BRAZIL'S VARIG AUCTION: DESTINED TO FAIL, IT DID

UNCLAS SECTION 01 OF 03 BRASILIA 001185

SIPDIS

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EAIR EIND OPRC BR
SUBJECT: BRAZIL'S VARIG AUCTION: DESTINED TO FAIL, IT DID


(U) This cable is business-sensitive. Please protect accordingly.


1. (SBU) VARIG, Brazil's troubled airline with USD 3.5 billion in
debt, went for auction in two rounds on June 8. After failing to
attract any bids at the USD 860 million minimum in the first round,
the company received a USD 449 million bid from an employees' group
(TGV) in the no-minimum-bid second round. The Rio judge presiding
over the auction has delayed decision about acceptance of the
employees' bid. Meanwhile, New York bankruptcy court judges gave
Boeing the go-ahead to repossess 7 aircraft. VARIG's fuel payment
abeyance granted by Petrobras ran out on June 9 with no signs of a
new agreement. Consequently, VARIG was forced to cancel at least 63
flights (4 of them indefinitely) over the period June 10-13 as the
airline was unable to pay for fuel. Competing airlines TAM and GOL
are the big winners from the uncertainty, with their stocks rising
12 percent and 5 percent, respectively, in the first day after the
auction. End Summary.

A BYZANTINE PROCESS, UNCLEAR RESULTS
--------------


2. (SBU) Boeing executive Jose Sicilla explained to Econoff that, in
the opinion of industry insiders, the auction, which required
up-front injections of cash but offered little security for
investors, was destined to fail. To comply with Brazilian
investment restrictions, a foreign investor would have to bring in a
Brazilian partner. The airline was to be sold in an open bid in
which a buyer could purchase VARIG's domestic operations (termed
"VARIG Regional") for USD 700 million or the entire airline ("VARIG
Operational") for USD 860 million. Within, three days after the bid
acceptance, the winning bidder, if any, would have had to inject USD
75 million in cash for immediate operations requirements. Thirty
(30) days after purchase, the winning bidder would have had to
inject another 50 million in cash into the company. Sicilla pointed
out that the minimum amount of time required to obtain all the
necessary legal operational approvals from Brazilian authorities is
30-60 days. Therefore, the winner, despite having injected up front
cash into the operation, could not move quickly to make any major
management decisions, for example dealing with the critical issues
of downsizing the workforce, the renegotiation of leasing contracts,
or achieving a collective bargaining agreement.


3. (SBU) In the event the winner of the initial round did not
receive all the necessary approvals, Sicilla continued, then the
second-place bidder would be declared the winner and would have to
pay back the first bidder's investments in the company (USD 125
million),but would still be required to start the approvals process
with Brazilian authorities from scratch. Moreover, if the money to
be used to re-pay the first bidder were needed to cover VARIG
operational needs, then the funding could be diverted to that
purpose instead, leaving the first bidder out USD 125 million with
nothing to show for its investment. The winner would then have to
wait through a legal process to recoup its investment. "What
business would put itself through that?" Sicilla asked.


4. (SBU) Initially, TAM, GOL, OceanAir, Ceu Azul and NV
Participacoes all paid Reals 60,000 (USD 26,000) to access the VARIG
data room, giving them access to what was supposedly the most
complete and accurate information on the airline. According to
Sicilla, nothing could have been further from the truth. The data
room was open for a mere 7 days, key officers lists in the company
were incorrect and valuation data included assets that had been
offloaded to TAP, Portugal's flagship carrier.

FINAL BID ABOUT HALF OF THE ASKING PRICE
--------------


5. (SBU) In the end, only the employees' association TGV (VARIG
Workers' Group) placed a Reals 1.01 billion (USD 449 million) bid on
the entire airline. The "winning" 449 million bid came in the
second round of bidding, which carried no minimum, after no bids
were received in the first round. To be valid, the 8th Circuit
Court judge in Rio has to accept the terms of the bid. The judge
delayed his decision to accept the bid from June 9 to June 14,
giving himself the weekend to interpret the law and later placing

BRASILIA 00001185 002 OF 003


two more conditions upon the bid. First TGV would have to increase
the cash portion of its offer from USD 125 million to USD 346
million (from a 28 percent to a 77 percent cash offer). Second, the
group has to prove it has the obligatory USD 75 million to inject
immediately into the company to pay VARIG creditors. Upon getting
the news, some members of the Brazilian Congress expressed concern
about how the employees would raise cash necessary to make the
upfront payments, a detail that has not been clear.

BIGGEST PROBLEM: UNCERTAINTY
--------------


6. (SBU) Many of the interested parties were unclear just what they
would be getting themselves into by buying the airline. Sicilla
estimates that about 46 percent of VARIG's USD 3.5 billion debt is
off-balance sheet (operating leases, synthetic leases,
securitizations, special purpose entities, etc.) and it is still
unclear as to how much exposure the 'winner' leaves itself open.
Officially, the auction did not include past due liabilities.
However, legal experts and industry analysts disagree with this
simple pronouncement. Nothing in Brazilian law has changed that
would prevent any debtor from suing the new owner of VARIG in court.
Just as unclear is whether the new owner or creditor litigants
would prevail in a court battle. Most experts agree that, more than
likely, the creditors would.


