Top 10 Investor Questions For 2014:

Will Latin American Corporate Credit

Quality Stay Stable?
Primary Credit Analyst:
Luis Manuel M Martinez, Mexico City (52) 55-5081-4462; luis.martinez@standardandpoors.com
Secondary Contacts:
Eduardo E Uribe-Caraza, Mexico City (52) 55-5081-4408; eduardo.uribe@standardandpoors.com
Patricia R Calvo, Mexico City (52) 55-5081-4481; patricia.calvo@standardandpoors.com
Fabiola Ortiz, Mexico City (52) 55-5081-4449; fabiola.ortiz@standardandpoors.com
Flavia M Bedran, Sao Paulo (55) 11-3039-9758; flavia.bedran@standardandpoors.com
Table Of Contents
Top 10 Investor Questions
Related Criteria And Research
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Top 10 Investor Questions For 2014: Will Latin
American Corporate Credit Quality Stay Stable?
Despite rising borrowing costs for the Latin American corporate sector, Standard & Poor's Ratings Services expects its
credit quality to remain healthy in 2014. Although risks from uncertain conditions in advanced economies are
diminishing, China's slower economic growth and global market volatility could present the biggest threats to the
region. Below, Standard & Poor's answers the top 10 investor questions for 2014 regarding Latin American corporate
credit quality.
Top 10 Investor Questions
What is Standard & Poor's general view on the Latin America corporate sector for 2014?
We currently rate 293 corporate entities in the region, 70% of which maintain a stable outlook, indicating our
expectations of limited chances for rating changes within the next 12 months.
Corporate credit quality should remain largely stable within the next 12 months. Sectors associated with commodity
products remain vulnerable to the moderation of China's economic growth-- and the related impact on prices--while
the lower-rated entities are subject to refinancing risk. We continue to see the impact of rising borrowing costs
stemming from the normalization of the U.S. Federal Reserve's monetary policy. That, coupled with ongoing market
volatility, has prompted a gradual decline in new Latin American bond issuance.
Our baseline economic growth forecast for Latin America is 2.4% in 2014, similar to 2013's growth, amid stronger
global economic activity, primarily the continued recovery in the U.S. and improved market sentiment in Europe.
However, renewed concerns about China's growth could undermine the region's positive trend. Still, we expect that
credit conditions for the corporate sector will remain somewhat favorable in 2014.
Consumer demand growth in the region and international commodity prices remain highly contingent on the pace of
recovery in the largest Latin American economies, Brazil and Mexico, as well as in the global economy.
We consider that country risk remains a key factor for the Latin American corporate sector because we view
country-specific business conditions as a significant constraint on credit quality. In particular, we see an unfavorable
business environment in Argentina and Venezuela, whose corporate sectors suffer from uncertain public policies and
regulations. Additionally, the sovereign downgrades of Argentina and Venezuela in 2013, due to weak domestic
economies, will most likely reduce the corporate sector's growth prospects in those two countries and undermine
credit quality.
In 2014, low commodity prices will continue to lower cash flow generation for the metals and mining sector as well as
for the chemicals and forest product industries. In addition, Brazilian sugar producers will keep struggling to protect
their liquidity amid currently unfavorable sugar prices. We also consider that stagnant demand for new housing in
Brazil in Mexico will maintain pressure on homebuilders.
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Based on Standard & Poor's macroeconomic prospects for Latin America in 2014, what's the potential
performance of corporate ratings?
As the global economy generally improves, most of Latin America is coming along for the ride. Brazil and Mexico,
however, also have a large impact on the region's growth trend. We expect their GDPs to increase by 1.8% and 3.0%,
respectively, in 2014. We also expect more robust growth in some smaller countries such as Chile, Colombia, Peru,
and Panama. Moreover, we project that the region's GDP growth in 2014 will reach about 2.4%. Risks emanating from
advanced economies, such as U.S. fiscal policy and contagion from eurozone problems, have receded. However, we
continue to see a gradual moderation in China's economic growth, which is in line with the policymakers' desire to
rebalance the economy and rein in financial excesses. Still, we consider that most of Latin American corporate entities
will retain their stable credit outlooks in 2014, despite the disparate economic performance throughout the region.
Also, many companies took advantage of the region's prosperity in the years after the 2008 global financial crisis to
consolidate their market positions, seize acquisition opportunities, reinforce economies of scale, or enhance
productivity and cost structures. All that allowed for more predictable and stable cash flows. Therefore, we upgraded
several companies, including consumer product companies across the region, mining companies in Mexico, and
shopping mall operators in Brazil. In addition, the global financial uncertainty spurred many companies to adopt more
prudent financial management to protect balance sheets and improve liquidity.
Does Standard & Poor's expect a significant impact from higher borrowing costs?
