1. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
* Employed by a non-US affiliate of Santander Investment Securities, Inc. and is not registered/qualified as a research analyst under NASD rules.
Latin American Equity Research Company Report
São Paulo, May 30, 2006 Brazil – Small Caps
WEG BUY
High Voltage Growth Powered by Motors and Execution
Bernardo Carneiro*
Brazil: Banco Santander Brasil, S.A.
(5511) 5538-6038
btcarneiro@santanderbanespa.com.br
(05/24/06)
CURRENT PRICE: US$3.39/R$8.08
TARGET PRICE: US$5.25/R$11.03
Initiation of Coverage
Rating: Buy
Price Target: US$5.25 per share for YE 2006
Estimates : EPS ’06 US$0.32
EPS ’07 US$0.34
EPS ’08 US$0.39
Company Statistics
Bloomberg WEGE4
52-Week Range (US$) 2.71-4.13
2006E P/E Rel to Ibovespa (x) 1.3
2006E P/E Rel to Small Caps (x) 0.9
Ibovespa (US$) 14,779
3-Yr earnings CAGR (05-08E) 16%
Market Capitalization (US$ Mn) 2,096.8
Float (%) 36.2
3-Mth Avg Daily Vol (US$000) 2,142
Shares Outst 617,627
Net Debt/Equity (x) -0.13
Book Value per share (US$) 1.10
Estimates and Valuation Ratios
2005 2006E 2007E 2008E
Net Earn (R$) 374.8 413.9 450.1 551.0
Current EPS 0.61 0.67 0.73 0.89
Net Earn (US$) 154.0 196.2 207.4 241
Current EPS 0.25 0.32 0.34 0.39
P/E (x) 12.8 10.7 10.1 8.7
P/Sales (x) 1.9 1.6 1.4 1.2
P/CE (x) 10.2 8.5 7.9 6.9
FV/EBITDA (x) 9.5 7.5 6.2 5.3
FV/Sales (x) 1.9 1.5 1.3 1.2
FCF Yield (%) 6.5% 1.9% 3.9% 5.9%
Div per share (US$) 0.11 0.14 0.15 0.17
Div Yield (%) 3.6% 4.2% 4.3% 5.1%
Sources: Bloomberg, Company reports, and Santander Investment
estimates.
Investment Thesis: WEG is a successful and profitable Brazilian
company that enjoys global competitive advantages, a highly successful
business model, market-leadership, and a clear international expansion
strategy. WEG enjoys positive momentum in the domestic market with
the downward trend in interest rates stimulating industrial activity and
heating up demand for equipment for energy generation, transmission,
and distribution (GTD). We believe that the strong 1Q06 results
reported on April 20 reflect that momentum. We are initiating
coverage of WEG, with a Buy rating and a 2006 year-end target
price of US$5.25 per share (R$11.03), implying 55% upside potential,
which is 13% above the upside expected for the Ibovespa.
Reasons for Recommending an Investment in WEG:
Valuations are attractive. In our view, the stock is trading at an
excessive 43% discount compared with the average 2006E P/E of global
electric motor manufacturers and other heavy electric equipment
producers.
WEG is a high-growth story in Brazil, with high leverage to industrial
production and, at the same time, hedged against economic downturns
due to its large customer base and wide product diversification. In the
past six years, WEG reported a net earnings CAGR of 29% in local
currency, and we estimate CAGR for EBITDA and net earnings in the
2005-2008E period of 21% and 14%, respectively.
We believe that WEG is an ideal candidate to join the Novo
Mercado, and our belief is backed by management’s recent comments,
as discussed later in this report.
Valuation and Risks to Investment Thesis: Our DCF valuation is
based on a beta of 0.50, a country risk premium of 250 basis points over
U.S. Treasuries, and a market risk premium of 12.5% for the Brazilian
equity market. Because of WEG’s underleveraged balance sheet and its
large net cash position, we discounted its free cash flows by a cost of
equity of 9.8%. We applied a 20% discount to calculate our fair value
per preferred share to reflect the granting of 80% of tag-along rights.
Our DCF fair value implies a target 2006E P/E of 16.5 times, 13% lower
than the average of international peers. Risks to our investment thesis
would include: unexpected increases in interest rates slowing down
GDP growth; continuing appreciation of the Brazilian real; and an
eventual increase in international competition.
2. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
2
WEG was founded in 1961 and is now the largest electric motors manufacturer in Latin America, generating revenues
in more than 100 countries. In 2005, the company reported roughly US$1.0 billion in net sales, sold 8.5 million electric
motors, and generated 35% of sales from exports and foreign subsidiaries. WEG has a wide and diversified product
portfolio, ranging from electric motors to energy generators and transformers, electronic components, industrial
automation systems, paint, and varnish, and uses state-of-the-art manufacturing processes.
EXECUTIVE SUMMARY
We are initiating coverage of WEG with a Buy rating and a 2006 year-end target price of
US$5.25 per share (R$11.03), which implies 55% upside potential (37% in local currency).
The company is a successful and profitable company in Brazil that has global competitive
advantages, a highly successful business model, market-leadership, and a clear international
expansion strategy. WEG enjoys positive momentum in the local market with the downward trend
in interest rates stimulating industrial activity and heating up demand for energy generation,
transmission, and distribution equipment. The stock is trading at what we regard as an excessive
38% discount compared with a 2006E P/E of global electric motor manufacturers and other heavy
electric equipment producers. Considering that 2005 represents an easy comparison basis, we
conservatively project CAGR for EBITDA and net earnings in the 2005-2008E period of 21% and
14%, respectively, in local currency.
