Trends we’re tracking range from Peña Nieto’s ambitious reform agenda and the resurgence of manufacturing in Mexico to Colombia’s peace dividend and Peru’s rapid rise. On a pan-regional level, energy resources will bolster government coffers and empower investment in infrastructure and human capital, while the rise of the Pacific Alliance will provide a decidedly pro-business counterweight to the increasingly anachronistic Mercosur. The region is on the rise, and there has never been a better moment to make—and win—the case.

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Many of this week’s US headlines primarily focused on the the imminent United States government sequestration.  In addition to following those developments, our research talent kept an eye on headlines pertaining to emerging markets, too.  Below are some headlines with FSG research analyst commentary:

Bloomberg News reported that Emerging Stocks Erase Weekly Gain on China, Commodities:

“Today’s headlines highlight the US budget sequester’s ripple effect on emerging-market growth. That could incrementally diminish the opportunities for MNCs in some EMs, but it doesn’t change the fundamentals. We are more concerned that US-based MNCs will react to economic mismanagement at home by remaining overly risk-averse abroad, allowing local competitors to capture yet more market share.”
- Joel Whitaker, Senior Vice President and Head of Global Research

The Wall Street Journal’s Deal Journal blog posted Doubts Over Returns Hit Fundraising in China:

“Look beyond headline GDP to gauge China’s economic performance. Look at corporate profits in China and return of PE investment is a good indicator.”
- Shijie Chen, Research Practice Leader for Asia Pacific

From Reuters - Brazil may use imports to curb inflation:

“Offhand comments by Brazil’s finance minister raise the possibility that the country could drop import tariffs in sectors and on goods where local producers have been raising prices aggressively. This would be a 180 turn from years past, when Brazil raised tariffs on imported goods in industries impacted by cheaper imports due to a strong currency.”
- Clinton Carter, Director of Research for Latin America

And lastly, another article from Reuters - Russia says central bank independence not at risk:

As CEE governments struggle to boost growth without increasing fiscal deficits, they are increasingly pushing regional central banks to cut interest rates, even at the expense of undermining the banks’ independence. This is a trend to watch in 2013, especially in Russia where reduced central bank autonomy could significantly undermine investor confidence.”
- Martina Bozadzhieva, Senior Analyst for Central and Eastern Europe

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Frontier Strategy Group’s survey of senior business executives was recently featured in a nationally syndicated article by Amy Guthrie of Dow Jones Newswire. The article, which was picked up by major news companies like Fox Business, highlighted Latin America’s high-profit performance relative to other emerging market regions.

FSG’s proprietary benchmarking data obtained from a survey of executives at multinational companies operating in Latin America’s emerging markets was highlighted in the piece as a solid indication that Latin America is well-poised for further growth.  Ryan Brier, Practice Leader for Latin America at FSG, was interviewed for the news piece and delivered further insight to the high-performing Latin America region:

“Optimism is skewed toward the region’s second-biggest economy, Mexico, aided by the country’s overhaul agenda and improved manufacturing competitiveness, as well as toward Colombia, whereas the outlook for Brazil is less certain given a slowing economy, burdensome regulation and a generally high cost of business in the region’s biggest economy. Yet executives still see Brazil’s long-term potential as promising, given the country’s large youthful population and natural-resource potential.”

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I spent last week in São Paulo meeting with GMs of Brazil and Latin America based there. Among the highlights was a working breakfast with eight country and region heads of US technology and telecom companies. My colleague Antonio Martinez shared the LATAM research team’s latest outlook for Brazil and the region, and we had a robust discussion about the Brazilian business environment and its proper place in the Latin America portfolio. Here are a few of my top takeaways:

• Tech has outperformed other industries recently in Brazil, but individual corporate performance divides largely by maturity in the market. Established firms are more impacted by the overall economy’s slowdown, but Brazil’s massive size still allows for rapid growth for tech companies that bring something innovative to the market.
• Brazil’s fragmented tax regime is the biggest headache for country managers. The complexity of state and local tax codes (companies must comply with >200 taxes!) adds to the cost of doing business and impedes companies’ ability to expand into fast-growing cities beyond the highly developed southeast, especially in northern states where millions of people are taking on middle-class spending habits and governments continue to invest heavily in infrastructure. From the LATAM perspective, Mexico’s simple, if higher, tax rate looks better and better.
• Country managers are in an uncomfortable dialogue with corporate headquarters. Top execs in the US are used to the BRICs story and are having a hard time wrapping their heads around the constant flow of downward revisions in the government’s growth forecasts. Everyone around the table believes in Brazil’s medium term growth prospects (on a 4-5 year horizon), but managing expectations for 2013 is tough. Particularly challenging is helping HQ understand currency volatility and inflation.
• Horror stories about Brazil’s political culture were abundant. “Labor litigation is becoming a monster.” “The political mentality is: for the friends, everything, and for everyone else, the law.”  But frustrations aside, the group was unanimous in its belief in Brazil’s long-term opportunity and commitment to invest. The lessons learned and innovative practices shared around the table – some of which our clients may well see in case studies later this year – were the true highlight of the session.

