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The fallout from Odebrecht’s admission of foreign bribery will likely affect its engineering and construction business, as well as its consortium partners throughout Latin America. Here an Odebrecht project in Peru. (Photo: Odebrecht)
Wednesday, June 21, 2017

Latin America Construction: Woes Not Over

Latin American construction companies’ woes may not be over, yet.


Can Latin American construction companies survive an expected plateau in gross fixed capital formation in a region that so desperately needs infrastructure investment?

In recent years, Latin American construction companies have faced deteriorating cash flows due to overexpansion at home or abroad, limited financing availability due to changing regulations and/or government investigations (i.e., “Lava Jato” in Brazil, also known as the Car Wash Investigation), falling commodity prices (primarily oil) and cutbacks in government spending; all of which have led to over-levered financial positions.

Many regional construction companies have experienced or will likely be going through restructurings. In Mexico, the three largest homebuilders went through restructurings between 2014 and 2016 and one of Mexico’s largest engineering and construction companies, Empresas ICA, S.A.B. de C.V., is currently being restructured. Similarly, in a process that has been ongoing since 2015, one of Brazil’s largest engineering and construction companies, OAS S.A. is also currently being restructured. Looking ahead, the fallout from Odebrecht’s admission of foreign bribery will likely affect its engineering and construction business, as well as its consortium partners throughout Latin America where projects are being cancelled, triggering sureties and bank guarantees.

Against this backdrop, the uncertainty with respect to future economic development makes capital investment decisions difficult. This is even truer today following the election of President Trump in the United States and the potential impact on global trade (particularly for its neighbors to the south), the strengthening dollar, flattish oil prices and the moderating growth outlook for China. For Latin America specifically, economic growth is further restricted by depressed commodity prices in metals and mining (gold, iron ore, copper, etc.). Indeed, although Bloomberg Analyst Consensus Forecasts show flat to modest price increases in these commodities from their troughs in 2015/2016, these prices are still below the prices of 2013, which was a year removed from the peak years of 2011/2012.

However, uncertainty in gross fixed capital formation (“GFCF”) and/or capital investment is not something the region can afford; the lack of investment and infrastructure in the region further deepens the deficit the region faces, impacting economic growth.

The World Economic Forum’s Global Competitiveness Report (2016-2017) ranks the infrastructure quality of 138 countries on a scale of 1 to 7 (7 being the best). The highest ranking country in the Latin American region is Panama at #36 (with an infrastructure quality score of 4.9), followed closely by Chile and Uruguay at #44 (4.7) and #47 (4.5), respectively. Panama’s ranking is not surprising given that it has one of the highest ratios of GFCF as a percentage of GDP, similar to that of China.

However, most of the Latin American region has an infrastructure score under 4.5 which compares unfavorably to the highest score of 6.7 achieved by Hong Kong SAR. Developed economies, such as United States, Canada and Europe generally have scores above 5.50.

One reasonable conclusion … is that Latin American countries seem to be underspending (and/or have historically underspent) on GFCF as a percentage of GDP compared to developed countries with higher scores. For example, Brazil (4.0), the largest economy in Latin America, spends less than 20 percent of its GDP on GFCF, and Mexico (4.3) fares only slightly better, spending between 20-25 percent. Similarly, it appears that Ecuador (4.0), Colombia (3.7) and Nicaragua (3.2) are making heavier investments, presumably trying to compensate for historical underspending in an effort to improve their scores to levels of developed economies.

The spending gap is even more apparent when considering that, while developed economies seem to spend around the same GFCF as a percentage of GDP as the average Latin American country, they already have high infrastructure quality, thus requiring less investment towards their infrastructure gap.

Along the same lines, according to the McKinsey Global Institute, Mexico is expected to have a projected infrastructure gap between actual spending and its infrastructure needs of $1.1 trillion between 2016 and 2030. Brazil’s projected gap over the same period is estimated at $0.7 trillion.  Indonesia ($1.3 trillion), South Africa ($1.2 trillion) and Saudi Arabia ($ 0.9 trillion) are expected to have larger infrastructure gaps than Brazil. Yet interestingly enough, both Indonesia and Saudi Arabia spent more in GFCF as a percentage of GDP than Mexico and Brazil in 2015.

It is therefore concerning that GFCF has declined in Latin America since 2014 and is expected to remain at low levels with limited growth over the next few years when there is clearly a need in the region for investment which drives economic growth and prosperity

The largest drop in GFCF as a percentage of GDP occurred in 2015 and 2016, coinciding with the decline in oil prices.

