Sluggish Growth in Brazil is Driving MNCs to Invest in Efficiency-Enhancing Measures

Brazil Economy

The case for Brazil is getting harder to make

While the Brazilian economy grew faster than expected during the second quarter, full-fledged recovery remains elusive and several rounds of interest rate hikes have yet to rein in stubbornly high inflation. FSG is expecting relatively weak GDP growth of 2-2.2% YOY in 2013, with potential for electorally-motivated fiscal stimulus to drive growth of around 2.7% YOY in 2014. These numbers are disappointing, and underscore the extent to which Brazil’s long-term potential remains constrained by structural bottlenecks and protectionist policies.

Most multinationals are in Brazil for the long haul, but many plan to limit investment

Here at FSG, we have been carefully tracking multinational sentiment with respect to Brazil, and on a recent trip to Miami, I had the opportunity to sit down with many of the LATAM executives we work with to discuss how the role of Brazil within their regional portfolios has changed as economic growth has slowed.

Suffice it to say that while weak prospects have put a damper on sentiment, few executives are contemplating pulling out of the market. However, many executives I have spoken with in recent weeks anticipate holding investment flat over the near- to medium-term, with the potential for scaling back presence if the situation does not improve over the course of 2014-2015.

Interestingly, this sort of pessimism is gaining ground in spite of high top-line growth. Most executives we work with don’t anticipate that Brazil’s slowdown will have a significant impact on their ability to reach ambitious revenue-growth targets, largely because in a market the size of Brazil, there is still white space to be found. Rather, they are concerned about hitting bottom-line targets, and with good reason: Brazil’s high-cost, protectionist operating environment poses a significant drag on margins for foreign multinationals.

Recent exchange rate volatility is making an already-difficult situation worse 

FSG Client Poll

The Brazilian real has been remarkably volatile over the course of Q3-early Q4, depreciating to a low of 2.45 BRL/USD in late August as investors were originally anticipating that the United States would begin to taper bond purchases in September. A majority of companies we work with report that they have built their budgets for 2013 around an anticipated exchange rate of exchange rate of 2.1–2.2 BRL/USD. As such, recent volatility has exacerbated their exposure to FX-related losses and made deal making a herculean endeavor.   

Companies able to take the long view are targeting their investments to improve efficiency

Top investment priority in Brazil

When all is said and done, there is little reason to believe that the protectionist bias of Brazilian labor, tax, and investment policies will change over the medium term. President Rousseff is likely to be re-elected, and domestic politics preclude any marked departure from the ad hoc interventionism that has defined her first term thus far. Executives that are able to plan for the long-term are increasingly coming to terms with this reality and targeting their investments accordingly in an effort to boost profitability. In the B2B space, many companies we work with view investing in local manufacturing as the best way to bring down costs over the medium to long run, while B2C companies are investing in their supply chains. 

Brazil: Consumer Fever – and Some Headache

Brazil Flag

Full article in Latin Trade

‘Custo Brasil’ alive and kicking

Nevertheless, exploring the expanding Brazilian market still comes at a price, and the business environment has remained remarkably difficult, if not hostile.

Brazil has fared badly in the World Bank’s annual “Doing Business” survey, putting the country at a disadvantage against its main competitors worldwide. The latest survey ranks Brazil 126th among 183 countries, including a dismal 150th in the “paying tax” category.

CFOs in multinationals operating in Brazil usually express a lingering concern – if not frustration – regarding tax complexity and compliance issues in Brazil, which often is described as the most critical case in the region. Almir Barbassa, CFO of Petrobras, the oil company, notes that 900 people are employed in Petrobras’ tax department.

Jorge Gerdau, chairman of Gerdau, the steel group, has complained that companies in Brazil typically need 2,000 hours to comply with their tax obligations. He is now part of a presidential steering group to improve management and try to cut bureaucracy, but executives still complain about the lack of tax and labor reforms. President Dilma Rousseff has pledged to cut the tax burden, but structural reforms are not on the agenda.

Rogerio Menezes, CFO of Akzo Nobel Pulp & Paper, is very critical of what he calls “the tax monster”. He says there already have been more than 300,000 changes in the tax legislation, which results in high compliance costs.  This is a drag on Brazil’s competitiveness as a whole.  At present, each of Brasil’s 26 states and the Federal District of Brasilia has its own tax legislation and is able to tax the so-called ICMS (a sort of sales tax on goods and services) at different rates.

“The cost of doing business in Brazil continues to climb, as Brazil has failed to address the principal elements of the ‘custo Brasil,’ such as poor infrastructure, an onerous regulatory burden, heavy taxation and non-compensation labor costs,” says Clinton Carter, head of research for Latin America at Frontier Strategy Group (FSG), a U.S. business advisory firm. “Add to this a scarcity of skilled labor that is pushing salaries through the roof, and the result is a ‘custo Brasil’ that is climbing.”

