This record is a partial extract of the original cable. The full text of the original cable is not available.

201519Z Oct 05

UNCLAS SECTION 01 OF 03 BRASILIA 002806 
 
SIPDIS 
 
SENSITIVE 
 
STATE PLEASE PASS TO USTR 
NSC FOR CRONIN 
DEPT OF TREASURY FOR FPARODI 
USDOC FOR 3000/JOHN TOCCO 
USDOC FOR 3134/USFCS/OIO/WH/EOLSON 
USDOC FOR 4332/ITA/MAC/WH/OLAC/MWARD 
USDOC FOR 6950/DEAN WODDARD - AEROSPACE 
DOT FOR SUSAN MCDERMOTT, CAROLYN COLDREN 
FAA MIAMI FOR MARK RIOS 
 
E.O. 12958: N/A 
TAGS: EAIR EINV PGOV ETRD
SUBJECT: BRAZILIAN GOVERNMENT INTERVENES IN VARIG - TOO 
LITTLE, TOO LATE? 
 
REFS: (A) BRASILIA 1839, (B) BRASILIA 1608, (C) BRASILIA 
 
1566 
 
¶1. (SBU) Summary.  For months the Brazilian government has 
been urging a market solution to the debt-laden airline 
Varig, which filed for bankruptcy protection in June 2005. 
The new Varig management council has, nevertheless, 
continued to struggle to maintain adequate cash flow and pay 
its lessors (making it clear that the problem is not only 
its enormous debt).  Since Varig's final effort to inject 
cash into the company by selling off its profitable VarigLog 
(cargo branch) fell through in September, no back-up plan 
has materialized.  In an apparent about-face, the GOB is now 
preparing to intervene and GOB VP Jose Alencar has publicly 
stated that there will be a solution this week.  On October 
20 the press reported a GOB proposal for an immediate cash 
injection into Varig via the Brazilian development bank (to 
pay the lessors) and partial financing for selling off some 
of Varig's most profitable subsidiaries.  It may be too 
little, too late because of the enormity of Varig's debt and 
operational inefficiencies, and because the lessors are 
poised to repossess their planes.  End Summary. 
 
GOB Intervention Plans 
---------------------- 
 
¶2. (U) According to press reports on October 18 the 
Brazilian government decided to intervene in the Varig 
crisis after months of pushing a market solution.  GOB VP 
Jose Alencar is quoted as saying there will be a solution 
"this week."  On October 20, the press reported that the GOB 
presented the following plan to the Varig creditors: a short- 
term capitalization by National Development Bank (BNDES) of 
US$62 million to pay the money Varig owes its lessors, and 
the creation of a Specific Purpose Society (SPE) to gather 
investors interested in purchasing Varig's two most 
profitable subsidiaries -- VarigLog (cargo branch) and Varig 
Engineering and Maintenance (VEM) -- with up to two-thirds 
of the value financed by BNDES.  Apparently the door opened 
for government intervention last week when the Ruben Berta 
Foundation (FRB), a key company shareholder, reported that 
it would provide seats on the council to its creditors, and 
most crucially, that the FRB would relinquish its 
controlling role.  A debt-swap, which we previously reported 
as essential for Varig's survival (Ref B), is not under 
consideration.  How the existing debt would be settled is 
unclear at this point. 
 
VarigLog Sale Blocked 
--------------------- 
 
¶3. (U) Varig attempted to sell off its VarigLog subsidiary 
to inject cash into the company in August, only to have it 
blocked by the airline labor unions.  The President of the 
Varig management council, David Zylbersztajn, publicly 
stated that the cash influx was necessary to make payments 
to the lessors in order to convince the U.S. courts to block 
repossession of the companies' airplanes.  The U.S. 
investment company Matlin Patterson had expressed interest 
in purchasing VarigLog and the sale negotiations appeared to 
have been progressing well.  It wasn't clear that the FRB 
would have granted final approval, but the deal didn't even 
make it to that point.  The sale of VarigLog, as well as 
future consideration of selling VEM, was blocked by Brazil's 
Labor Court after a filing by the labor unions.  In obvious 
desperation, Zylbersztajn admitted that the Varig council 
didn't have a "Plan B" if the sale of VarigLog fell through. 
We do not know if the new GOB plan will overcome the Labor 
Court decision. 
 