Next week I look forward to sharing insights from a similar executive breakfast I’ll be attending in Shanghai, discussing the long-term outlook for China.

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FSG recently surveyed our clients and expert advisors regarding their expectations for their businesses in Brazil over the next 5-10 years, and the results reflect two important trends: cost-consciousness and path-dependency. For many years now, companies have invested in Brazil and been content with robust top-line growth. However, in the wake of the financial crisis, as the US and Eurozone markets have struggled and China is currently experiencing a slowdown, many multinationals are running out of patience. Increasingly, top-line growth in Brazil is not sufficient, and our clients are concerned with cutting costs and improving operational efficiency so as to improve their bottom-line performance.

As they do so, they remain cognizant of the potential for government action to address specific constraints—while many of our clients are skeptical about the true impact reforms will have, our view is that government actions will help mitigate the impact of some constraints, most notably infrastructure and access to financing, while failing to address others, due in large part to domestic politics. This variation is impacting our clients’ strategic plans in quite interesting ways.

For example, while companies continue to equate geographic expansion in the Northeast and Center-West with growth potential, they are primarily planning for product-led growth over the near term, due to the logistical costs associated with expanding to lesser-penetrated regions where infrastructure is poor or non-existent. It should be noted that a zero-sum approach is neither evident nor expected. FSG clients are not discounting geographic expansion, but many executives are being forced by cost concerns to make trade-offs, and this often results in short-term concerns dictating strategic priorities.

Over the medium-to-long term, we do expect that push and pull factors, including market saturation and the need to serve existing accounts will continue to drive expansion, and we also expect infrastructure reforms to decrease the marginal costs associated with geographic expansion, making this approach much more feasible from a cost-benefit perspective. Of critical importance are external urgency drivers, including the 2014 World Cup and 2016 Olympic Games, which help raise the stakes and motivate the government to engage the private sector in infrastructure projects.

As executives plan for growth in Brazil, their decisions are increasingly motivated by the need to ensure the growth they deliver is profitable. Trends worth tracking in light of this paradigm shift are those that promise to tilt the balance down the road in favor of outcomes that may not be feasible from a cost-benefit perspective at present.

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Last week I interviewed Gerardo Mendoza, one of Frontier Strategy Group’s Expert Advisors.  Gerardo is originally from Mexico, and also spent some time working in Argentina, before landing in Brazil where he has been an entrepreneur and business advisor for the last fourteen years.  He has become a specialist on corporate tax concerns and the healthcare industry, but this post will be about neither of those themes, per se.  Instead, I want to discuss a trap that Gerardo has seen pharmaceutical companies fall into in Brazil.  This trap is a cautionary tale, because it could easily become a problem for companies in other countries and other industries.

Before I go further, since this is my first post on the FSG blog, let me also introduce myself.  My name is Dan Kornfield, and I spend my time interacting with clients and working with them to uncover useful perspectives on and solutions to common management challenges they face in emerging markets.  I tackle these challenges primarily from a thematic rather than geographic angle.  Specifically, I serve as FSG’s Director of Strategic Research.

One of the areas where I believe FSG is doing truly groundbreaking work is on “channel management,” which is business jargon for managing sales channels, or the variety of ways a company gets its products to end customers.  For many global businesses operating in emerging markets, the most common sales channel is to operate through distributors. In fact, a great deal of business in emerging markets would come to a screeching halt if distributors stopped offering their services.

Distributors are intermediary third party companies that serve as a sales organization (and usually logistics provider as well) for their clients, the producers.  Unlike wholesalers, transactional links in the value chain that simply purchase based on bulk discount and then resell, distributors become active agents for their business partners.  Some distributors work for one company, but most work for several at once.  Some companies have one distributor authorized to operate in a country or region, and others have many.

