Volume 4 | Issue 1 | Year 2008

Rising wealth, changing diets, and increased food consumption across the developing world, along with a growing global population, are fueling a steady rise in demand for agricultural commodities such as sugar, soybeans, and meat. Consequently, the prospects for growers, ranchers, processors, and other agribusinesses are blossoming – and perhaps nowhere more so than in Brazil and to a certain extent in Argentina, already agricultural giants that accounted for $73 billion in exports last year.
The opportunities are considerable. Historically fragmented businesses such as livestock and sugar, for instance, are beginning to consolidate, offering companies the benefits of increased scale. New sources of financing allow players to overcome historically underdeveloped capital markets. Increased demand for affordable and clean energy is creating nontraditional opportunities, such as the production and export of biofuels. (Brazil is already the world’s largest producer of ethanol; its exports rose by more than 65 percent in 2006.)

Yet some domestic companies (including local ones and local units of multinationals) aren’t benefiting fully, because they aren’t as efficient as they could be or aren’t getting as much as they could from technology. Smaller enterprises often lack the sophistication to use new financing options to pay for their growth. Moreover, in some cases, complex or rigid organizational structures promote duplication and inefficiency, which prevent agribusinesses from taking full advantage of a changing commercial environment.

Still, a few companies are moving to address these and related issues and thereby positioning themselves to be leaders in the sector. A look at the practices of these companies – a mix of global powerhouses and smaller players – can show others how to confront some of Latin America’s perennial challenges, shed light on the evolution of agribusiness in Argentina and Brazil, and offer insights into the skills and strategies competitors will need in the coming years.

Feeding a hungrier world

Population growth, changing dietary habits, and increased openness to trade across much of the developing world are sparking an increase in the consumption of foodstuffs (including proteins), particularly in China and India (with 2.4 billion consumers between them) but also across most other emerging markets. The Food and Agriculture Organization of the United Nations (FAO) predicts that the average daily caloric intake in the developing world will rise more than 10 percent by 2020, to 2,800 calories a day. Likewise, the Organisation for Economic Co-operation and Development (OECD) predicts that sales of beef in the developing world will rise 31 percent by 2015. Higher beef consumption accelerates grain production because it takes about 10 kilograms (22 pounds) of feed to produce 1 kilogram of beef.

This is welcome news for agribusinesses in Argentina and Brazil, where favorable weather and soil create an ideal environment for crops and livestock. Brazil’s endowment of arable land, for example, is a whopping 4,100,000 square kilometers – roughly the size of the European Union before the addition of Bulgaria and Romania – only 17 percent of it now in use. Indeed, Brazil could more than double its current utilization level without harming the country’s Amazon rainforest. China, India, and the United States all have less farmland and much higher utilization rates. Argentina, for its part, has 1,700,000 square kilometers of available farmland, and its pampas boasts 760,000 square kilometers of the world’s most fertile farmland and pastures.

Such natural blessings, coupled with low labor costs, help explain how Brazil has become the world’s largest producer of frozen orange juice, sugarcane, poultry, beef, and coffee, and the second-largest producer of soybeans. Argentina leads the world in soy oils and flours and is a significant player in soybeans and beef. In 2005 Brazil and Argentina were the world’s 6th- and 13th-largest agricultural producers, respectively, by export value.

The impact of agribusiness on the economies of Brazil and Argentina is profound. For both countries, agriculture is a significant source of competitive advantage and a critical component of external accounts. In 2006 agribusiness represented 36 percent of Brazil’s exports and 52 percent of Argentina’s (worth $49 billion and $24 billion, respectively). Moreover, in both countries agribusiness and related activities generate roughly one-third of GDP.

The road ahead

Agribusinesses in both Argentina and Brazil are rightly bullish about the future, given the glowing outlook for demand, their strong competitive position, and their enviable production advantages. Still, a few companies in the region are recognizing that the full exploitation of the opportunities will require new skills; for example, stronger financial ones that help companies to overcome region-specific challenges (such as underdeveloped capital markets) and to finance new ventures. Others are increasing production yields through better technology. Some companies, exploring alternatives to the traditional cooperative model of asset pooling, are learning how to mitigate risk and boost growth more successfully.