Varig Must Pay Its Lessors 
-------------------------- 
 
¶4. (SBU) The GOB plan indicates its recognition that 
whatever the long-term plan for Varig may be, Varig must pay 
its lessors immediately.  According to one industry source, 
the lessors have been very patient, but must have an 
investment return on their assets.  If Varig does not pay 
them, our contact noted, the New York judge may lift the 
temporary restraining order (TRO) blocking the lessors' 
repossession of their airplanes before its current November 
11 deadline.  Repossession of these aircraft would be a 
mortal blow for Varig because it would mean the loss of its 
major income earning assets (the international flights). 
 
Slow Death or Mortal Blow? 
-------------------------- 
 
¶5. (SBU) According to another industry source, the 
intervention of the GOB could increase lessors' confidence 
in a solution; this could include the GOB imitating the 
Matlin Patterson deal but with BNDES financing instead and 
extending the sale to include VarigLog, VEM, and possibly 
Smiles.  (Note: The press expressed concern that Matlin 
Patterson is a "vulture" investment fund, which could have 
been a stumbling block to consummating the VarigLog sale. 
When EconOff mentioned this, our contact said it would be 
ironic if Matlin Patterson were viewed as the vulture when 
they offered US$103 million for only VarigLog, while BNDES 
may be asking for VarigLog, VEM, and Smiles for only US$130 
million. End Note.)  On the other hand, some believe that 
the GOB intervention could be only a ploy so that when Varig 
sinks, the GOB can say "we tried, but the U.S. companies 
repossessed the planes" (a perfect alibi). 
 
Not to Mention Maintenance, Lease Renewals, Insurance 
--------------------------------------------- -------- 
 
¶6. (SBU) Even if Varig is able to retain possession of its 
leased planes, it faces three additional obstacles to 
viability: its dismal maintenance record, expiring leases, 
and its insurance policy renewal.  First, Varig's failure to 
keep current on its maintenance requirements may result in 
the grounding of a total of 29% of its fleet by the end of 
the year.  According to press reports earlier this month, 
Varig's VP of Operations produced a technical report that 
predicted that Varig would have to ground at least eight of 
its planes by the end of the year because of maintenance 
reasons.  The grounding would be the result of a pattern of 
cost reductions in maintenance over the last few years.  The 
same article reported that Varig had only purchased 10% of 
its parts supplies needs in September, only 40% YTD, and 62% 
in 2004.  If the additional eight planes were grounded, it 
would bring the total non-operating fleet to 23 planes, or 
29% of it total fleet.  Second, approximately 40% of the 
Varig leases will expire in 2006, and their renewal would 
seem unlikely if Varig were not in better health.  Third, if 
Varig's insurance policy were not renewed or if its premiums 
increased (although relatively small in comparison to the 
leasing payments), this could be a serious problem. 
Comment: Economics versus Politics 
---------------------------------- 
 
¶7. (SBU) Looking at the problem from a strictly economic 
perspective, the rest of the airline industry in Brazil is 
booming, and trying to fix Varig would certainly be more 
expensive for the GOB than letting it ground to a halt. 
From a political perspective, however, with an election year 
in 2006 and a political crisis already on its hands, the GOB 
may have decided to intervene in the restructuring of its 
flagship air carrier to avoid another black spot on its 
record (e.g., the sacking of thousands of airline 
employees).  Given VP Alencar's statements that the GOB 
intervention was motivated by its concern for "the workers," 
however, and given that the solution at this point may only 
be a leveraged cash-influx from BNDES, we believe that the 
GOB may still only be avoiding the inevitable.  Indicative 
of its two minds on these issues, the GOB allowed the civil 
aviation authorities to order VASP to cease flying earlier 
this year, but then agreed to intervene to see if recovery 
was possible (which is dragging on in the judiciary). 
 
¶8. (SBU) In any case, we do not believe the lessors will be 
appeased by superficial measures or wait for a prolonged 
viability study.  We also do not believe that a short-term 
cash-influx from BNDES or even the sale of VarigLog and VEM 
will solve the problem.  If the BNDES money only becomes 
available after a 3-4 week period, for example, that would 
be too long.  If Varig does not pay the lessors quickly, we 
consider it highly likely that the lessors will seek to 
repossess their planes and take their business elsewhere. 
If beyond the cash injection and sale of VarigLog and VEM, 
there are not deep structural changes and downsizing to 
Varig, the loss of its profitable subsidiaries may only 
speed up the demise of the remaining (unprofitable) Varig. 
In sum, the GOB intervention may allow Varig a gentler or 
prolonged finale, or allow Varig to grind to a halt with the 
U.S. lessors as the scapegoat.  However the GOB proceeds, it 
must maintain clear communication with the lessors or the 
fate of Varig may be out of its hands. 
 
DANILOVICH