Distributors represent the producer client’s brand, and take its products to end customers more efficiently and/or more effectively than the client believes they could accomplish by themselves.  Sometimes, distributors are also hired by a company to avoid hassle, or, whether they know it or not, to take on risks that the producer would rather not assume.  For example, a company recently told me they employ a distributor to sell to the Mexican government, because they do not want to have to deal with all the paperwork.

Regardless of industry (e.g. consumer goods, healthcare, heavy industrial, or technology and telecom), about 94% of our clients rely at least partially on distributors, and just over 50% of our clients’ sales volume is brought in through these “indirect” (distribution) channels.

Okay, enough background.  Now back to Gerardo and his cautionary tale.

He explained that many pharmaceutical companies in Brazil have relied too heavily on distributors.  The distributors have grown up to become indispensable partners.  And as the market has grown, distributors have undergone a flurry of M&A activity amongst themselves.  Now some pharmaceutical companies have to reach their end customers through distributors that have larger annual revenues than their clients, and they gain that revenue from a more diversified set of partnerships.  This has led, and is continuing to lead, to a significant imbalance of power in the producer-distributor relationship.

At the end of the day, this means that it is hard for pharmaceutical manufacturers to be able to offer enough sales volume to really matter to some of the major distributors.  Now the only way they can gain preferential time and attention from their own third party agents is to pay them more – at the risk of beginning a margin-conceding arms race with other companies that employ the same distributor.  The alternative is to exit the distributor relationship and, if there are no good alternatives, to shift to operating their own direct sales force.  Now that the market is both complex and well developed, the easiest way to “go direct” would be to acquire some existing distributors.  Unfortunately, many of the good targets have already been gobbled up.

Gerardo believes pharmaceutical companies in Brazil waited far too long to make their move.  If they had diversified earlier into more of a hybrid model, employing distributors while simultaneously developing their own formidable sales force, they would be better off and less drastically dependent.  They also should have had their eyes on acquisition targets earlier, before the distribution market became more consolidated on someone else’s terms.

If you are operating in a fast-growing emerging market country, this story could happen to you.  In your team meeting this month, ask your team members whether they are concerned about overdependence and the potential for consolidation in the distribution space.  You’ve heard the warning that your value chain is only as strong as its weakest link.  But what happens when one of the links in your value chain becomes stronger than you are? That, too, is a problem.

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Brazil has been a cause of concern for multinationals as of late, with credit-fueled consumer spending and GDP growth both trending downwards in Q3. This slowdown is particularly worrisome for B2C companies, who fear for their ability to meet annual growth targets.  The macroeconomic drivers of this trend paint a mixed picture: on the one hand, inflation and unemployment both remain low, and an emerging middle class continues to benefit from government cash transfers and social programs. On the other hand, even after the central bank’s most recent round of rate cuts, interest rates remain relatively high, external headwinds continue to hamper demand for exports, and consumers are increasingly hesitant to take on additional debt.

There is, however, an upside to this story which bodes well for long-term growth: consumer spending is expected to rebound over the medium-term, as government spending ramps up in preparation for the 2014 electoral cycle and World Cup. Furthermore, the Rousseff administration has begun the politically difficult process of setting Brazil on the path towards an investment-led growth model. This transition is likely to proceed in fits and starts, given that more than 50% of federal government spending goes towards pensions and government salaries at present, and Rousseff’s left-wing and labor union supporters will adamantly oppose any cuts. These challenges, while not unique to Brazil, are exacerbated by the sheer size and diversity of the country, and multinationals should expect structural reforms to proceed gradually, with limited impact over the short-to-medium term.

Many multinationals in Brazil who have long been concerned with growth have responded to the current slow-down by shifting their focus to operational efficiency and profitability. Notable best practices include: transitioning from an indirect to a direct or hybrid distribution model, streamlining and centralizing back office services, leveraging technology to improve supply chain efficiency, and pursuing growth by expanding within Brazil’s five regions and second-and third-tier cities.

The experience of Takeda Pharmaceuticals in Brazil illustrates that these strategies often work best in tandem. Takeda entered the Brazilian market in 2011. While its initial acquisition gave Takeda access to major wholesalers and chains, regional wholesalers and smaller pharmacies remained out of reach. Takeda then acquired Multilab, a locally based pharmaceutical company with an established regional distribution network. As a result of this acquisition, Takeda was able to increase its product portfolio and market share within Brazil, while gaining a valuable foothold within Brazil’s emerging regions that leaves it advantageously poised for future growth. Main take away points from Takeda’s success story include the following:

1. Multinationals should anticipate and plan for growth beyond the South and Southeast regions. The North and Northeast in particular are expected to experience economic growth, and multinationals that successfully penetrate these markets now will be poised for success down the road.