Circumstances outside the control of any company will certainly affect agribusiness in the region. New trade agreements could increase access to foreign markets with the stroke of a pen – if, for example, the deadlocked Doha Round of world trade negotiations were revived. Still, market access remains affected by the developed world’s subsidies, tariffs, quotas, and antidumping provisions (such as those imposed by the United States on Brazil’s shrimp and frozen orange juice). Likewise, inadequate regulation and the informal economy will continue to sap productivity in Brazil and Argentina by allowing subscale enterprises to compete alongside efficient ones. Despite the presence of large, well-managed Brazilian players that control big shares of output and trade, the country’s agricultural labor productivity, for instance, is only 5 percent of that in the United States. The size of the labor productivity gap is directly related to the large number of agricultural concerns dedicated to subsistence activities, often characterized by low capital utilization, suboptimal scale, and dismal efficiency levels. Such challenges lie outside the scope of this article.

Still, examining the way savvy companies are meeting the challenges they can control makes it possible to discern the evolving shape of a sector on the cusp of change. Four elements of the pattern that emerges should serve as both an aspiration and a challenge for agribusinesses in Argentina and Brazil.

The efficiency imperative

A poor transport and storage infrastructure means that agribusinesses in Argentina and Brazil frequently operate at a disadvantage to their competitors in the developed world. The cost of transporting soybeans, Brazil’s most valuable export crop, to port is nearly twice as high in Brazil as in the United States, for example. Worse, because of this poor infrastructure 7 percent of Brazil’s soybeans and up to 12 percent of its rice spoil before reaching either ports or customers. In all, Brazil wastes 26 million tons of food each year, enough to feed 35 million people. Most of this waste occurs between harvest and storage.

A few agribusinesses are taking matters into their own hands by structuring creative partnerships with governments and even competitors to finance much-needed infrastructure projects. In Brazil, for instance, the sugar producer Cosan partnered with three competitors, Cargill, Crystalsev, and Nova América, to build a specialized port for ethanol exports. Bunge Argentina and a competitor, Aceitera General Deheza (AGD), jointly own Terminal 6, a port designed specifically for grain and soybean shipments. Other companies have even developed similar business models to supply third parties with noncore activities, such as logistics, warehousing, or railroad management.

Still, the dearth of roads, ports, and railroads in both countries means that greater operational efficiency is vital for companies to remain competitive. The U.S. Department of Agriculture reckons that Argentina’s corn yields rose by nearly 50 percent from 1990 to 2000, largely because of the increased use of fertilizer, the introduction of genetically modified seeds, and the willingness of companies to promote the use of new technologies. Likewise, Brazil produces sugarcane at a lower cost than any other country in the world thanks to constant productivity gains in planting over the past 30 years. Only by raising yields still more can Brazil ensure the availability of sugarcane to support the rapid expansion of its biofuel industry without affecting domestic consumption.

Against this backdrop, Cosan is optimizing its operations by using satellite technology to monitor cultivation areas and by enhancing the quality of its sugarcane through steps (at harvest time and during transport) to remove mineral impurities that would require expensive washing before the cane was processed. These programs enabled Cosan to increase its output from 2005 to 2006 in excess of 30 percent and to operate at more than 90 percent of its crushing capacity (40 million tons a year). Other agribusinesses are looking to find new practices in far-flung markets. One sugar company in Brazil, for example, studied techniques used in South-east Asia in hopes of reducing its purchasing costs and improving its yields. The company identified several promising initiatives, such as “deep-ripping” soil to break up compacted subsoil, thereby improving drainage and reducing compaction’s negative effects on soil nutrition. Likewise, the company found that a more sophisticated spraying regime could help it prevent crop damage during ripening and that hot-water treatments applied to seeds before planting could cut the incidence of disease. All told, the company estimates that these and other such initiatives could more than double its EBIT margin within five years.

Increased financial sophistication

Inflation, exchange rate volatility, and underdeveloped capital markets have long hampered the profit margins of agribusinesses in Argentina and Brazil. Brazil’s nominal exchange rate against the U.S. dollar, for example, has declined by 40 percent since 2003, increasing local costs denominated in the U.S. dollar and thus reducing the country’s competitiveness by making agricultural exports more expensive abroad. Double-digit inflation in Argentina limits the competitiveness of local producers in a similar way.

Few smaller players in either country have access to (or experience with) futures contracts that might allow them to mitigate such risks.

Underdeveloped financial markets also limit the availability of credit and raise the cost of capital for domestic companies, immobilizing large amounts of cash that could be used more productively.

