BRAZILIAN GOVERNMENT INTERVENES IN VARIG - TOO

UNCLAS SECTION 01 OF 03 BRASILIA 002806

SIPDIS

SENSITIVE

STATE PLEASE PASS TO USTR
NSC FOR CRONIN
DEPT OF TREASURY FOR FPARODI
USDOC FOR 3000/JOHN TOCCO
USDOC FOR 3134/USFCS/OIO/WH/EOLSON
USDOC FOR 4332/ITA/MAC/WH/OLAC/MWARD
USDOC FOR 6950/DEAN WODDARD - AEROSPACE
DOT FOR SUSAN MCDERMOTT, CAROLYN COLDREN
FAA MIAMI FOR MARK RIOS

E.O. 12958: N/A
TAGS: EAIR EINV PGOV ETRD
SUBJECT: BRAZILIAN GOVERNMENT INTERVENES IN VARIG - TOO
LITTLE, TOO LATE?

REFS: (A) BRASILIA 1839, (B) BRASILIA 1608, (C) BRASILIA

1566


1. (SBU) Summary. For months the Brazilian government has
been urging a market solution to the debt-laden airline
Varig, which filed for bankruptcy protection in June 2005.
The new Varig management council has, nevertheless,
continued to struggle to maintain adequate cash flow and pay
its lessors (making it clear that the problem is not only
its enormous debt). Since Varig's final effort to inject
cash into the company by selling off its profitable VarigLog
(cargo branch) fell through in September, no back-up plan
has materialized. In an apparent about-face, the GOB is now
preparing to intervene and GOB VP Jose Alencar has publicly
stated that there will be a solution this week. On October
20 the press reported a GOB proposal for an immediate cash
injection into Varig via the Brazilian development bank (to
pay the lessors) and partial financing for selling off some
of Varig's most profitable subsidiaries. It may be too
little, too late because of the enormity of Varig's debt and
operational inefficiencies, and because the lessors are
poised to repossess their planes. End Summary.

GOB Intervention Plans
--------------


2. (U) According to press reports on October 18 the
Brazilian government decided to intervene in the Varig
crisis after months of pushing a market solution. GOB VP
Jose Alencar is quoted as saying there will be a solution
"this week." On October 20, the press reported that the GOB
presented the following plan to the Varig creditors: a short-
term capitalization by National Development Bank (BNDES) of
US$62 million to pay the money Varig owes its lessors, and
the creation of a Specific Purpose Society (SPE) to gather
investors interested in purchasing Varig's two most
profitable subsidiaries -- VarigLog (cargo branch) and Varig
Engineering and Maintenance (VEM) -- with up to two-thirds
of the value financed by BNDES. Apparently the door opened
for government intervention last week when the Ruben Berta
Foundation (FRB),a key company shareholder, reported that
it would provide seats on the council to its creditors, and
most crucially, that the FRB would relinquish its
controlling role. A debt-swap, which we previously reported
as essential for Varig's survival (Ref B),is not under
consideration. How the existing debt would be settled is
unclear at this point.

VarigLog Sale Blocked
--------------


3. (U) Varig attempted to sell off its VarigLog subsidiary
to inject cash into the company in August, only to have it
blocked by the airline labor unions. The President of the
Varig management council, David Zylbersztajn, publicly
stated that the cash influx was necessary to make payments
to the lessors in order to convince the U.S. courts to block
repossession of the companies' airplanes. The U.S.
investment company Matlin Patterson had expressed interest
in purchasing VarigLog and the sale negotiations appeared to
have been progressing well. It wasn't clear that the FRB
would have granted final approval, but the deal didn't even
make it to that point. The sale of VarigLog, as well as
future consideration of selling VEM, was blocked by Brazil's
Labor Court after a filing by the labor unions. In obvious
desperation, Zylbersztajn admitted that the Varig council
didn't have a "Plan B" if the sale of VarigLog fell through.
We do not know if the new GOB plan will overcome the Labor
Court decision.

