Ultrapar Participacoes SA (UGP)

Sao Paulo, Brazil-based Ultrapar Participa es S.A. is a major Brazilian holding company, engaged through its four subsidiaries in fuel and lubricants distribution, liquefied petroleum gas (LPG) distribution/production, chemicals and petrochemicals, and the storage and transportation of chemicals and LPG. The group's four subsidiaries are Ipiranga, Ultragaz, Oxiteno and Ultracargo.

Ipiranga: At the end of 2007, the company acquired Ipiranga. According to the deal, Ultrapar acquired the fuel and lubricant distribution business in the South and Southeast Brazil and a smaller chemical company called EMCA. This new business segment is now responsible for around 80% of the company's total revenues.

Ultragaz: Ultragaz was the first LPG distributor in Brazil and remains one of the largest players in the Brazilian LPG market. The company supplies both the bottled and bulk segments of the market and has operations in all of Brazil's significant population centers, with the exception of the northern region. Ultragaz supplies bottled LPG to more than seven million residential consumers, who use it for cooking and water heating. The company's distribution in the bottled segment includes sales through its own home delivery service, its retail stores and independent dealers. The bulk segment of the market includes commercial and industrial consumers, who are supplied through large cylinders and bulk deliveries. Ultragaz generates approximately 13% of Ultrapar's revenue.

Oxiteno: Oxiteno is a major Brazilian producer of commodity and specialty chemicals. The company's primary commodity products include ethylene oxide, ethylene glycols, ethanolamines, glycol ethers and methyl-ether acetates. These products are used in industrial applications such as the production of polyester, packaging, paints, varnishes and cosmetics. Oxiteno supplies both the domestic and international markets. Oxiteno generates 6% of the company's revenues.

Ultracargo: Ultracargo is one of the leading providers of integrated transportation and storage services to the LPG, petrochemical, and chemical industries in Brazil. Ultracargo generates the remaining 1% of UGP's revenues.

Ultrapar has been growing through acquisitions. In August 2003, Ultrapar acquired Shell Gas in Brazil. In December 2003, the company acquired Canamex, a Mexican chemical facility. On June 30, 2004, Ultrapar announced the acquisition of the operating assets of Rhodia Especialidades S.A. de C.V. in Mexico again. Ultragaz has achieved impressive economies of scale, due to those acquisitions, particularly in the case of Shell Gas.

During the fourth quarter 2006, UGP announced plans to acquire three companies outside Brazil, one in U.S., another one in Venezuela and the third one in Europe and on September 2007 UGP acquired by US$7.6 million Arch Andina in Venezuela, a subsidiary of the American company Arch Chemicals Inc. On March 2007, Ultrapar together with Petrobras (PBR) and Braskem (BAK) announced the acquisition of the Brazilian Ipiranga Group, in one of the largest acquisitions ever in Brazil. In August 2008, Ultra signed an agreement to acquire Texaco-branded fuels marketing business in Brazil from Chevron Corporation at an amount of R$ 1.161 billion, which together with Ipiranga will make a nationwide fuels marketing business. Finally, in October, 2008, through Ultracargo, UGP closed an acquisition of 100% of the shares of Uniao Terminais at US$205 million.

During the first quarter of 2007, Grupo Ultra, Petrobras (PBR) and Braskem (BAK) announced the acquisition of Grupo Ipiranga in Brazil. We think this was very positive news for UGP for three basic reasons: (i) UGP will gain its own retail business with a considerable network (15% market share), being the second-largest fuel distribution company in Brazil with 3,300 service stations, (ii) the deal is a definitive step in the consolidation of the petrochemical business in Brazil, a fact that will reduce competition and increase margins in the short-to-medium term, and (iii) it will avoid the entry of a big international player in the Brazilian market. In the end of the first quarter 2008, the final stage of the Ipiranga deal was finally reached and UGP received the final payment from Petrobras and Braskem on May 2008.

In August 2008, the company signed an agreement to acquire Texaco-branded fuels marketing business in Brazil from Chevron Corporation for R$ 1.161 billion, which will be entirely funded from Ultra's existing cash resources. Closing of a deal will occur once the segregation of Chevron's lubricant and oil exploration activities is completed, which is expected to take place at the beginning of 2009. Texaco's brand name use will be licensed for up to five years, to ensure a gradual re-branding of the entire network to Ipiranga's brand name. The acquisition will create a network of more than 5 thousand service stations and will have 23% market share in Brazil. The merging of the two fuel distribution networks will allow important economies of scale, such as optimized use of the distribution terminals, improved efficiency in the sales process, dilution of advertising, marketing, new products development and management functions. The incorporation of Texaco's services stations in Central West, Northeast and Northern regions of Brazil will allow Ipiranga to more efficiently serve its clients with nationwide operations and requirements. Ipiranga will have exposure to regions with higher fuel consumption growth.

Until the third quarter 2008, domestic demand for fuels, mainly ethanol, was growing considerably. During the second quarter of 2008, Ipiranga's ethanol volume sales increased by 71% year-over-year. In the third quarter 2008 ethanol volume sales were up 48% year-over-year. Domestic ethanol demand in Brazil is growing very fast. Currently, 87% of all cars sold in Brazil are "flex fuel" cars, which can use ethanol, gasoline or any blend of both. Additionally, the Brazilian flex-fuel fleet is over 4 million vehicles, around 20% of the country's total light vehicle fleet. According to ANP (Brazilian national Petroleum Agency), between January and May 2008, domestic ethanol consumption exceeded gasoline consumption. Even better, according to Anfavea (Brazilian association of cars manufactures), the first six months of 2008 were the best of the year ever for the Brazilian auto industry, with a growth of 30% from the same period of 2007.