The bottom line for foreign investors is that “Brazilian business units are less profitable than those in other Latin American countries,” says Ryan Brier, FSG’s Associate Practice Leader for Latin America.

According to an FSG survey , “net margins in Brazil are 5.1 percent narrower, on average, than in the rest of Latin America, largely due to taxes.” Whereas the average corporate tax paid amounted to 48 percent of profits in Latin America, the figure reached 69 percent in Brazil, FSG says. Fast-moving consumer-goods companies are much more heavily taxed than those operating in other sectors, it says.

 

Brazil: High Costs Weigh on Profitability, Limiting the Impact of Growth

Brazil Revenue Growth

Brazil remains a growth engine for multinationals in Latin America:

Despite the economic slowdown, multinationals are counting on Brazil to deliver significant growth in 2012.

But the high cost of doing business, known as Custo Brasil, is eroding the profitability of Latin American business portfolios:

92.3% of executives believe that doing business in Brazil is at least somewhat more costly than the in other Latin American countries.

MNCs and Local Companies Fight for Brazil’s Middle Class

Brazil Middle Class

Multinationals in the consumer space are looking increasingly to the middle class for growth as high-end segments mature.

Local firms are following their traditional customer base as it moves into the middle and upper middle class, putting them on a competitive collision course with multinationals moving down market.

“New middle class consumers are bringing their traditional tastes and preferences with them, helping incumbent local producers tap into the emerging consumer segments.” – FSG Executive FMCG Company

Drivers

The middle class is surpassing the lower class in quantity of households, which changes the traditional shape of the market pyramid and demands a change in strategy.

Leading multinationals are acquiring local producers to enhance their product portfolio and distribution infrastructure in order to meet emerging middle class demand.

Companies that are reluctant to adapt products or stretch their brand equity risk losing middle class customers to more nimble local competitors.

Middle- and higher-end segments are becoming more competitive.

As more multinationals enter Brazil, higher-end segments are becoming increasingly saturated, forcing multinationals to look down-market for new opportunity.

Frontier Strategy Group View

Multinationals that continue to focus primarily on the higher-end segments risk losing emerging middle class consumers to local competitors who are consistently improving and expanding their capabilities in the  medium and high-tier segments in order to gain first-mover advantage.

A failure to plan accordingly will result in MNCs being restricted in their maneuverability as local companies grow in strength.

 

Financial Times: The high price of booming Brazil

Original article appeared in the Financial Times on February 21, 2012

A friend recently joked over dinner that it is cheaper now to get your shoes shined by a Brazilian in New York than by a Brazilian in São Paulo.

This week, a quick check showed the claim to be true – the price of a shoe shine in central São Paulo was R$10 (about $6) before a tip while one from a Brazilian shoe shiner working the New York office market was $5 including tip.

You might say that serves people right in the first place for getting others to shine their shoes, but that is an argument for another column. The fact is the shoeshine test is just another indicator of the remarkably high cost of business in Brazil.

For managers of multinationals in the booming economy, particularly those arriving fresh off the boat with a spreadsheet full of profit targets copied and pasted from the business plans of their peers in India and China, the country’s high-cost base is the first thing that will hit them. Whether it is that credit-card bill after a night out in Rio de Janeiro or the first hard look at the company wage bill in the office, the new manager will soon have to confront what is called Custo Brasil – the Brazil cost.

This is the conundrum businesses face: Brazil is a high-growth market in terms of opportunities for revenue expansion but it is on average a low-margin market in terms of profitability, particularly for companies in the start-up phase.

The new chief executive will quickly realise that his or her success or failure in Brazil will depend on managing the expectations of the company’s overseas bosses. The trick is to persuade them to invest in the country’s growth while also counselling patience when they demand to know why margin growth is not, at least initially, matching that of other emerging markets.

The conundrum was captured in a survey by Frontier Strategy Group, an business advisory company with a focus on emerging markets, which quoted an unnamed client with a consumer goods business as saying: “I know that Brazil is key to our long-term growth strategy, but my biggest challenge is that for every additional percentage point of growth that we see from Brazil, our overall regional profitability declines.”

Frontier Strategy estimates that the average net margin in Latin America is 10.5 per cent, or nearly a third of gross margins. In Brazil, net margins are 5.4 per cent, or nearly one-seventh of gross margin.

Manufacturers are generally worst hit by the Custo Brasil. A startling illustration of this is the Volkswagen Fox, a Brazilian-made car that has a starting price of more than R$32,000 ($18,660) but sells in the UK at just under £7,000 ($11,100).