We view WEG as a high-growth story in Brazil, with high leverage to industrial production
and, at the same time, hedged against economic downturns due to its large customer base
and wide product diversification. In the past six years, consolidated sales have increased 26%
per year in local currency, along with 25% CAGR in EBITDA and 29% CAGR in net earnings.
In terms of corporate governance, in our opinion, WEG could raise its standards by improving
transparency and disclosure of results, in particular providing a more detailed breakdown of
revenues (prices and volumes) and costs per segment. At present, WEG offers 80% tag-along
rights to preferred shareholders, alternates independent auditors frequently, and is part of Level I
of Bovespa Corporate Governance Standards. In a recent speech to IBGC (Brazilian Institute
of Corporate Governance) on May 7, Décio Silva, the company’s CEO and son of one of the
three founders of the company, stated that WEG is a likely candidate for the Novo Mercado
classification (which would mean transforming preferred shares into voting shares and offering
100% tag-along rights). As controlling shareholders have 64% of the total capital, we do not
believe there would be any impediment to WEG joining the Novo Mercado.
Insufficient transparency of revenues and costs, excess cash, and the company’s large
exposure to cyclical commodities (steel and copper) are the main concerns in our investment
case. Although we believe that WEG still has some way to go, some progress has been made in
terms of liquidity and disclosure. In 2004, some large preferred shareholders sold a large block of
shares, which improved the stock’s liquidity, and in 2005, management restructured the IR
department to improve its disclosure policy. Despite our concerns about transparency and the
company’s ability to pass through hikes in costs (such as copper prices, which soared 122% since
December 2004 in dollar terms), we view WEG as an attractive investment in the long term
among the Brazilian small caps.
Positives Concerns
• Product and market diversification.
• Clear growth strategy.
• Highly successful business model.
• Market leadership.
• Unexplored growth opportunities.
• Insufficient transparency of results.
• Costs exposure to cyclical commodities.
• Uncertainty in the use of excess cash.
WEG enjoys
positive
earnings growth
momentum.
WEG is both a high-
growth and
a defensive story.
3. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
3
INVESTMENT POSITIVES
PRODUCT AND MARKET DIVERSIFICATION
WEG’s sales are diversified not only in regard to business segments but also in terms of
markets. It offers a wide range of motorized products and automation, with exposure to different
industries such as consumer goods (home appliances), energy, oil & gas, steel, mining, pulp &
paper, and ethanol. The company is known as a “one-stop-shop” for electric motors, as it has a
complete and differentiated portfolio of motors, producing more than 25,000 different types of
electric motors every year. According to the company’s 2005 annual report, its largest client
accounted for 2.3% of consolidated sales and the largest 10 accounted for just 10.2% of that total.
Exports and local sales are balanced in a way that places the company as a direct supplier of
capital goods to countries experiencing steady industrial growth and mitigates risks as business
cycles alternate among countries. Export sales, including revenue from foreign subsidiaries,
accounted for 35% of consolidated sales in 2005 and were generated in more than 100
countries.
Figure 1. Sales Breakdown by Business and Market
Electro-Electronic
Industrial Equipment
62%
Paints and
Varnishes
6%
Electric Motors
for Domestic
Use
18%
Energy GTD
14%
Brazil
65%
Africa
2%
Europe
13%
North America
12%
Latin America
5%
Asia & Oceania
3%
Sources: Company reports and Santander Investments.
CLEAR GROWTH STRATEGY
WEG has a clear growth strategy delineated by business segments and markets. After
carving out a significant 80% market share in Brazil in electric motors (the segments of industrial
electric motors and motors for domestic use), WEG plans to grow in the GTD arena (equipment
for energy generation, transmission, and distribution) and in paint and varnish, leveraging the
customer loyalty built up on the electric motors front.
In the international market, WEG has a growth strategy based on three phases:
(1) “Entrance,” which is entering new markets through the sale of electric motors via export
and local distribution centers, with the goal of studying the markets and diversifying;
sales;
(2) “Stabilization,” by opening sales subsidiaries with its own sales force or acquiring local
representatives and selling non-motor products, such as GTD energy equipment; and
(3) “Dominance,” by establishing a solid presence through greenfield plants or acquiring
existing plants and introducing other product lines such as paint, varnish, and automated
Six of WEG’s 13
facilities are
located abroad
(two in Argentina,
one in Portugal,
two in Mexico,
and one in China).
4. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
4
systems. Outside Brazil, WEG has 16 sales subsidiaries and 13 industrial plants. In
November 2004, the company acquired one electric motor manufacturer in China, and
last March, it acquired a strategic stake in Voltran, a manufacturer of electric
transformers in Mexico, to increase exposure to the NAFTA market, particularly for GTD
equipment.
We acknowledge that in the short term, some international plants may dilute consolidated
margins, as they do not have the scale, market-leadership, and access to cheap raw material as in
Brazil. Over the long term, management believes that they should add value to the consolidated
company as they protect WEG from Brazilian economic volatility, provide access to fast-growing
markets, and eliminate tariffs that otherwise would be charged on imports from Brazil.