The outlook for the Brazilian auto industry is not that encouraging. The international credit crisis will affect the short-term growth on the Brazilian auto industry and demand for fuels will certainly be affected too. Despite the international crisis, Brazil will keep on growing in the following quarters, albeit at a slower pace. The international crisis reaches Brazil in a more positive way. The country has huge international reserves (above US$200 billion), a positive trade balance, slightly negative current account balance, reasonably solid fiscal situation and very high interest rates that could be reduced over the following quarters in order to keep the economy growing. Even though Brazil will be affected by this crisis, we do not expect a recession or anything alike, GDP growth for 2008 will be over 5% and expected Brazilian GDP growth for 2009 remains around 3.5%.

Even better, we think Ipiranga benefited from a recent legislation change in the fuel sector. Since April 2008, it has become obligatory for fuel producers, distributors and resellers to issue electronic tax invoices in all states of Brazil. Additionally, it was also approved the concentration of PIS and Cofins (withholding taxes) in the ethanol distilleries and it is now mandatory to install flow meters in the distilleries. We do believe that measures will considerably reduce unfair competition in the fuel distribution segment. Additionally, some months ago Petrobras announced the acquisition of Suzano Petroquimica, another important player in the Brazilian Petrochemical industry. We have few doubts that the consolidation of the Brazilian Petrochemical industry is underway and that UGP will be benefited by this development in the short-to-medium term.

Grupo Ultra has been doing many investments, which will help to boost revenues and earnings in the medium-term. In the end of 2006, UGP announced investment in a huge petrochemical complex project with Petrobras (PBR), BNDES (Brazilian national development bank), among other companies, in the State of Rio de Janeiro, Brazil. The total investment in this project will reach US$3.5 billion in the following years. Additionally, the company has been doing smaller investments in its existing facilities in order to be adapted to a growing demand. During the third quarter 2008, Oxiteno invested US$96 million on production capacity expansion projects, particularly in the conclusion of a new fatty alcohol plant and the expansion of the ethylene oxide capacity of the Maua plant. Moreover, Oxiteno's production capacity expansions scheduled to start operations during the second half 2008 were completed, including (i) start up of an oleochemical unit with capacity of 100,000 tons of fatty alcohols and by-products (ii) expansion of the ethilene oxide unit adding 38,000 tons and (iii) expansion of the ethoxylate and ethanolamine production. These expansions should have a positive impact from following quarter onwards.

Additionally there were investments of US$34 million and US$8 million in Ultragaz and Ultracargo respectively. In October, 2008, UGP finally acquired, through Ultracargo, 100% of the shares of Uniao Terminais at US$205 million, with a net present value of R$ 200 million. With this acquisition UGP will become the largest bulk liquid storage company in South America. Recently the company's Board of Directors approved an investment plan for 2008 of US$470 million (57% for Oxiteno, 20% for Ipiranga, 17% for Ultragaz and the balance for Ultracargo). These investments are part of UGP's expansion plan, including the growth of production and scale and optimization of costs and expenses. The amounts do not contemplate possible acquisitions.

Third quarter 2008 results were in line with our expectations. The main engine behind the company's revenues and earnings increase was the positive performance of the Ipiranga division, including higher volume sold, improved revenues and sound cash-flow generation. As we expected, after the conclusion of the Ipiranga deal, net debt was dramatically reduced and so was net financial expenses. We believe excessive leverage will not be a short-term problem anymore. Even better, the company has now a sound financial position with a low net debt, a very important asset during a credit crisis.

Oxiteno is the sole producer of ethylene oxide and its derivatives in the Mercosul area (Brazil, Argentina, Uruguay and Paraguay). Thus, the company should benefit from its monopolistic position. It is also important to note that Oxiteno's large production capacity, in excess of Brazilian demand, acts as a barrier to entry to new producers. During the third quarter 2008, Oxiteno decreased by 11% its total volume sales as a result of scheduled maintenance stoppages and lower glycol sales. We expect a better performance in the fourth quarter 2008, mainly considering the recent capacity expansion.

The strength of the Brazilian real had a negative net effect on UGP's earnings in recent quarters. Oxiteno has been particularly affected by this challenging business environment, with tight operating margins in its exports. It is true that the appreciation of the real helps to reduce domestic price of naphtha, which is quoted in dollars, but the net effect is for sure negative for the company. In fact, all the international businesses of UGP have been under pressure due to strength of the Brazilian currency. As a result of the economic crisis, the Brazilian real depreciated sharply against the U.S. dollar in the last weeks. This is positive for Oxiteno's exports however we believe most of this movement will be short-lived. Interest rates in the U.S. are quite low and will remain like this for a long time, by the other side Brazilian interest rates will remain high and Brazil still has a positive trade balance and a very small current account deficit. Nevertheless, some depreciation of the Brazilian real will remain and Oxiteno will benefit somehow. Additionally, the international crisis had another positive effect for Oxyteno. Falling oil prices and, as a consequence, Naphta prices. We expect better margins for Oxiteno in the following quarters.

We believe UGP has been posting good results and successfully became a major player in the fuel distribution segment in Brazil, which will not be that much affected by the international crisis. Lower oil prices and some depreciation of the Brazilian real should help Oxiteno. Additionally, the company has a strong balance sheet and is trading at an attractive valuation. All considered we are changing our current recommendation from Hold to Buy.

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