New sources of financing are available, however, and growing numbers of companies are using them to explore alternative ways to hedge risks and finance operations, and in the process gaining valuable financial experience. Cosan, for instance, was the first agribusiness in Latin America to undertake an initial public offering, raising more than $350 million on the Brazil Stock Exchange (Bovespa), in November 2005. The company subsequently floated bonds on the U.S. market. Encouraged by the region’s record poultry exports (for example, Argentina’s poultry export volumes grew tenfold from 2003 to 2006), agribusinesses are looking for ways to finance capacity expansions. Sadia, a poultry producer in Brazil, has said that it plans to invest nearly $400 million in 2007 alone. Argentina’s Avex, a poultry exporter, recently assembled a consortium of private investors to finance its greenfield poultry-processing plant in central Argentina.

In Brazil venture capital, private equity, and other funds (such as Rio Bravo and Santos Asset Management) are testing alternative-finance mechanisms; for example, hedged agricultural funds that combine asset-backed receivable instruments with trading options for selected commodities (say, coffee or soybeans). These asset-backed funds provide an intermediation vehicle for investors and funding for an increasingly entrepreneurial but capital-starved agribusiness base.

As Latin America’s financial systems develop, sources of funding more common in developed markets are becoming available in the region for the first time. These products are increasingly standardized, thus promoting their rapid adoption. In Brazil, for example, the use of derivatives and insurance products and of guarantee instruments based on receivables (such as crops) is growing at annual rates of 25 and 50 percent, respectively. Such products, which involve a number of financial interactions with suppliers and intermediaries, will challenge players across the region to become more sophisticated in financial matters and to ratchet up their risk-management capabilities. Companies that can rise to this challenge will dramatically increase their odds of success—for example, by gaining the financial sophistication needed to participate in M&A.

New organizational schemes

Although agribusiness in Argentina and Brazil continues to become more professional, companies there face significant organizational challenges; for instance, the rapid swings in profitability that result from exchange rate volatility make it difficult to forecast labor needs. Moreover, the expense of firing employees in Argentina (and, to a lesser extent, Brazil) often makes companies reluctant to hire full-time professionals. Finally, fewer professionals are available to agribusinesses in Latin America than in developed markets: university graduates represent only 2.6 and 3.2 percent of the populations of Argentina and Brazil, respectively, compared with 33 percent in the United States. The resulting talent shortfalls are all the worse because companies must frequently undertake noncore activities (for instance, coping with a weak infrastructure).

The upshot is that companies in both countries are less willing to consider changing their organizational structures, which tend to be difficult to dismantle. In our experience, over time this problem can undermine the coordination between functional areas or businesses and even lead to the unintended duplication of activities (for instance, two sales groups calling on the same customer).

Still, some companies are finding ways to buck these trends and, in the process, positioning themselves to succeed as the region’s agriculture sector professionalizes further. In Brazil, for example, the sugar producer Copersucar has evolved from a traditional cooperative (pooling the functional activities of individual farmers) into a more targeted partnership; in 2001, for instance, core functions such as R&D, transportation, and recruitment were outsourced. The company’s efforts to professionalize itself have helped it become one of the world’s largest sugarcane producers and processors, with an estimated 18 percent share of Brazil’s sugar processing and revenues above $2.1 billion in the 2005–06 season.

Argentina’s Los Grobo has taken the cooperative model further still: the group functions as a holding company that coordinates its interests in many specialized businesses, including livestock, wheat and soybeans, finance, and inputs such as fertilizer. The parent company runs some of these businesses, with a number of partners holding equity stakes; others are financed and supported by Los Grobo but operated by outsiders. This flexible governance arrangement allows the company to specialize, to share knowledge, and to diversify its exposure to risk, while entrusting accountability (on a case-by-case basis) to those best qualified to run and supervise individual operations. The company also looks for clever ways to leverage available skills and capital—for instance, by relying heavily on third parties, including, for example, landowners who lease their property to Los Grobo on variable or fixed terms. The company’s results in recent years suggest that this approach is working; its revenues increased at rates approaching 45 percent a year from 2003 to 2006.

The need to innovate

For agribusinesses everywhere, product innovation is a crucial way not only to gain broader access to existing markets abroad but also to defend domestic ones. Moving up the value chain from commodities into specialized products or even services gives producers a path to higher margins. For Brazil and Argentina, the coming years offer domestic agribusinesses both traditional and nontraditional innovation opportunities.