Figure 2. WEG’s Growth Strategy
Stage Main Markets Product Objective Channel
(1) Entrance New markets in Asia Electric motors Establish brand and build
customer relationship
Distribution
offices
(2) Stabilization Brazil, Europe, U.S.,
and Latam
Other electro-
electronic products
and GTD
Cross-sell non-motor and
value-added products
Own
subsidiaries
(3) Dominance Brazil, Mexico,
Argentina, and China
Industrial solutions
and systems
Improve customer service
and expand market-share
Production
facilities
Sources: Company reports and Santander Investments.
INTEGRATED BUSINESS MODEL HARD TO REPLICATE
WEG combines large-scale production with vertical integration, providing significant
competitive advantages and superior margins. The company has the world’s largest plant for
electric motors, giving the company strong bargaining power with suppliers and the ability to
pass-through some cost increases. The production process is completely integrated, and, in our
view, it would be very difficult for any other company to replicate it. WEG has a high-quality
labor force (with good, variable compensation and employee training), easy access to raw
materials, a tradition of strong customer service, and a successful and well-defined international
expansion strategy with solid operations in dozens of countries.
The company forges part of its steel, melts and injects alumina, and works the metals that make
up the body parts of its motors through thermal treatment and stamping. WEG designs and
produces the tools used in these activities and sets up the equipment purchased from third parties,
adding to them its own technology. The company also wires the copper used in the motors and
generators and produces most of the packaging materials for its final products (WEG has its own
forestry reserve for its wood needs). All of that integration is observed at its main site, located in
the city of Jaraguá do Sul (state of Santa Catarina), while the five other local smaller plants are
integrated with the main site by completing the final step of the production process.
MARKET LEADERSHIP
WEG has 80% of the domestic market in electric motors and is the first or second player in
automation solutions and GTD energy equipment. Its products are widely recognized for
quality, as WEG provides customer service, post-sales support, and in-depth technical assistance
not only in Brazil but in the major markets in which it operates. WEG has a network of more than
1,250 technical assistants, of which 850 are based abroad. The global market, however, is very
fragmented, and WEG has just 4% of the market-share in three-phase motors, a market with
US$8.5 billion in sales, according to management. The company has a very small presence in the
international market for electric-electronic equipments other than motors, which is larger than the
market for electric motors. This would, in our opinion, present a huge opportunity for WEG to
expand.
WEG is the largest
foreign player in
the U.S. market of
electric motors.
5. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
5
UNEXPLORED GROWTH OPPORTUNITIES
Because of its long track record of investment in personnel and engineering know-how, we
believe that WEG is well prepared to benefit from attractive growth opportunities. The
company has been investing roughly 2% of net sales in R&D –R$63 million in 2005 – to innovate
and increase technological content in its products. It also established partnerships with universities
in Brazil and abroad (i.e., in Germany, the U.S., and other countries). The fast development of IT
and engineering technology has opened a large market for the replacement of mechanical
processes, and motorized parts for electronic devices. In addition, electric motors are becoming
more sophisticated, requiring digital processes and automated control through digital sensors,
which allows for significant cross-selling opportunities. In the field of automated solutions, WEG
has a big opportunity to sell smaller and high-tech frequency inverters and logical controls to a
wide range of industries that aim to increase their productivity and reduce their costs. We point
out that almost half of the electric motors WEG sold in 2005 were tailor-made.
INVESTMENT NEGATIVES
EXPOSURE TO CYCLICAL COMMODITIES
WEG is exposed to the cyclical volatility of steel and copper prices, which together
represented roughly 50% of total costs in 1Q06. The past year has seen a sharp rise in copper
prices, which followed a dramatic increase in prices of long and flat steel in 2004. WEG wires
copper in different widths so that they can fit inside the electric motors and around the generators.
Copper prices soared 122% in dollar terms since December 2004, while steel prices are down
20%. Usually there is a time lag (estimated at six-to-nine months) before the company can pass
through the rise in costs, as it studies the economic activity and the demand status first before
raising prices. Therefore, we can expect some initial margin contraction after hikes in metal
prices, such as those reported in the first half of 2005. However, considering the scarcity value of
electric motors and their importance in the expansion projects of leading industries, customers end
up absorbing the changes in raw material prices. Therefore, WEG has been able to pass through
costs hikes over time.
Figure 3. WEG’s Breakdown of Costs of Good Sold
Labor
17%
Other costs
11%
Depreciation
5%
Copper & Steel
47%
Other materials
20%
Sources: Company reports and Santander Investment estimates.
There is a time lag
before cost
increases are fully
passed through
to customers.
6. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
6
INSUFFICIENT DISCLOSURE
Management has improved the disclosure of results through clearer press releases and now holds
quarterly conference call with analysts and investors. However, in our opinion, there is still room
for further improvement in terms of the disclosure and transparency, as WEG does not provide
information on exports and costs per business segment, just a consolidated figure for each.
In addition, the company does not give out details on the consolidated costs on a historical basis,
which makes any horizontal analysis difficult. We believe that a more detailed disclosure on
export growth per segment and on the cost structure per segment would enhance our analysis and
improve the market’s perception on the company.
EXCESS CASH POSITION
The company has a very conservative financial profile and holds a substantial cash position
that, in our view, needs to be reinvested in the business in order to accelerate growth. At the
end of 1Q06, WEG had R$1.3 billion in cash, representing a net cash amount of R$190 million.