In our base-case scenario, we expect long-term interest rates to rise modestly and gradually. We forecast the U.S.
Treasury 10-year yield averaging 3% this year. In this scenario, we expect financial conditions to remain supportive in
the near term, particularly for the Latin American corporate sector.
In our view, the Fed's tapering of its bond-buying program and normalization of interest rates will continue to
gradually increase borrowing costs, which may change investor appetite for Latin American high-yield bonds.
However, we believe that overall credit quality remains healthy. In addition, we expect rating trends to remain
generally unchanged within the next two years, in line with our stable rating outlooks for the corporate sector. In fact,
thanks to highly favorable funding conditions over the last couple of years, several corporate entities issued close to
$180 billion in debt, which they partly used to extend debt maturities and increase liquidity.
Industries with highly leveraged capital structures, such as real estate, will be more vulnerable to rising interest rates.
Also, capital-intensive sectors that face overcapacity, somewhat rigid cost structures, and relatively low margins will
struggle to improve cash flow metrics. Some of these sectors include those tied to commodity prices, including metals
and mining, housing, chemicals, and forest products.
Is liquidity a major risk for the corporate sector?
Latin American companies have been increasing cash balances in recent years. Since 2009, total cash and short-term
investments have increased almost 50% in dollar terms, a significant accumulation considering the depreciation of
Brazilian, Colombian, Chilean, and Peruvian currencies. Total liquidity of rated corporates in the region reached about
$250 billion by Dec. 31, 2013, which represented approximately 11% of their total assets. This ratio is in line with their
U.S. peers, whose cash to assets reached about 12% in 2013. Latin American corporate issuers with "adequate" or
"strong" liquidity (per our criteria) account for approximately 80% of the total debt outstanding.
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In terms of external liquidity, domestic banks and investors remain liquid and are the primary alternatives for funding.
However, this funding depends on industry sector, country, and the issuer's credit quality. In addition, banks may not
be willing to take on additional risks with leveraged companies. We expect investors to remain wary because of global
economic developments, and we believe speculative-grade issuers will continue to pay higher yields--if they are able to
issue debt abroad. Consequently, with approximately $18 billion in maturities due in 2014 and about $17 billion due in
2015, we believe short-term refinancing risks will remain the primary threat for corporate issuers in the region. In that
sense, liquidity may be a key determinant of rating stability.
What are the main short-term risks for the corporate sector?
The short-term outlook for the corporate sector in Latin America benefits from more positive prospects for the
eurozone's economic performance, as well as our expectations for underlying economic momentum in the U.S.
continuing through 2015. Additionally, the global economic recovery is on track, and the risks emanating from
advanced economies have generally receded. However, the regional corporate sector faces significant economic and
political hurdles as well as global market volatility that can rapidly undermine investor confidence. In addition, the
region is dependent on the outlook for China. because several Latin American economies have strong commodity links
and/or important trade and investment ties with China.
As these market conditions persist, we believe short-term factors will continue to weigh on Latin American corporate
credit quality, especially for speculative-grade companies. We estimate that rated Latin American corporate issuers
have close to $90 billion in bond maturities within the next four years, including the $35 billion coming due within the
next two years. Many issuers, particularly investment-grade, have already started to address potential short-term risks
by reducing debt and increasing liquidity. This, in our view, would allow them to withstand systemic shocks during the
next 15 months.
However, downside risks remain, and the market challenges for Latin American corporates could continue pressuring
credit quality into 2014. Issuers that have prepared for potential market volatility--by expanding and diversifying their
market presence, strengthening their balance sheets, stabilizing cash flow generation, and limiting liquidity risks--will
be in a better position to weather risks that could materialize in the months to come.
Which companies could benefit from the energy reform in Mexico?
In December 2013, the Mexican government approved the energy reform, which will end the state's 76-year old oil
monopoly, allowing private-sector participation in the oil and gas sector. In our opinion, several large international oil
and gas companies and contractors will be interested in participating in exploration and production in a variety of
indirect ways and to engage directly in midstream and downstream operations.
We also believe that several Mexican companies that currently do business with Petroles Mexicanos (PEMEX; foreign
currency: BBB+/Stable/--; local currency; A/Stable/--) in various areas can benefit as well. For example,
conglomerate Alfa S.A.B. de C.V. (BBB/Stable/--) has recently issued $1 billion in senior unsecured notes to mainly
finance investments in the energy division through its subsidiary, Newpek. This entity is engaged in the exploration
and exploitation of gas and oil fields in southern Texas through a joint venture with Pioneer Natural Resources and
Reliance Industries. Newpek has about 400 wells in production in Texas' Eagle Ford Shale and has services agreement
with PEMEX to exploit two mature fields in the state of Veracruz.
