When Marcelo Martins, CFO of sugar producer Cosan in Brazil, discusses how the skyrocketing cost of commodities has been putting excruciating margin pressure on his firm in recent months, other finance chiefs can empathize. In February, the Thomson Reuters/Jefferies CRB Index, which tracks the prices of 19 commodities, hit its highest level since September 2008, while the United Nations' Food and Agriculture Organization (FAO) stated a few weeks later that record-high food prices are likely to be sustained this year because of escalating oil costs and smaller harvests.

Food-price inflation is now the catchphrase of the day in boardrooms around the world, and the latest financial results season has become an unenviable job for CFOs like Martins. As he announced to investors in February, rising prices of sugar were largely to blame for Cosan's balance sheet being hit with an 83% drop in net income in the third quarter ended December 31, to R$27.9 million (US$16.9 million) from R$167.1 million a year earlier. Cosan buys at least 50% of the sugarcane it crushes from non-Cosan farms, for which it has to pay market prices — which adverse weather conditions at home and abroad continue to ensure will keep moving upward.

But escalating commodity prices represent both good and bad news for Martins. On the one hand, Cosan — the largest sugarcane producer and sugar exporter in the world — has benefited as market prices for the raw material climbed to near 30-year highs earlier this year. On the other, the company has been held hostage to the vagaries of supply and demand, causing volatile and hard-to-anticipate swings in prices from which even Martins' variety of hedging tools can't protect Cosan's balance sheet.

Yet even as global sugar supplies struggle to keep up with demand, Cosan has much to look forward to. Sugar and sugarcane-based ethanol fuel are Cosan's core business, but it is becoming less so thanks to a shrewd diversification strategy that Martins has been a part of since joining the family-owned, New York and Sao Paulo-listed firm in 2007, where he has been CFO since 2009.

According to Felipe Monteiro, a Wharton management professor from Brazil, a clutch of acquisitions and joint ventures has already begun transforming the company — enabling it to both gain greater strategic holdings in the sugar industry and to reduce the company's dependence on that very industry. "These guys know the sugar and ethanol business inside out and you see them now investing and expanding in distribution," he says. "They're thinking globally with their recent joint ventures. A lot of people think about raw commodities as an old world, basic industry, but that's not the case with Cosan."

Now, the company’s push further into the new world is gathering momentum, thanks in large part to the vision of a management team that "has both the local expertise and a global orientation," says Monteiro. In Brazil's burgeoning economy, that is attractive for multinational investors. It has just led to one of Cosan's boldest deals in its 75-year history — its new US$12 billion joint venture with Royal Dutch Shell aimed at transforming it into a major energy player. "It's a game changer, no doubt about it," says Martins from Cosan's Sao Paulo headquarters.

Brazil's California

Like Brazil's other sugar companies (of which there are hundreds), Cosan started as a family business in 1936 with a sugarcane-crushing mill in the interior of São Paulo state. Sugar plantations had been migrating from their 19th-century roots in the poorer northeast to the richer south and center west states. The main state where nearly half of the country's sugarcane crops can be found is São Paulo, Brazil's California, with a long growing season and rich soil nurturing soybeans, citrus, wheat and, of course, sugar, among other food crops.

Commodity exports account for most of Brazil's US$12 billion trade surplus, with sugar accounting for about 6%. Helping the industry is the fact that few other countries have the necessary infrastructure, natural resources and experience commercializing sugar and numerous other raw materials that Brazil has. According to the most recent annual figures from the intergovernmental International Sugar Organization in London, Brazil is the world's top sugarcane producer, at 33.45 million tons in 2009, putting it well ahead of the world's other top producers, including India, China and Australia.

In São Paulo state, sugarcane crops have tripled over the past 20 years. To show that, the industry measures production in terms of "crush" size — that is, the amount of cane stalks cut out of the ground and crushed into sugar and its derivatives, including the ethanol used as a biofuel additive for gasoline. In the most recent market year, which finished harvesting in January, São Paulo's sugar companies crushed more than 350 million metric tons, up 16% from the previous year and a near threefold increase during the market year 1990-1991, according to industry trade group Unica.