Varig Must Pay Its Lessors
--------------


4. (SBU) The GOB plan indicates its recognition that
whatever the long-term plan for Varig may be, Varig must pay
its lessors immediately. According to one industry source,
the lessors have been very patient, but must have an
investment return on their assets. If Varig does not pay
them, our contact noted, the New York judge may lift the
temporary restraining order (TRO) blocking the lessors'
repossession of their airplanes before its current November
11 deadline. Repossession of these aircraft would be a
mortal blow for Varig because it would mean the loss of its
major income earning assets (the international flights).

Slow Death or Mortal Blow?
--------------


5. (SBU) According to another industry source, the
intervention of the GOB could increase lessors' confidence
in a solution; this could include the GOB imitating the
Matlin Patterson deal but with BNDES financing instead and
extending the sale to include VarigLog, VEM, and possibly
Smiles. (Note: The press expressed concern that Matlin
Patterson is a "vulture" investment fund, which could have
been a stumbling block to consummating the VarigLog sale.
When EconOff mentioned this, our contact said it would be
ironic if Matlin Patterson were viewed as the vulture when
they offered US$103 million for only VarigLog, while BNDES
may be asking for VarigLog, VEM, and Smiles for only US$130
million. End Note.) On the other hand, some believe that
the GOB intervention could be only a ploy so that when Varig
sinks, the GOB can say "we tried, but the U.S. companies
repossessed the planes" (a perfect alibi).

Not to Mention Maintenance, Lease Renewals, Insurance
-------------- --------------


6. (SBU) Even if Varig is able to retain possession of its
leased planes, it faces three additional obstacles to
viability: its dismal maintenance record, expiring leases,
and its insurance policy renewal. First, Varig's failure to
keep current on its maintenance requirements may result in
the grounding of a total of 29% of its fleet by the end of
the year. According to press reports earlier this month,
Varig's VP of Operations produced a technical report that
predicted that Varig would have to ground at least eight of
its planes by the end of the year because of maintenance
reasons. The grounding would be the result of a pattern of
cost reductions in maintenance over the last few years. The
same article reported that Varig had only purchased 10% of
its parts supplies needs in September, only 40% YTD, and 62%
in 2004. If the additional eight planes were grounded, it
would bring the total non-operating fleet to 23 planes, or
29% of it total fleet. Second, approximately 40% of the
Varig leases will expire in 2006, and their renewal would
seem unlikely if Varig were not in better health. Third, if
Varig's insurance policy were not renewed or if its premiums
increased (although relatively small in comparison to the
leasing payments),this could be a serious problem.
Comment: Economics versus Politics
--------------


7. (SBU) Looking at the problem from a strictly economic
perspective, the rest of the airline industry in Brazil is
booming, and trying to fix Varig would certainly be more
expensive for the GOB than letting it ground to a halt.
From a political perspective, however, with an election year
in 2006 and a political crisis already on its hands, the GOB
may have decided to intervene in the restructuring of its
flagship air carrier to avoid another black spot on its
record (e.g., the sacking of thousands of airline
employees). Given VP Alencar's statements that the GOB
intervention was motivated by its concern for "the workers,"
however, and given that the solution at this point may only
be a leveraged cash-influx from BNDES, we believe that the
GOB may still only be avoiding the inevitable. Indicative
of its two minds on these issues, the GOB allowed the civil
aviation authorities to order VASP to cease flying earlier
this year, but then agreed to intervene to see if recovery
was possible (which is dragging on in the judiciary).


8. (SBU) In any case, we do not believe the lessors will be
appeased by superficial measures or wait for a prolonged
viability study. We also do not believe that a short-term
cash-influx from BNDES or even the sale of VarigLog and VEM
will solve the problem. If the BNDES money only becomes
available after a 3-4 week period, for example, that would
be too long. If Varig does not pay the lessors quickly, we
consider it highly likely that the lessors will seek to
repossess their planes and take their business elsewhere.
If beyond the cash injection and sale of VarigLog and VEM,
there are not deep structural changes and downsizing to
Varig, the loss of its profitable subsidiaries may only
speed up the demise of the remaining (unprofitable) Varig.
In sum, the GOB intervention may allow Varig a gentler or
prolonged finale, or allow Varig to grind to a halt with the
U.S. lessors as the scapegoat. However the GOB proceeds, it
must maintain clear communication with the lessors or the
fate of Varig may be out of its hands.

DANILOVICH