Net debt to equity was -0.1x, but we do not think this represents a sub-optimal capital structure
because of WEG’s very low cost of equity (at high single digits). However, with falling domestic
interest rates (and should they continue to fall), the cost of debt would soon become lower than
the cost of equity, and it would make sense for the company to increase its financial leverage. If
the company does not want to pursue higher returns for its cash position by raising capital
expenditures (such as going for greenfield projects or acquisitions), it could return that cash to
shareholders in the form of larger dividend payments. In the past four years, the dividend pay-
out ratio has averaged 42%, and we estimate a ratio of 45% going forward.
Meanwhile, WEG has been using its large cash holdings to increase customer financing and
achieve better negotiation terms with suppliers. Given our estimates of free cash flow generation,
we expect the net cash position to increase significantly in the next few years.
VALUATION
We are initiating coverage of WEG with a Buy rating and a 2006 year-end target price of
US$5.25 per share, implying 55% upside in dollar terms from current levels (13% higher
than the upside we expect for the Ibovespa in the period). WEG looks cheap compared with
the valuation of global manufacturers of electric motors and industrial equipments. We believe
that the stock’s 4% underperformance versus the Ibovespa YTD and the strong 1Q06 results
reported on April 20, suggesting earnings momentum, support our recommendation.
DCF ANALYSIS
WEG’s DCF valuation was based on the following assumptions: (1) a beta of 0.50, (2) a
country risk premium of 250 basis points over U.S. Treasuries; and (3) a market risk premium of
12.5% for the Brazilian equity market. WEG has a completely underleveraged balance sheet and,
in our view, the company does not need to incur any debt given our expectations for positive and
large free cash flow generation going forward. Because of that, we believe that the best discount
rate to calculate the present value of WEG’s cash flows is not the WACC but the cost of equity.
We arrived at a U.S. dollar-based cost of equity of 9.8% for WEG and used a perpetuity growth
rate for free cash flows of 3%. We applied a 20% discount to our fair value per share to reflect the
minority shareholder discount (WEG offers 80% tag-along rights to preferred shares). If WEG
migrates preferred shares to the Novo Mercado, we would eliminate that discount and, as a
result, our current target price would automatically rise by 25%.
The substantial
cash position is
an overhang, in
our view, due to
the uncertainty
over its use.
Our target price
implies 55%
upside potential in
U.S. dollar terms.
7. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
7
Figure 4. WEG – Free Cash Flow Calculation, 2006E-2010E (U.S. Dollars in Millions)
2006E 2007E 2008E 2009E 2010E
EBIT 228.3 280.8 324.5 368.6 415.9
EBIT (1-tax) 150.7 185.3 214.2 243.3 274.5
(+) Depreciation 50.1 56.9 62.2 68.3 74.4
(-) Capital Expenditure (93.8) (108.4) (106.4) (106.3) (106.1)
(-) Change in Working Capital (67.1) (52.1) (48.8) (53.2) (59.3)
(=) FCF to Firm 39.9 81.7 121.1 152.2 183.5
Key Data 2006E 2007E 2008E 2009E 2010E
EBITDA Margin 20.7% 21.8% 22.7% 23.0% 23.2%
Net Debt (R$ Million) (179.4) (176.3) (232.5) (330.8) (474.0)
Net Debt/EBITDA (0.3) (0.2) (0.3) (0.3) (0.4)
Source: Santander Investment estimates.
Figure 5. WEG – Target Price Sensitivity (U.S. Dollars per Share)
Growth in Perpetuity
5.32 1.0% 2.0% 2.5% 3.0% 3.5% 4.0% 5.0%
8.3% 5.47 6.11 6.50 6.98 7.55 8.26 10.33
8.8% 5.05 5.58 5.91 6.29 6.75 7.30 8.85
9.3% 4.68 5.13 5.40 5.72 6.09 6.53 7.72
WACC 9.8% 4.36 4.74 4.97 5.23 5.53 5.89 6.83
10.3% 4.07 4.40 4.59 4.81 5.06 5.35 6.11
10.8% 3.82 4.09 4.26 4.45 4.66 4.90 5.52
11.3% 3.59 3.83 3.97 4.13 4.31 4.51 5.02
NM not meaningful. Source: Santander Investment estimates.
Figure 6. WEG –Sensitivity to FX Curves and Brazil Risk Premium
Average FX Rate 2006 Brazil Risk Premium*
R$1.90 R$2.11 R$2.30 150 bps 250 bps 400 bps
EBITDA (R$ Million) 503.3 587.4 659.2 587.4 587.4 587.4
EBITDA Margin 18.4% 20.7% 22.6% 20.7% 20.7% 20.7%
EPS (R$) 0.61 0.67 0.73 0.67 0.67 0.67
Target Price per Share (US$) 5.20 5.25 5.25 6.30 5.25 4.15
* Using current economic scenario of an average FX rate of R$2.11/US$ for 2006. Source: Santander Investment estimates.
PEER ANALYSIS
On a P/E basis, WEG trades at a discount of 43% to the average 2006E P/E of 18.9 times of U.S.
and European capital goods and motor manufacturers. Our DCF fair value analysis implies a
target P/E 2006E of 16.5 times, 13% lower than current global average, which is fair.
Despite WEG’s strong balance sheet and superior margins, our growth estimates for WEG’s net
earnings are lower than the earnings growth expected for foreign peers. Therefore, we do not
believe that WEG deserves to sell at a premium to them.
WEG has
no peer group in
Brazil in the
manufacturing of
electric motors and
GTD equipment.
8. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
8
Figure 7. WEG – Valuation Comparison as of May 24, 2006 (in U.S. Dollars)
Mkt Cap FV/EBITDA P/E EPS Growth
US$ Mn 2006E 2007E 2006E 2007E 2006E 2007E
ABB Group 26,453 9.2 8.3 25.4 20.4 41.5% 24.4%
Baldor Electric 986 10.4 8.9 20.2 17.0 13.4% 19.0%
Emerson Electric 33,165 10.1 9.2 18.4 16.3 26.5% 13.0%
Regal Beloit 1,497 8.6 7.8 15.1 13.3 42.8% 13.3%
Siemens 77,393 8.5 7.0 16.9 13.0 60.0% 30.4%
Average 27,899 9.0 7.8 18.9 15.2 36.8% 20.0%
WEG 2,096.8 7.5 6.2 10.7 10.1 27.4% 5.7%
Sources: Santander Investment and Bloomberg consensus for international companies.
RISKS TO INVESTMENT THESIS
• Unexpected increase in interest rates. In order to decrease volatility in the economy and
ease political tensions, the Brazilian government opted on many occasions in the past to
increase basic interest rates, which had a negative impact on the economy (i.e. a contraction
in the industrial activity and postponement of investments). Should this happen again, in our
opinion, WEG’s main customers would likely reduce their investment plans. Consequently,
demand for electric motors, automotive systems, and other industrial equipment would fall,
hurting WEG’s sales.
• Further appreciation of the Brazilian real. Roughly 35% of WEG’s consolidated sales are
represented by exports plus sales generated by its foreign subsidiaries. Any appreciation of
the real relative to foreign currencies would reduce the profitability of foreign-based
operations and erode consolidated margins, as observed since 2003 when the company’s
gross margin peaked at 39.4%, and fell to 37.7% in 2004 and 33.3% in 2005. Part of that
margin contraction is also explained by the increase in steel and copper prices.
• Stepped-up competition from international players. Although we acknowledge WEG’s
competitive advantages and its successful business model, we can not rule out the possibility
of more competition looking forward. For instance, large competitors in major developed
markets could launch new technologies and pursue low cost and efficient production in other
emerging markets, transferring their know-how and facilities to these countries. This would
create a tougher competitive environment in the global market for WEG.
EARNINGS OUTLOOK
Figure 8. WEG – Earnings Estimates, 2006-2008E (Reais in Millions)
2006E 2007E 2008E
Net Sales 2,833.0 3,359.9 3,896.6
Gross Margin 33.9% 34.9% 35.6%
EBITDA 587.4 732.8 885.5
EBITDA Margin 20.7% 21.8% 22.7%
Financial Results 45.2 (11.6) (12.7)
Earnings 413.9 450.1 551.0
EPS 0.67 0.73 0.89
Net Debt (42.6) (34.1) (84.7)
a Except per share/ADR amounts. NM not meaningful. Sources: Company reports and Santander Investment estimates.
9. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
9
WEG does not give out information on volume or average prices for each of its business
segments, but limits disclosure to gross sales per segment. Because of that, it is not easy to
forecast the company’s consolidated sales. Based on the historical sales per segment, we
calculated backwards a historical price index for each segment and then calculated an implied
volume index per segment. For export sales, we applied the same rationale.
Domestic sales. (1) Industrial equipment: we estimate that volume sales will grow at 1.5 times the
industrial GDP in Brazil supported by new applications, customers’ search for energy efficiency,
and growing investment plans from industries. (2) GTD energy equipment: because of the strong
investments in energy generation and transmission in Brazil and the construction of many small
hydro-plants, we believe that sales volume in this segment will continue to grow fast. We forecast
growth rates of 5.0 times the industrial GDP in 2006 and 4.0 times GDP from 2007 onward. (3)
Domestic motors: considering the weak activity in 2005, the low basis of comparison and the
good results posted in 1Q06 in this segment, we estimate volumes could grow at 2.0 times the
GDP in Brazil for 2006 and 2007, and then decline to 1.5 times thereafter. (4) Paint and varnish:
this is a relative new segment for WEG and one of its focus in the domestic market. Because of
that, we foresee volume growth of 3.0 times industrial GDP for 2006 and 2007 falling to 2.5 times
thereafter. For all the segments, we decided to be conservative and estimated flat real prices
for our forecasting period (2006E-2015E).
Exports and foreign-based sales: (1) Industrial equipment: because of the recent aggressive
international expansion, we expect export volumes to continue to grow very fast at 3.3 times the
growth observed in the domestic market in 2006 and 2007 and then decline to 2.7 times the
domestic growth. (2) GTD energy equipment: we believe that export volumes will grow as fast as
in the Brazilian market throughout our forecast horizon. (3) Domestic motors: we estimate
volumes should grow at 2.0 times the growth expected in local volumes, reflecting the company’s
expected successful performance in entering new markets; (4) Paint and varnish: due to its small
size (1.4% of consolidated sales), exports of chemical products are projected to grow at very fast
rates such as three times more than in the local market. By 2010, we estimate it will represent just
2.9% of total sales. We also opted to be conservative in forecasting export prices and, thus,
we estimated flat dollar prices for our forecasting period (2006E-2015E).