While many companies in the Middle East process more sugar than Cosan, they do not grow it from sugarcane. They buy the raw sugar from Brazil and India and beet sugar from Europe to turn it into crystal sugar for exports. In growing the sugarcane that it uses to produce sugar for export, Cosan has few rivals.

That's an accolade that Martins and the rest of Cosan's executive team can be proud of, but one packed with challenges. If sugar supply is low, as it was in this recent crop cycle following a drought in Brazil and floods in Australia, sugar prices rise. When governments like India's ban sugar exports, as it has recently, prices rise even higher. In those situations, global pricing for sugar can become Cosan's Achilles' heel.

Diversification holds the key. Around 45% of Cosan's earnings before interest, taxes, depreciation and amortization (Ebitda) come from gasoline, oil lubricants and co-generation projects to sell surplus electricity and energy produced by its mills. A look at its balance sheet shows that these are Cosan's fastest growing segments. In particular, Martins cites Cosan's lubricants business that was part of a pivotal deal with oil major ExxonMobil signed in 2008 to produce and sell Mobil branded lubricants, which now has cornered a market share of more than 10% in Brazil. "They bring technical expertise; we bring market knowledge of Brazil," says Martins. "We've created a lot of value — Ebitda has more than doubled in the last three and a half years."

If there have been concerns among stakeholders about the risks of diversification, results like those give Martins a sense of vindication. As he told analysts during a conference call in early February, "Even though we had a disappointing quarter and year so far because of sugar prices, we are impressed with our downstream business. This proves our … strategy to invest in these segments is working and the results have definitely exceeded our expectations." Even more critical from the CFO's vantage point, however, is that its non-sugar segments provide something that has been in short supply at the company — a stable cash flow.

But as Cosan continues to diversify, it will still be at the whims of commodity markets, which in turn have increased the value of Brazil‘s currency — in 2009 and 2010, the real appreciated against the U.S. dollar by 34.2% and 10%, respectively. A weak dollar can help Cosan pay its US$3.6 billion in dollar-denominated debt, but it does mean less income from sugar and ethanol exports even as revenues rise. "The problem for me all of a sudden is that Cosan becomes less competitive if it can‘t compete because of the real," says Monteiro.

There are other — arguably more contentious — elements of Cosan's business that Martins' risk management strategy must encompass. One of them is addressing the heavy criticism from environmentalists, human and labor rights activists, and others that Brazil's sugar and ethanol industry has faced. Often for well-founded reasons, the industry stands accused of health and safety violations — even forcing cane cutters to work under slave-labor conditions — and reckless deforestation to make way for sugarcane plantations. And as the second-biggest producer of ethanol in the world, after the U.S., there's also growing concern in Brazil about food crops being diverted into energy sources at a time when organizations such as the FAO are warning of global food shortages. 

These are issues that Martins, who is also the firm's investor relations officer, can't sidestep. Hiring the first sustainability officer and publishing the company's first annual sustainability report last September are a good start in providing transparency to stakeholders about actions it is taking to combat those issues. The 2010 sustainability report itself describes a number of recent initiatives at Cosan, including its involvement in developing an international compliance system of socio-standards that sugar firms must meet.

The report also describes the company's use of new technology to increase the efficiency, productivity and safety of its crop harvesting — but in that regard experts point out that Brazil is in an enviable position relative to the U.S., the world's largest ethanol producer. Brazil's sugarcane-based ethanol manufacturers get eight units of energy for every unit that goes into making their product; their U.S. counterparts, who use corn rather than sugarcane, get only 1.5 units of energy output per unit of input.