2. Multinationals hoping to increase their presence in Brazil through acquisition must carefully analyze the distribution capabilities of potential targets, and choose those with capabilities that best address existing deficiencies. This is especially crucial in lesser-penetrated regions, including the North and Northeast. Infrastructure is less developed in these regions, making scalable direct distribution quite difficult, while indirect and hybrid models require relationships with regional wholesalers and local retailers that foreign multinationals are often unable to forge endogenously.

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Weaker regional growth in the first half of the year has driven multinationals to reevaluate their growth targets for 2012 as Argentina’s business landscape grows increasingly unnerving, Brazil’s economy slows, and devaluation risks in Venezuela swell as President Chavez drives up fiscal spending as part of his reelection campaign. However, many regional executives are looking towards new opportunities in Mexico as higher labor costs in China and election of business friendly Enrique Peña Nieto leads executives to believe the new administration will be able to implement structural reforms aimed at boosting higher and sustainable long-term economic growth. Meanwhile, many multinationals are undeterred by the weaker first half growth as they continue to invest in Brazil, hoping that government stimulus measures to revive consumer spending and industrial production in Brazil in the second half of 2012.

Argentina: Multinationals are dealing with an increasingly dire business environment by decreasing investments and lowering growth expectations

Brazil: Foreign investors shake off short-term woes as some multinationals position themselves for the long-term rewards that Brazil offers

Chile: The forecast is upbeat as production, consumption, and high consumer sentiment all point to a favorable economic outlook for 2012

Colombia: Colombia’s economy will continue to be a growth leader in 2012, but sluggish retail and falling industrial production dim its prospects

Mexico: Multinationals remain bullish on Mexico’s growth prospects as a new administration offers hope for necessary structural reforms

Venezuela: Multinationals remain cautious as ballooning fiscal spending contributes to rising currency devaluation risks for the beginning of 2013

Antonio Martinez and Erick Soto contributed to this piece.

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Frontier Strategy Group Expert Adviser, David Wolf recently wrote the following on his Silicon Hutong blog:

While the Fourth BRICS (Brazil, Russia, India, China, and South Africa) summit was nearly three months ago, the meta-message that is emerging from the aftermath is that these countries do not yet form anything resembling a bloc of interests.

Ruchita Beri’s short piece (linked above) is guardedly optimistic about the grouping, but if you read between the lines you can almost feel the divergence of interests that is pulling this grouping apart. Beri, a senior researcher at India’s Institute for Defence Studies and Analyses, gently suggests that China is part of the problem.

“While the BRICS grouping does provide an opportunity for each member to play an important role on the global stage, one of the challenges that it faces is cohesiveness. Take the issue of the BRICS development bank. While it is indeed a laudable initiative, the challenge lies in aligning the differing interests of the member countries. Moreover, other members of the grouping are wary of China’s domination over the bank given that China holds very large foreign exchange reserves ($ 3 trillion).”

All of this serves to underscore the real elephant in the room, which is the fact that while some of the BRICS might trust each other, most are having a hard time trusting China. As it considers its soft power challenges, China also needs to see that being a trustworthy player in the global system would do a lot toward making it influential (rather than disruptive) in such international groupings, and in turn toward making those groupings influential.

To view the original post, click here.

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How important are the Brazilian and Mexico markets to your business?  Are they important enough?  With multinational companies placing an increasing emphasis on these two Latin American giants, many executives yearn to understand how Brazil and Mexico fit into the big picture.

In a recent senior executive poll, Frontier Strategy Group benchmarked the relative revenue contributions of Brazil and Mexico to total global revenue, on a company-by-company basis.  By segmenting the results into industry cohorts, our clients are able to see in detail how their organizations stack up against their peers.

Consumer goods companies are far outpacing other industries in their expansion into these markets, which indicates that industrial, pharmaceutical, and technology companies have a huge opportunity to solidify their positions in these markets and create a more sustainable growth platform for the future.

With the often conflicting growth and profitability imperatives, it is useful to know where you stand in order to set reasonable expectations with corporate centers.  And as is true with any business, knowledge is the key to unlocking the secrets of effective growth.

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