Figure 9. WEG – Gross Sales Evolution (Reais in Millions)
535 679 854 1,004 1,234
1,552
1,897
2,204
2,538
218
284
415
531
781
1,051
1,081
1,148
1,437
1999 2000 2001 2002 2003 2004 2005 2006E 2007E
Domestic Market External Market
CAGR 22.9%
753
963
1,269
1,535
2,015
2,603
2,978
3,322
3,909
Sources: Company reports and Santander Investment estimates.
In 2010, we expect
exports and
foreign-based
sales to represent
42% of total sales,
compared with
34% for 2006.
10. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
10
Costs. The company is trying to mitigate the negative impact of the sharp and recent appreciation
of copper and steel prices. For instance, it is importing long steel to benefit from the strong real.
WEG is also constantly updating its product mix and customizing products, enabling it to add
value to final products and offset any margin contraction on the raw material situation. We
estimate that 95% of total COGS are cash costs, of which 70% are variable and 30% are fixed.
Even considering our Chilean analysts’ forecasts for a 25% decline in copper prices in 2H06 and
estimates of flat steel prices for both 2006 and 2007 (based on the forecast of our Steel & Mining
analysts in Brazil), we opted to be conservative. We estimate that variable costs would change
according to the changes in sales volume plus inflation, whereas for fixed costs we assumed they
would increase with inflation. We expect that the gross margin should oscillate between 33%
and 36% in the next five years and will likely not peak as it did in 2003, or at 39.4%, given
the still-strong real.
Figure 10. WEG – Steel and Copper Prices, 2001-2006 (U.S. per Ton)
100
200
300
400
500
600
700
800
Jan-01
Apr-01
Jul-01
Oct-01
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
500
1,500
2,500
3,500
4,500
5,500
6,500
7,500
Steel (left) Copper
Source: Bloomberg.
Figure 11. WEG – EBITDA Evolution (Reais in Millions)
131
184
248 280
504
587
733
394
492
20.0%
20.7%21.0%
23.0% 23.0%22.0%
21.8%
23.0% 22.0%
0
100
200
300
400
500
600
700
800
1999 2000 2001 2002 2003 2004 2005 2006E 2007E
10%
12%
14%
16%
18%
20%
22%
24%
EBITDA EBITDA Margin
Sources: Company reports and Santander Investment estimates.
11. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
11
Operating expenses. WEG’s sales expenses should, according to our estimates, perform in line
with sales evolution. However, given the company’s search for operational efficiency, we believe
it will be able to reduce sales expenses by 10 bps of net sales every year. As for general and
administrative expenses, we also estimate them as a percentage of sales but reduced them every
year by 20 bps when measured against net sales. We estimated profit-sharing expenses as being
12% of the previous period pre-tax earnings, as guided by management.
Figure 12. WEG – Operating Assumptions, 2006E-2010E (Reais in Millions)
2006E 2007E 2008E 2009E 2010E
Gross Sales 3,351 3,975 4,610 5,315 6,136
Industrial Equipment 1,995 2,350 2,717 3,117 3,579
Local 1,119 1,253 1,375 1,506 1,647
Foreign 876 1,097 1,342 1,611 1,932
GTD 545 675 814 976 1,169
Local 440 548 658 789 944
Foreign 105 128 156 187 225
Domestic Motors 580 663 735 812 895
Local 464 522 569 619 672
Foreign 117 141 166 193 223
Paints 231 287 343 410 493
Local 181 215 245 279 316
Foreign 50 71 98 132 177
Taxes and Deductions (518) (615) (713) (822) (949)
Net Sales 2,833 3,360 3,897 4,493 5,187
COGS (1,871) (2,188) (2,508) (2,886) (3,333)
Variable (1,290) (1,574) (1,857) (2,198) (2,609)
Fixed (476) (491) (508) (525) (542)
Depreciation (106) (123) (142) (162) (182)
Gross Profit 962 1,172 1,388 1,608 1,854
Operating Expenses (480) (562) (645) (734) (835)
Sales (266) (319) (366) (418) (477)
G&A (150) (171) (191) (211) (233)
Profit sharing (64) (72) (88) (105) (124)
EBIT 482 609 743 874 1,019
Depreciation 106 123 142 162 182
EBITDA 587 733 885 1,035 1,201
Source: Santander Investment estimates.
We expect a decline in earnings growth rates compared with the recent growth due to the
end of fiscal benefits. WEG was able to book tax incentives up to 2005 reflecting the purchase of
the REFIS credits, a special tax restructuring implemented by the federal government in 2002.
According to management, in 2007 another tax benefit (the presumed profit regime) should
mature, and it expects a higher tax bracket on pre-tax earnings. The payment of dividends in the
form of interest on equity has been providing WEG relevant tax shields and that should offset part
of the increase in the tax payments. Our CAGR estimate for net earnings in the 2005-2008E
period is 16% in U.S. dollar terms, lower than our CAGR estimate for EBITDA of 23%.
Capital expenditures. According to management, WEG should invest R$175 million in 2006 in
fixed assets (maintenance and modernization of facilities). It plans to spend an additional R$23
million in deferred assets (R&D and IT projects such as an advance version of the ERP system).
For 2007 onward, we simply estimated inflation pass-throughs over the 2006 planned
investments. Considering the strong EBITDA growth expected, capex should decline from 35% to
25% of consolidated EBITDA in the 2006E-2010E period.
We treated the
impact of changes
in the exchange
rate on foreign
assets as financial
expenses,
removing them
from the operating
expense line.
12. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
12
FINANCIAL PROFILE
As we previously mentioned, we view WEG as a very solid and healthy company with a net cash
position of R$190 million as of March 2006. However, the company has significant exposure to
the exchange rate in terms of sales (export sales plus foreign-based sales account for 35% of the
total) and the effect of exchange rate variations over assets and dollar-denominated debt of foreign
subsidiaries.
WEG has a standard policy of managing its exchange rate exposure by balancing the assets and
working capital loans held by foreign subsidiaries, the dollar-denominated debt backed by export
receivables, and the proceeds from export sales. In order to limit the negative effect of sharp
currency appreciation on export margins, WEG has been increasing the imports of raw materials,
reducing costs denominated in local currency by increasing production in its offshore facilities,
and being more efficient in cost control. We estimate that in 2006 WEG should report R$45
million in net financial revenues but an expense of R$12 million in 2007, reflecting lower
interest income and expectations of a weaker real generating foreign exchange losses.
Figure 13. Brazil – Select Economic Projections, 2004-2007F
2004 2005 2006E 2007F
Real GDP (%) 4.9 2.3 4.1 3.6
CPI Inflation (%) 7.6 5.7 4.5 4.3
US$ Exchange Rate (Year-End) 2.65 2.32 2.10 2.25
US$ Exchange Rate (Average) 2.93 2.43 2.11 2.17
Interest Rate (Year-End) 17.8 18.0 14.5 12.5
Interest Rate (Average) 16.2 19.0 15.7 13.1
Fiscal Balance (% of GDP) -2.7 -3.3 -3.1 -2.5
Current Account Balance (% of GDP) 1.9 1.8 1.0 0.6
International Reserves (US$ Bn) 52.9 53.8 54.5 55.0
Total External Debt (% of GDP) 33.3 21.3 14.3 14.2
Source: Santander Investment historicals and forecasts.
In the short term,
we expect WEG to
continue to report
large financial
revenues.
15. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
15
APPENDIX: COMPANY OVERVIEW
WEG is the largest electric motor manufacturer in Latin America and generates sales in
more than 100 countries, covering the Americas, Asia (Japan and China), and Europe. In Brazil,
the company is the market leader in electric motors and at least the second-largest player in other
segments. WEG reported annual sales of R$2.9 billion in 2005, generated 35% of consolidated
sales in foreign markets, and has about14,100 employees. It sold eight million electric motors in
2005.
In 1961, WEG began producing electric motors in Jaraguá do Sul in the state of Santa Catarina.
After two decades, the company expanded production to the manufacture of generators, electronic
components, industrial automation systems, energy and distribution transformers, and paint and
varnish. WEG has attempted to explore opportunities in international markets, seeking to
consolidate of its global presence by establishing commercial partnerships, distribution offices,
and, finally, overseas plants.
Figure A1: WEG Corporate Structure May 2006
Voigt
33.3%
Werninghaus
33.3%
Silva
33.3%
TC: 14% TC: 51% TC: 35%
WEG
Industries
WEG
Electric Equipment
WEG
Trading
WEG S/A
Others
(free float)
WEG Participações e
Serviços S/A
Founding Families
(directly)
Paint
Vanishes
Motors
Machines
Transformers
Controls
Automation
Trading Company
Units outside Brazil
Source: Company reports.
WEG S/A is a holding company owned equally by three families and controlling three
subsidiaries: (1) WEG Industries, which manufactures paints & varnishes and is in charge of
local sales; (2) WEG Electric Equipment, focused on developing, manufacturing, and selling
electro-electronic products in the local market; and (3) WEG Trading, which handles
international operations and promotes exports. In addition, WEG Trading controls foreign
branches and subsidiaries (i.e., production facilities in Argentina, Mexico, Portugal, and China;
distribution offices in the U.S., Belgium, Germany, England, Australia, Spain, Sweden, Italy,
Venezuela, Chile, Colombia, India, and Japan; and strategic partnerships located in Canada and
South Africa).
16. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
16
WEG’s top management is professional and independent from the controlling shareholder, with
the exception of the CEO, Décio da Silva, who has been with WEG for 27 years and is the son of
Eggon da Silva, one of the founders. The other three executives have been with WEG for at least
29 years and were, like Décio, former assistants and managers. The board of directors is
comprised of seven people, four of whom are not related to the controlling families (one was
elected by minority shareholders). The chairman is a respected executive, Nildemar Secches, who
is also the CEO of Perdigão. WEG also has permanently established a fiscal board to oversee the
board of directors.
BUSINESS LINES
In March 2006, WEG announced a new disclosure structure for reporting sales, divided into four
business segments. This is another effort to improve the transparency of results and clarify the
nature of its operations.
WEG’s business segments share synergies in cost and operating expenses and complement each
other to some degree. The four segments are: (1) electro-electronic equipments for industries;
(2) equipment, systems, and solutions for energy generation, transmission, and distribution
(GTD); (3) motors for domestic use (basically home appliances); and (4) paint and varnish,
which results from a recent business diversification. WEG’s main customers are heavy industries
(energy, oil and gas, steel, mining, pulp & paper, and sugar alcohol) and OEMs of home
appliances.
