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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