7. (SBU) The airline's debt to the labor union and the pension fund,
taxes owed to the government, and the lack of a collective
bargaining agreement mean the airline's attractiveness to any
serious bidder drops to zero, said Sicilla. The lack of a
collective bargaining agreement is a particular hindrance to any
potential suitor, as the new owner would be unable to fire workers
to bring the workforce in line with the current minimal operational
levels without being sued -- a suit the employees would more than
likely win, according to Sicilla.


8. (SBU) Another uncertainty was the question of what exactly the
winning bidder would be buying. Sicilla cited as an example the
failure of the data initially made public to clarify precisely what
rights the purchaser of VARIG regional would gain. Only after
inquiries from some of the potential bidders was it made clear that
the domestic VARIG operations would not include rights to trunk
routes, the domestic routes that feed into VARIG's (relatively)
profitable international routes. As public property, the rights to
those trunk routes would revert to ANAC, the Brazilian Civil
Aviation Authority, which would be free to assign routes and airport
space as it sees fit. Sicilla stated that most of these would not
be transferred to VARIG's new owner.

IT'S NOT THAT WE'RE LAZY, BUT WHAT'S OUR MOTIVATION?
-------------- --------------


9. (SBU) Sicilla noted that private debtors are well down the
priority queue to recover their debt once VARIG is at last declared
bankrupt. The debt owed private debtors like the 19 American
aircraft leasing companies (of the total of 29 aircraft lessors)
would receive very low precedence, after the labor union, the
pension fund, Brazilian IRS, Petrobras and INFRAERO. Aircraft
lessors, however, can work to recover their assets, even if they
have little prospect of recovering their back payments. Until last
week, VARIG had still been paying its largest aircraft lessor, ILFC,
even if not in full, according to Sicilla. He added that Bristol,
the company that repossessed its aircraft at JFK two weeks ago, has
3 more craft with VARIG and will process the paperwork to get those
back. FOCUS, a company with 6 MD-11s, intends to pull out their
aircraft at lease term end, at the rate of one a month through
February 2007. While Boeing was unable to get some other lessors to
agree to take collective action on repossessing their aircraft, the
company was able to get the New York Bankruptcy court judge to grant
them the right to repossess seven of the ten aircraft it is leasing
to VARIG. Sicilla expects Boeing to be more successful this time
compared to its last abortive attempt to repossess one of its
VARIG-leased aircraft, when VARIG cancelled a Miami flight that was
serviced with Boeing's plane and then switched the aircraft to a
European route. From June 10-13, VARIG cancelled 63 flights and

BRASILIA 00001185 003 OF 003


counting. It has also suspended indefinitely four international
flights to Miami, New York, Mexico City and Santiago, Chile, all of
which are served by Boeing aircraft.

AND THE WINNERS ARE: TAM AND GOL
--------------

10. (SBU) For a mere Reals 60,000, TAM and GOL, VARIG's largest
competitors, got a cheap look at just how bad off VARIG was. After
seeing what was an unattractive prospect, a TAM executive offered,
"after a detailed analysis of the risk/return, we opted not to make
an offer on VARIG." GOL did not even bother to make an excuse.
Now, if VARIG is liquidated, TAM and GOL will get the bulk of the
airport slots and routes. As successful airline companies, they
look like attractive partners for leasing companies who will court
them. They are almost guaranteed VARIG customers for free. On the
news of the failed auction, TAM stock jumped 12 percent and GOL
stock rose 5 percent the day after the auction. May year on year,
TAM improved its local market share to 45.6 percent and GOL
increased to 33.6 percent. On the international front, TAM's market
share increased to an all-time high of 28.6 percent, exceeding many
analyst expectations. Airline industry experts now predict an even
higher market share increase by December 2006.

COMMENT
--------------


11. (SBU) None of the proceedings of the auction come as much of a
surprise, not even the Rio judge's weaseling out of an immediate
decision. The bankruptcy law states that immediate liquidation is
required in the case of a failed auction -- and 52 percent of the
asking price looks like a failure to us. Worse still is the judge's
final decision to place two more requirements on the TGV offer, thus
merely postponing VARIG's certain death. There was a momentary stay
of execution for the carrier as creditors waited to see how the
auction went. Now that the result has come, creditors like
Petrobras -- an immediate threat to VARIG operations since its
agreement to supply gas on credit has not yet been renegotiated --
could pound the final nail into the VARIG coffin. Other leasing
creditors will await the results of this week's ordered return of
craft, and more than likely follow suit. The lack of fuel, which has
already led to numerous flight cancellations, impending
repossessions, and failing public confidence may make the Rio
judge's decision moot.

CHICOLA