1) ELECTRO-ELECTRONIC INDUSTRIAL EQUIPMENTS
This is WEG’s largest business and represented 62% of total sales in 2005. The segment
comprises low- and medium-tension electric motors, industry automation equipment, components,
and technical support services. WEG has a high market share of 80% of the local market in
electric motors and is one of the leaders in other products in the segment. Consumer markets
for the afore-mentioned products are diversified, having both capital goods original equipment
manufacturers (OEMs) and large industrial corporations as major clients. WEG has considerably
increased its international footprint in recent years and sees room for additional growth as the
markets are rather fragmented.
Figure A2: Motors and Automation Products
Source: Company reports.
The main drivers for sales growth in this segment are industrial expansion and investments in
capacity (capital expenditures).
Management is
very experienced
and is mostly
independent.
17. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
17
2) ENERGY GTD
This segment’s product portfolio is composed of electric generators for hydraulic, thermal, and
wind-power plants, as well as transformers, distribution substations, control panels, and
diversified energy automation services. WEG is one of the largest players in this segment, and
we expect good growth opportunities. The main customers in GTD are concessionaires of
electric energy generation, transmission and distribution, small hydraulic power plants (PCH),
energy co-generators. and large industrial corporations. Strategically, WEG aims to consolidate its
presence all over the Americas.
The energy GTD segment was responsible for 14% of consolidated sales in the last year and is
expected to be WEG’s fastest-growing market in the near future, because of the expansion in
energy-generation capacity in Brazil in the next three years and growing operations in America.
Figure A3: Energy Generators and Transformers
Source: Company reports.
3) ELECTRIC MOTORS FOR DOMESTIC APPLIANCE USE
Figure A4: Motors for Home Appliances
Source: Company reports.
The variety of products in this business consists of single-phase motors. The client base for this
segment is not that diversified, with some concentration in home appliances (white-line OEMs)
such as washing machines and dryers, heaters, ventilation and air conditioning, general water
pumps, exercise machines, and lawn mowers, among others. Operations are essentially oriented to
18. WEG: High Voltage Growth Powered by Motors and Execution
Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
18
Latin America, with client companies that include Multibrás, Eletrolux, and Springer Carrier.
Overall, sales performance is dependent on credit availability, disposable income, and low interest
rate levels. Electric motors for domestic appliances accounted for 18% of total sales in 2005.
4) PAINT AND VARNISH
This is the only non-electric business in the four main segments. As a result of the diversification
strategies adopted in the past, this segment supports the company’s core businesses. This product
line includes liquid and powder paint and electro-isolating varnish for industrial applications, for
shipbuilding, both commercial and for the Navy, and aggressive industrial uses. Many customers
for this segment are WEG’s regular clients in other businesses lines, reflecting successful cross-
selling and allowing considerable operating synergies. Performance is spurred by industrial
production and industrial GDP growth, with plenty of growth opportunities still remaining in
Brazil and South America. This segment contributed 6% of WEG’s gross sales in 2005.
Figure A5: Paint for the Navy and the Painting Process
Source: Company reports.
TIME LINE
• 1961: WEG is founded by Werner Ricardo Voigt, Eggon João da Silva and Geraldo
Werninghaus; 146 motors assembled during the first quarter of operations.
• 1971: Company’s shares are listed on the stock exchange (Bovespa).
• 1972~1974: Intensive expansion of industrial facilities through the construction of a forging
unit and additional plants in a 400,000-square-meter area, including the actual 30,000-square-
meter complex (initial verticalization and construction of its current state-of-the-art site)
• 1975: The company produces its millionth motor.
• 1980: Search for diversified opportunities, bundling products by selling more technologically
integrated systems. Founding of WEG Máquinas (large scale machines), WEG Acionamentos
(electronic components)
• 1981: WEG acquires Ecemic Transformadores and changes it name to WEG
Transformadores to begin manufacturing energy distribution equipments for industrial plants,
utility companies, hospitals, shopping centers, etc.
• 1983: Tintas Michigan acquired, also in the state of Santa Catarina; renamed WEG Química.
The company focused on producing industrial paints, electric insulation, paint and varnish.
• 1986: Creation of WEG Automação (automation) to prevent employees from being exposed
19. Important disclosures/certifications are in the “Important Disclosures” section of this report.
U.S. investors’ inquiries should be directed to Santander Investment Securities Inc. at (212) 407-7809.
19
to harmful elements while handling, loading, and unloading materials and parts. Substitution
of human personnel by industrial robots.
• 1991: Internationalization process is fueled by the creation of distribution offices in foreign
countries: WEG Electric Motors U.S. and WEG Europe in 1992.
• 2000: International expansion evolves to an acquisition strategy, trying to benefit from
economic advantages in Mercosur, Nafta, and the European Union.
• 2001: Join Level 1 of Bovespa’s Corporate Governance Standards.
• 2002: Offers 80% tag-along rights to preferred shareholders.
• 2004: International expansion continues; acquires and builds facilities in Mexico, Portugal
and China. Secondary share offering improved stock’s liquidity.
• 2006: Acquisition of a strategic stake in a leading transformer manufacturer in Mexico, called
Voltran. In 1Q06, WEG improved the transparency of sales by unifying the business areas
into four large segments.
IMPORTANT DISCLOSURES
WEG – 12-Month Relative Performance (U.S. Dollars)
Ibovespa
WEG
80
100
120
140
160
180
200
220
M-05
J-05
J-05
A-05
S-05
O-05
N-05
D-05
J-06
F-06
M-06
A-06
M-06
80
100
120
140
160
180
200
220
Sources: Bloomberg and Santander Investment.