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Top 10 Investor Questions For 2014: Will Latin American Corporate Credit Quality Stay Stable?
Another good example is Grupo Mexico S.A.B. de C.V. The company is leasing marine platforms engaged in oil and
gas exploration, and has offered its geophysical services to PEMEX for new discoveries. Last year, Grupo Mexico
acquired two new platform oil rigs. Therefore, we believe it has significant interest in expanding its operations in the oil
and gas sector.
The opening of Mexico's energy sector could also benefit the petrochemical producers, such as Mexichem S.A.B. de
C.V. (global scale: BBB-/Stable/--; national scale: mxAA/Stable/mxA-1) and Alpek S.A.B. de C.V. (BBB-/Stable/--).
For example, Mexichem formed a joint venture last year with PEMEX to produce vinyl chloride monomer. The
project's cost is about $205 million and consists of carrying out engineering, procurement, construction, maintenance,
and commissioning services. We expect Mexichem to continue investing in the sector to strengthen its vertical
integration and competitive position, as well as incorporating more value-added products into its portfolio.
Which sectors are mostly exposed to the severe drought in Brazil?
The magnitude of damage from the drought in Brazil is uncertain. The low levels of the water reservoirs and the lack of
rain have increased the energy prices, and the productivity of some agricultural plantations has dropped.
High energy prices have had a direct impact on industrial production, resulting in lower operating margins. However,
industrial players in the metals and mining, forest products, and branded consumer producers that we rate have
adequate liquidity and are rated 'BB-' or higher, which in our view, provide financial flexibility to address potential
short-term pressures. As these sectors face lower margins and slow volume growth in light of a stagnant economy that
is suffering from higher unemployment rate, some industrial players are protecting liquidity needs by scaling back
short-term capital investments related to capacity expansion.
In the agribusiness sector, we expect a short-term effect from the drought, particularly in the next harvest. A small
decline in volumes and productivity can take a toll on small producers with limited financial flexibility, as is the case
for some companies rated in the 'B' category. We believe that the Brazilian sugarcane processors are particularly
vulnerable, as most of them have highly leveraged financial profiles, and higher working capital requirements could
reduce their liquidity rapidly. Currently, about 20% of the sugar processors that we rate have a negative outlook.
For protein players, the draught could pressure the livestock prices, reflecting higher production costs on the fattening
of the grass-fed cattle. However, the companies we rate in this sector are better prepared to mitigate volume risks,
given that volume demand from export markets has been gradually recovering, and meat producers have more
leverage to pass through the cost increases to end consumers.
What are the main challenges for Latin American corporate issuers whose fortunes are tied to
commodity prices, on both the revenue and cost side?
Due to the historic fluctuations in commodity prices, our corporate ratings incorporate the potential volatility in raw
materials or earnings forecasts, although volatility of commodity prices may still have various rating effects.
We expect a gradual decline in iron ore prices in 2014 due to rising supply. We also expect that high-quality ore and
low production costs will be the main profitability drivers for most Latin American mining companies. We have
negative outlooks on most steel producers, reflecting the risks of a global weak demand and oversupply, as well as the
potential threat of increasing import volumes resulting from changes in trade tariffs. However, steel producers have
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recently benefited from the depreciating local currencies, which have enhanced export competitiveness, and from
improving domestic market demand.
We consider that the sugarcane processing sector has the higher downside risks, particularly due to still-low sugar
prices. Although we have a stable outlook on about 80% of rated companies in the sector, most of them are in the 'BB'
and 'B' rating categories. In our view, most of these companies are highly vulnerable to external market conditions,
and consequently, to rating changes. In the case of sugar processors in Brazil, inflation continues to pressure the cost
structure, and margins may come under additional pressure if we continue to see weak global sugar prices and
domestic ethanol prices capped by gasoline prices.
Market conditions for forest products companies are somewhat favorable. We don't expect any significant deceleration
in pulp prices, despite some minor discounts for short-fiber pulp in the past few months. Despite a slow recovery in
global GDP growth, we are not concerned about oversupply risks because we expect consumer markets to remain
stable and paper companies to continue operating at full capacity, thus generating sound operating margins.
Downward price pressures remain a risk that we will continue to monitor, although we believe a downside scenario is
less likely to materialize, given rising consumption and disposable income in Latin America, as well as improving
economic trends in the U.S.
Can corporate ratings be higher than those on the sovereign under Standard & Poor's criteria? Does
Standard & Poor's have a rating "ceiling"?
