Brazil Equity Strategy

1. Brazil Equity Strategy Part 1 Marcelo Mesquita marcelo.mesquita@ubsw.com 5521 2555 3333 Marcio Brito marcio.brito@ubsw.com 5521 2555 3031 April 11, 2003 Companies mentioned and disclosures on page 25

2. Summary • UBSW Market view: • Short-term (until May) Positive: Lula building credibility and a majority in Congress; details of structural reforms. (Our view: 15,000 Ibovespa; FX less volatile around 3.3) • Medium-term (May to Dec.) Neutral/Positive: Implementation risks (Congress and State controlled companies hard to manage?). Two scenarios: 15,000 to 20,000 range Ibovespa at 3.3 FX (if reforms approved) or 10,000 at 4.0 (no reforms and non-market oriented management). • Long-term (next 2 to 4 years): Drivers are “2004 Municipal elections” and “Twin Deficit performance” (primary fiscal surplus and current account). That will set parameter for Lula’s actions and ability to control Congress (approving reforms).Bull case (25,000 at 3.3). Bear case (10,000 at 4.5) • Best stocks (“domestic plays”, “winners of stronger Real”, “higher betas with low debt”): Petrobras, Sabesp, Brasil Telecom, Telemar, Eletrobras, Unibanco, Ambev, Gerdau, CCR. • Avoid: high financial leverage and low pricing power.

3. The necessary agenda of Structural Reforms: • Already in the official agenda: (1)Social Security (fiscal+efficiency) (2) Tax Reform (boost exports+efficiency+maybe fiscal) (3) Central Bank independence (expectations) (4) New Labour law (incentive to hire officially) (5) New bankrupcy law (reduce banking spreads) • To be included later in the agenda ? (6) FTAA (Mexico convergence case, fiscal+trade) (7) Judiciary reform (efficiency + costs). (8) Political Reform (better representation=efficiency) (9) Privatisation (gencos + water, fiscal, FDI)

4. Toward equilibrium, not collapse… • The good news: (1) Congress and institutions are now a strong anchor; (2) The floating exchange rate is working and is a consensus; (3) Companies and individuals in Brazil have low leverage; (4) The Fiscal Responsibility Law works (5) The IMF agreement (Primary fiscal surplus targets) (6) The PT wants to be re-elected. • Main risks: (1) The world should remain hostile for how long? (2) The new economic team is crucial (3) Implementation risk at “micro” level (4) Debt dynamics still hard to handle without structural reforms

5. Our scenarios and the difficult questions: • 60% chance “slowly in the correct direction” (inflation?) • 30% chance “happy ending” (Lula better than Cardoso) • 10% chance “default” (if capital controls necessary) • (60% x 16,000) + (30% x 25,000) + (10% x 10,000) = 18,100? • Global: (1) When the US recovery starts (timing of War)? (2) impact on commodity prices (Oil) and volumes exported, (3) impact on FDI, global credit and global equity risk premium. • Local: (1) How far can selic rates fall (with and without Structural Reforms)? (2) Where the real exchange rate must be to generate at least US$ 15 billion trade surplus?

6. “Normal times” = 600 to 800 bp Brazil Risk

7. Bottom-up approach: 15,882 points (12m) possible IBOVESPA CURRENT PRICE: 11, 626 Upside Potential: 36.6% Source:Broadcast, UBS Warburg prices as March 27, 2003 10.0% upside used for Restricted or Not Rated companies

8. Brazil vs. Global (valuation and profitability) Valuation Profitability and Growth Source:UBS Warburg; (1) As of March 21, 2003; (2) Based on 2003 estimated figures.

9. Equity is now “cheap” relative to debt EMBI BR Spread x Ibovespa (Constant Prices IGP-DI) EMBI BR Spread x Ibovespa (Constant Prices IPCA) • Assuming current country risk is “correct”, the Ibovespa should be around 19,224 points • At 750 bp: Ibovespa target at 22,192 • At current levels, each 100bp change in country risk implies in some 1,468 points for Ibovespa; but At 700bp, each 100bp change in country risk implies in some 1,955 points for Ibovespa • Assuming current country risk is “correct”, Ibovespa should be around 16,338 points. • At 750 bp: Ibovespa target at 18,686 • At current levels, each 100bp change in country risk implies in some 1,160 points for Ibovespa; but at 700bp, each 100bp change in country risk implies in some 1,547 points for Ibovespa Source: Tendências, Economatica and UBS Warburg; (1) Figures as of March 27, 2003.

10. “Yield Gap” implying no growth of earnings Necessary Growth Rates to Justify Equity Risk Premium of 4.5% Debt Yield (Global 27) vs. Earnings Yield EV/EBITDA vs. EMBI Spread P/E vs. EMBI Spread Source: Tendências, MCM, Economatica and UBS Warburg; (1) Figures as of February 20, 2003.

11. Bond vs. Earnings Yields: now favouring equities Source: (1) Hurdle rate calculated assuming a required equity risk premium of 5%; (2) Using Earnings and OpFCF in US$ estimated for 2003; (3) Using average prices (bid, ask) to calculated bond yields; (4) Price and Market Cap. figures in US$ as of March 20, 2003.

12. 4Q02 Earnings Wrap-up: worse than expected... Source:Company Balance Sheets, UBS Warburg; (1) Figures in R$ million.

13. 14,000 12,000 10,000 8,000 6,000 4,000 2,000 US$ 3,692 0 US$ Ibovespa: a history of Political Cycles Itamar FHC 2 FHC 1 Sarney Collor Lula Asia crisis Thailand crisis Russia crisis Electricity rationing starts WTC Attack Selic rates fall and locals go to equities Real devaluation Arminio Fraga

14. Historical Multiples (52w forward EV/EBITDA) Source:Bloomberg, UBS Warburg; Updated as of April 9, 2003 (1) These multiples were calculated using figures in Dollars (US$)

15. Historical and relative EV/EBITDA by Sector Historic EV/EBITDA by Sector Current EV/EBITDA (52w fwd) by Sector Minimum, Maximum, Average and Current EV/EBITDA Source: UBS Warburg; (1) Multiples based in figures in Reais (R$); (2) Calculated using 52 weeks forward estimates.

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