Fuel for the Fire

As sugarcane-based ethanol gains in popularity as an alternative to environmentally unfriendly fossil fuels, it's easy to see why Cosan is attracting the attention of big multinationals seeking brand name companies in Brazil with good management to put their capital to work. Cosan owes most of this attraction to the story behind rising sugar prices, and expectations for ethanol to become a global commodity, too. It's helped Cosan acquire other sugar companies — like most recently its February deal to buy Sao Paulo-based Usina Zanin Acucar & Alcool — and made it the first sugar company in Brazil to break into the gasoline business — an important segment of the market that's unique to Brazilian sugar, because of the government mandate to mix around 22% sugar-based ethanol with gasoline. Brazil also has 100% ethanol pumps at all filling stations. And while Cosan accounts for around 9% of the total sugar and ethanol market in Brazil, it controls a much larger portion of ethanol distribution and rivals market leader Petrobrás, the state-owned oil giant.

"Cosan likes this segment," says Monteiro, citing among other deals Cosan's 20% of a new multibillion dollar ethanol pipeline being built in São Paulo to deliver around 39 billion liters of ethanol annually to the Port of Santos. "So you have Cosan now investing heavily in gasoline and ethanol distribution."

Monteiro also points to Cosan's acquisition of Petrosul — a small, regional network of 80 gas stations in southern Brazil — two years ago to add to the Esso stations it bought from ExxonMobil for nearly US$1 billion in 2008. The Esso purchase came just days after U.K. oil company BP acquired a stake in local sugarcane ethanol company Santelisa Vale. While BP became the first international oil major to move upstream into the ethanol segment, Cosan became the first sugar major to move downstream into the gasoline segment, and now has an estimated 7% share of the gasoline distribution market in Brazil.

For Martins, the ExxonMobil deal was the "real transformation" of Cosan, one that would pave the way for its next big deal. As Martin sees it, in increasing Cosan's exposure in the downstream business, "we were able to attract the attention of Shell and interact with one of the biggest biofuels distributors in a way we wouldn't have been able to otherwise."

Martins says all this has been part of positioning to become one of the world’s largest sugarcane-based power and ethanol producers via its new joint venture with Shell. "We always wanted to establish the company as one with serious growth potential in biofuels and not just sugar," he told analysts in a conference call when Cosan signed the agreement in February to combine US$4.9 billion of their ethanol, sugar and fuel distribution assets in a new company called Raizen. The subsidiary has an estimated market value of US$12 billion, employing around 40,000 people and producing over 2.2 billion liters (580 million gallons) of ethanol annually for Brazilian and international markets. Raizen will be Brazil's biggest joint ethanol fuel venture once it receives regulatory approval and begins operation later this year.

It is the R$3.4 billion of synergies between Shell and Cosan that both Martins and CEO Marcos Lutz are stressing in meetings and interviews about the deal, which increases Cosan's network of gas stations from around 1,600 currently to 4,422. But perhaps more important is the venture's technology transfer from Shell to Cosan to raise the bar in terms of the quality of its ethanol and R&D efforts.

With the deal, Cosan “gets a big brother — a very wealthy big brother,” is how Jansen Moura, a corporate bond analyst with BCP Securities in Rio de Janeirodescribed the deal to Bloomberg when it was unveiled back in June. Indeed, it does, say other experts. At 3.3 in the third quarter, Cosan’s leverage ratio — measured by net debt to Ebitda — may fall, according to some analyses. Others also predict that the deal will take some of the pressure off Cosan's Ebitda margins, which had fallen to 8.7% from 12.9% a year earlier.

"The deal wasn't just about cash but about gaining skills and knowledge," says Martins. "The idea is to become the largest fully integrated biofuel producer in the world." The aim now, he adds, is to focus on integration, and replicate what Cosan achieved with the ExxonMobil deal. With Exxon, "we succeeded because we're flexible and focused on value creation. That's not easy to do, especially for a company that's family owned as we are."

But Martins isn't standing still. Having headed downstream, it's nearly time to look elsewhere for the next sweet spot. "We have to get ready for the next wave of consolidation in the upstream business," he says.