The sovereign rating doesn't act as a "ceiling" for corporate ratings. Instead, we assess how resilient an entity could be
to a simulated sovereign default scenario. However, the sovereign foreign currency rating does limit how much higher
a corporate credit rating can go in terms of sensitivity to country risk. When assigning a corporate credit rating to an
entity that's higher than the sovereign foreign currency rating, Standard & Poor's believes there is an appreciable
likelihood that the entity wouldn't default if the sovereign were to do so. According to our recently published "Ratings
Above The Sovereign--Corporate and Government Ratings: Methodology And Assumptions" criteria, we can rate the
companies in sectors with "high" sensitivity to country risk by up to two notches above the sovereign and those in
sectors with "moderate" sensitivity by up to four notches higher.
We impose rating caps to anticipate low-probability but high-severity risks associated with sovereign distress and
default scenarios, which our stress test does not specifically capture. We divide such caps into two categories,
recognizing that companies in industries with "moderate" sensitivity to country risk have a better ability to mitigate the
country and sovereign risks. Still, we understand that under sovereign stress, all companies will face some challenges.
Also, foreign currency ratings on domestic companies are usually no higher than the transfer and convertibility (T&C)
risk assessment. However, factors that can allow foreign currency ratings to exceed the T&C include exporters with
certain additional mitigating characteristics and geographic diversification. Finally, we may further evaluate group
support or structural aspects, such as guarantees, to consider whether a rating can exceed the sovereign ratings or
T&C assessment.
After determining the stand-alone credit profile (SACP) of an issuer according to our assessment of its business and
financial risk profiles and modifiers, we compare it with the sovereign foreign currency rating on the country (or
countries) where the company does material business. For the corporate credit rating to be higher than the country (or
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countries') sovereign foreign currency rating, we apply a hypothetical sovereign foreign currency default stress
scenario (stress test). To get rated above the sovereign foreign currency rating, the company must maintain a ratio of
sources to uses over a one-year stress scenario of more than 1x, as defined in our "Methodology And Assumptions:
Liquidity Descriptors For Global Corporate Issuers," criteria.
What are Standard & Poor's main assumptions in the stress test scenario for Brazil?
The stress test includes the following factors:
A decline in revenues and earnings due to the simulated severe economic downturn in Brazil, which includes a GDP
drop of 6%-10%, an unemployment spike of 20%-30% (subject to a minimum rate of 15%), a doubling of inflation
rates, and a 50% devaluation of Brazil's real (50% loss of value compared with the dollar);
A haircut (a percentage cut in the par values) to holdings of domestic marketable securities;
A sharp increase in funding costs for floating-rate or short-term debt because of the expected interest rate shock
(doubling of nominal interest rates);
A lack of capital market access for debt refinancing;
Increased export duties; and
Frozen tariffs for utilities.
However, the stress test also incorporates the rated companies' ability to reduce capital expenditures to maintenance
levels and to lower dividends to a required minimum or even delaying them to mitigate liquidity pressures. Passing the
stress test means the entity won't be in default under this hypothetical macroeconomic environment, although we
could lower its ratings.
We currently rate six Brazilian corporate entities at 'BBB' with stable outlooks: Razen (combination of Raizen
Combustiveis S.A. and Raizen Energia S.A.), Votorantim Participacoes S.A., Ultrapar Participacoes S.A., Natura
Cosmeticos S.A., Embraer S.A., and Multiplan Empreendimentos Imobiliarios S.A. The stress tests on these entities
depend on what share of their operations relies on Brazil's economy. For example, the fuel distribution businesses of
Ultrapar and Razen Combustveis correlate highly to Brazil's GDP growth and its influence on fuel demand, while
global demand dictates Razen Energia's sugar output. Votorantim benefits from its international cement operations
and metals division, Natura benefits from being a stable consumer products producer, and Embraer from its heavy
reliance on exports. In light of these factors, we consider all companies to have a "moderate" sensitivity to country risk,
except for Ultrapar, which has "high" sensitivity.
Although the Latin American corporate sector faces various challenges ahead, we still expect that credit quality will
remain healthy in 2014. However, we'll be keeping a close eye on any changes to current conditions that would alter
our current views for general credit stability.
Related Criteria And Research
Related criteria
Ratings Above The Sovereign--Corporate and Government Ratings: Methodology And Assumptions, Jan. 2, 2014
Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Nov. 19, 2013
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Top 10 Investor Questions For 2014: Will Latin American Corporate Credit Quality Stay Stable?
Related research
Top Investor Questions For 2014: Most Latin American Financial Companies Are Likely To Maintain Stable
Outlooks, April 29, 2014
Top Investor Questions For 2014: Latin American Infrastructure Sector Is Poised For Robust Expansion, While
Brazil's Drought And Mexico's Energy Reform Are Key Issues Facing The Utilities Sector, March 31, 2014
Top 10 Investor Questions For 2014: The Story On Latin American And Caribbean Sovereigns Is Country Specific,
March 26, 2014
Top 10 Investor Questions For 2014: Structured Finance Securitizations Will Find Stronger Footing In Latin
America, March 20, 2014
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