Skyrocketing oil prices and growing environmental concerns, for example, are creating nontraditional openings in the production and export of biofuels made from sugar and oilseeds. Brazil is already the world’s largest ethanol producer, with 37 percent of global production, and the country’s ethanol exports have more than tripled since 2003. To maintain this lead, the industry must find ways to unleash latent demand; for example, by promoting the adoption of flex-fuel technology (used to convert automobiles to run on ethanol) among foreign car manufacturers. Likewise, it must find ways to ensure a reliable supply of biofuels by means such as investments in fuel storage and new distribution networks

Product innovation may also take more traditional forms; agribusinesses might, for example, get into the distribution of packaged goods, either under their own brand names or by offering private-label products to others. Bunge is a leading seller of refined oils in Europe, as well as in Brazil, where it also markets branded margarine and mayonnaise. Likewise, Sadia has introduced specialty cuts of poultry to meet the tastes of Asian customers. Such moves require agribusinesses to develop a keen understanding of their customers and channels and to operate on a much faster innovation cycle in order to compete with fast-moving consumer goods companies.

Companies looking for examples of product innovation in Latin America should consider Chile, where aquaculture (fish farming) has grown into a $1.7 billion export industry and one of the country’s most important businesses. Indeed, over the past decade its exports of salmon and trout have risen more than fourfold, and today the country accounts for about 38 percent of global salmon production, almost as much as Norway, the world’s largest producer.

Innovation has been central to this success. Chilean producers were quick, for example, to introduce new products to meet shifting consumer tastes; for instance, farming Atlantic and Coho salmon in response to a growing global preference for higher-grade seafood. Moreover, the transition to high-value-added products (such as boneless salmon filets and smoked salmon) allowed local producers to leverage their labor cost advantage over producers in developed countries and thus to survive the industry’s sharp price declines in the mid-1990s.

The vertical integration of the past two decades also made local producers significantly more competitive, among other ways, by allowing them to control and optimize their operations and R&D. After purchasing local feed suppliers, for example, producers developed better techniques for regulating and monitoring how much food their fish eat (feed costs represent 45 percent of the final sale price). This achievement in turn improved yields from 1.8 kilograms of food per kilogram of fish in the early 1990s to around 1.2 kilograms per kilo of fish today, in line with yields in Norway.

Chile also benefited from an effective framework of public-private collaboration: workforce qualification standards and tax incentives help to ensure the availability of talent and infrastructure. Moreover, the local salmon producers’ association played a key role by defining quality and sanitary standards that the industry could promote in its main export markets and by collaborating with Chile’s government to fight accusations of dumping.

Agribusiness in Brazil and Argentina is booming, presenting companies operating there with a mix of traditional and nontraditional opportunities. By examining the practices of leading local companies, others can gain insight into the skills and strategies that will be required to thrive in the years to come.

Fragmented markets

Despite recent consolidation, important agricultural segments in Latin America, most notably sugar, coffee, and livestock and leather, remain fragmented. In Brazil the four largest players in these segments represent only 45, 37, and 17 percent of output, respectively, because small, unproductive, and informal concerns manage to survive. Fragmentation not only limits the ability of agribusinesses to increase their scale (by reducing bargaining power for inputs) but also makes it harder to gain access to financial markets, limits the availability of credit, and raises intermediation costs.

In Argentina, for example, 40 percent of the country’s 500,000 cattle producers maintain herds of fewer than 50 animals. The top nine abattoirs account for only 18 percent of the slaughtering, packaging, and shipping of livestock. Overcapacity among processors can reach 40 percent. Fragmentation extends to distribution, with supermarkets accounting for barely one-quarter of sales. This structure has created market distortions that undermine the favorable economics of the livestock industry. In late 2006, for example, as domestic producers scrambled to meet rising demand, they could not expand supply sufficiently. The result was higher domestic prices and, ultimately, a government ban on exports, as well as price controls that provoked a two-week strike among producers.

By contrast, Argentina’s dairy sector underscores the benefits of consolidation. Here, only nine processors hold more than 70 percent of output. Increased scale has helped Argentina’s dairy sector to increase its exports by more than 30 percent since early 2006.

While much more consolidation must take place, there are positive signs that the structures of some sectors are changing through a combination of alliances and M&A. The Brazilian sugar companies Copersucar and Cosan, for example, have between them crafted processing deals with more than 40 independent processing plants in recent years and are negotiating alliances with local companies in foreign markets, including India, Japan, South Africa, and the United States. The Brazilian poultry producer Sadia’s attempt, in 2006, to acquire a majority stake in its local rival Perdigao, while rejected, suggests that M&A is coming to this industry as well.

Jorge Fergie is a director in McKinsey & Company’s São Paulo office, and Matias Satz is an associate principal in the Buenos Aires office.

This article from the McKinsey Quarterly was reprinted by permission of McKinsey & Company, www.mckinsey.com.