The Brazil cost is also reflected in the country’s number 126 ranking out of 183 in the World Bank’s Doing Business report. Frontier Strategy details how it costs double a person’s salary to hire someone in Brazil because of taxes and welfare payments. Meanwhile, it takes 120 days to open a new business in Brazil compared with the OECD average of just under two weeks. So does all this mean that no one is making money in Brazil? No, it is just that the barriers to entry are higher. Companies must clearly identify those costs that are associated with Brazil and benchmark themselves against their peers to see whether their costs are in line with industry averages.

The next step is to develop a strategy that minimises the Custo Brasil – for instance, by identifying the fastest-growing regional markets within the country that have the best infrastructure. Or by finding a balance between targeting the wealthier but more mature south-east and the faster-growing but under-developed north-east.

Companies can also try to make the Custo Brasil work for them. The government is erecting barriers against imports but foreign companies that set up plants locally – such as in the automotive sector – usually enjoy the same protections as Brazilian ones.

Most important is that headquarters understands the equation that, at least in the early years, top-line growth in Brazil will not necessarily mean equivalent expansion of the bottom line.

Ask the shoeshine men. It is a safe bet that even though the São Paulo shoe shiner is earning more per shine, the cost of his brushes and polishing creams are a lot higher than for his brother in New York.

Brazil: Avoiding Recession by a Narrow Margin

FSG View: Stimulus efforts are beginning to take effect, but Brazil is not out of the woods yet as industrial output continues to stall

Market Trends

The two-speed economy continues to develop in Brazil with unemployment sinking to a record-low 4.7% in December. Tight labor markets and real wage hikes are helping to fuel consumer spending while industrial output and manufacturing continue to lag.

Current stimulus measures, coupled with an increase in public spending and lending by the BNDES, should keep the Brazilian economy out of recession in 2012, but will likely be less effective than in 2009 as consumer expectations and business confidence are not as anchored as they were during the previous crisis.

Key Developments

Government efforts to jumpstart the economy by loosening consumer credit are bearing fruit as recent data released by the central bank show that seasonally adjusted economic activity rose 1.15 percent in November from October. Retail sales rose 1.3% over the same period, the fastest pace in 15 months.

Labor costs are expected to rise even further as the government enacts new regulations requiring companies to pay overtime rates for after-hours work calls or emails. While this measure is unlikely to affect compensation for senior managers, FSG expects companies to see an uptick in overtime pay at the analyst and junior management level.

The government announced that the manufacturers of certain tablet computers will qualify for a series of tax incentives, clearing the way for Foxconn to begin producing Apple iPads in Brazil.

The fact that Foxconn required preferential tax treatment to make iPad production profitable is illustrative of the type of cost challenges faced by multinationals looking to produce in Brazil.

Looking Ahead

FSG will be monitoring consumer prices in Brazil to see if the central bank can manage to bring inflation down while continuing to aggressively slash interest rates

Growth in Brazil Presents a Double-edged Sword


As developed economies continue to muddle through an increasingly tenuous economic recovery, the need for multinationals to find new sources of growth in emerging markets is becoming ever more important. This is a trend that Frontier Strategy Group has been tracking for some time across our client base, and one that is particularly apparent in Latin America, where renewed focus on the region has led to average growth targets in excess of 20% for 2011. In order to meet these growth targets, executives are adopting a combination of strategies that includes expansion into new geographies and consumer segments as well as implementation of aggressive M&A plans.

One country where multinationals have seen a tremendous amount of growth over the past two years is Brazil. In the first half of 2011 Frontier Strategy Group member companies averaged 27% YoY growth in Brazil despite a cooling economic environment. These types of results are capturing the attention of corporate centers; however, the stellar performance of Brazilian business units presents a serious conundrum for many heads of region.

The conundrum stems from the fact that as regional heads are seeing more and more of their top-line growth in Latin America come from Brazil, they are experiencing a narrowing of bottom-line margins. The cost of doing business in Brazil, or Custo Brasil as it is known locally, is so high that business units there contribute significantly less to overall profitability than they do in other countries. For executives tasked with maintaining current levels of profitability while achieving unprecedented growth targets, the challenge posed by Custo Brasil is particularly daunting.

For this reason, Frontier Strategy Group is undertaking an effort to help multinationals diagnose and quantify Custo Brasil. The output from this effort will give executives the tools to identify and mitigate some of the more pernicious effects of Custo Brasil in their cost structures and determine which costs are due to local conditions as opposed to organizational structure and execution. By finding ways to narrow the gap in profitability between Brazilian business units and the rest of Latin America, Frontier Strategy Group is looking to ensure the continued success of multinationals in O País do Amanhã.

If you are interested in participating in this effort, please take a moment to fill out the following survey by clicking here (go to survey) or pasting the following link into your web browser: (http://vista-survey.com/survey/v2/survey2.dsb?ID=5131690207).