Similarly, the growth in GFCF between 2011 and 2014 seems to have been at least partially driven by oil prices. The outlook for oil is relatively flat over the next few years, and GFCF is expected to grow at a tempered pace, not reaching historical levels that would benefit the region. Will the low rates of GFCF as a percentage of GDP last just 2-3 years as forecasted or will the situation be worse than expected?

Oil’s modest outlook has far reaching implications for Brazil and Mexico’s economies. Brazil is already feeling the effect with a decline in royalties, special participations and income tax revenues from oil production. Cash received from royalties declined 25 percent in 2015 and 29 percent in 2016, reaching similar levels last seen in 2009. The combined impact in both years is over USD 5 billion in fewer funds received by all three levels of government (federal, state and municipal). This has directly impacted governments that are already cash strapped and/or had committed to projects assuming these sources of funds would continue near historical levels. While oil production in

Brazil is increasing, financial crisis has impacted Petrobras’ (Brazil’s semi-public multinational crown oil corporation) expansion plans and, as such, the pace of exploration has been delayed. Petrobras has calculated that for the next 8 years, the government will lose out on about $12 billion of royalties, special participations and income tax

Similarly, Mexico’s capital expenditure budget for 2017 has been reduced 23 percent (in real terms) compared to 2016’s approved budget, signaling a large contraction in investment expected by the Mexican Federal Government. Of the decline, about 60 percent of the reduced budget affects Pemex (Petróleos Mexicanos, Mexico’s state owned oil company) directly. So while Mexico has become less dependent on oil revenues to drive economic growth, the effects on government capital expenditures are clear. Pemex’s oil production has fallen from over 3 million barrels per day (pre-2007) to just 2 million barrels per day in 2017, the lowest levels since 1980. The cut in oil investments, lower production and low oil prices in Mexico are having their impact on investment. Furthermore, with the current outlook for oil prices, future capital expenditures by the Mexican and Brazilian governments may be limited.

So what’s in store for Mexico and Brazil, Latin America’s two largest economies?

Construction activity is not looking promising in the short term.

The Brazilian cement producers’ union (SNIC)’s consumption data show the correlation between GDP and cement consumption.

Cement consumption is closely correlated to construction activity and economic activity and, hence, to GDP. Since its peak in 2010, cement consumption has been declining rapidly despite the investment in construction for the 2014 World Cup and the 2016 Summer Olympics. While 2016 appears to be the trough year, the tempered GDP growth forecast does not signal a great improvement for cement consumption in the country.

The President of the SNIC has recently stated that the consumption of cement in Brazil for 2017 is expected to decrease 5 to 7 percent from 2016, implying that economic activity and/or construction activity will be subdued in 2017 as well.

The Economist Intelligence Unit’s (EIU) latest assumptions (February 1, 2017) are consistent with the SNIC, as they expect GDP to have contracted 3.5 percent in 2016, with 2017’s GDP increasing slightly by 0.5 percent. However, the EIU notes that the weak activity in the fourth quarter of 2016 may further weaken 2017’s GDP projection, and that due to a projected growth slowdown in China and the US, GDP growth is not expected to exceed 2 percent until 2019.

Mexico’s construction activity is not expected to fare any better. The CMIC (Camara Mexicana de Industria de la Construcción) is expecting a relatively low growth scenario for construction in 2017, of between 0.5 and 1 percent due to economic uncertainty, and average annual growth of 2.3 percent in the next few years, when the industry has potential growth of 4 to 5 percent. Mexico’s GDP is expected to grow moderately at just approximately 2 percent per year through 2019.

Construction companies in the region have already been negatively impacted by the decrease in GFCF with leverage increases over the period. With the contraction in international construction and the less than stellar prospects at home, many construction companies have already undergone restructurings and/or retreated from international operations, either by choice or necessity (e.g., as the result of exclusions from countries due to foreign bribery and corruption allegations).

While more restructurings in the sector are anticipated in the short term, particularly in Brazil, they provide an opportunity for right-sizing the capital structure and operations of construction companies, allowing for survivors of this turbulent period to be well positioned to capitalize on the vast but more distant opportunities in the region.

Brock Edgar is a senior managing director in FTI Consulting’s Corporate Finance practice and head of FTI’s Latin American Restructuring Practice, based in Toronto.  Devi Rajani is a managing director in FTI Consulting’s Corporate Finance practice and is based in Toronto.

This article has been republished with permission from Cleary Gottlieb Steen & Hamilton LLP. The article was originally published in Cleary Gottlieb’s Emerging Markets & Restructuring Journal, Issue No. 3 Spring 2017. The full issue can be viewed here

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