UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 20-F

 

 

 

REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

OR

 

 

 

ý

 

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

 

OR

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File No. 1-11005

 

ARACRUZ CELULOSE S.A.

(Exact name of Registrant as specified in its charter)

 

Aracruz Cellulose

(Translation of Registrant’s name into English)

 

Federative Republic of Brazil

(Jurisdiction of incorporation or organization)

Rua Lauro Müller, 116, 40th floor

22299-900 Rio de Janeiro, RJ, Brazil

(Address of principal executive offices)

 

Securities registered or to be registered pursuant to Section 12(b) of the Act.

 

Title of each class:

 

Name of each exchange on which registered:

 

 

 

American Depositary Shares (as evidenced by American Depositary Receipts), each representing ten shares of Class B Stock

 

New York Stock Exchange

 

Securities registered or to be registered pursuant to Section 12(g) of the Act.

None

 

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.

None

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

 

455,390,699

 

Shares of Common Stock

38,022,178

 

Shares of Class A Stock

539,141,243

 

Shares of Class B Stock

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes   ý       No                  o

 

Indicate by check mark which financial statement item the registrant has elected to follow.

 

Item 17   o       Item 18   ý

 

Please send copies of notices and communications from the Securities and Exchange Commission to:

 

Ross Kaufman

Greenberg, Traurig LLP

Met Life Building

200 Park Avenue

New York, NY 10166

 

 



 

TABLE OF CONTENTS

 

PART I

 

 

 

ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

 

ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE

 

ITEM 3. KEY INFORMATION

 

ITEM 4. INFORMATION ON ARACRUZ

 

ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

 

ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

 

ITEM 8. FINANCIAL INFORMATION

 

ITEM 9. THE OFFER AND LISTING

 

ITEM 10. ADDITIONAL INFORMATION

 

ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES

 

 

 

PART II

 

 

 

ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES

 

ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS

 

ITEM 15. CONTROLS AND PROCEDURES

 

ITEM 16. RESERVED

 

ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT

 

ITEM 16B. CODE OF ETHICS

 

ITEM 16C. PRINCIPAL ACCOUNTANT FEE AND SERVICES

 

ITEM 16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES

 

ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

 

 

 

PART III

 

 

 

ITEM 17. FINANCIAL STATEMENTS

 

ITEM 18. FINANCIAL STATEMENTS

 

ITEM 19. EXHIBITS

 

 

i



 

INTRODUCTION

 

Unless otherwise specified, all references in this annual report to:

 

                  “U.S. dollars,” “$” or “US$” are to United States dollars;

 

                  reais,” “real” or “R$” are to Brazilian reais, the official currency of Brazil;

 

                  “Brazilian government” are to the federal government of the Federative Republic of Brazil;

 

                  “consolidated financial statements” are to the Consolidated Financial Statements of Aracruz Celulose S.A. at December 31, 2003 and 2004 and the corresponding Report of Independent Registered Public Accounting Firm;

 

                  the “Company,” “Aracruz,” “we,” “us” and “our” are to Aracruz Celulose S.A. and its consolidated subsidiaries (unless the context otherwise requires);

 

                  “our preferred shares” and “our common shares” are to our authorized and outstanding preferred stock and common stock, respectively;

 

                  “Class A Stock” and “Class B Stock” are to our non-voting preferred stock class A (ações preferenciais classe A) and non-voting preferred stock class B (ações preferenciais classe B), respectively, which together are referred to as the Preferred Shares; and

 

                  “tons” are to metric tons of 1,000 kilograms each.

 

As used in this annual report, one hectare equals approximately 2.471 acres, one kilogram equals approximately 2.2 pounds and one kilometer equals approximately 0.621 miles.

 

Unless otherwise indicated,

 

                  all references in this annual report to percentages, tons and U.S. dollar or real amounts of pulp are to “market pulp”; and

 

                  amounts in reais stated at a particular date and followed by U.S. dollar equivalents have been converted using the reais to U.S. dollars commercial selling rate in effect on such date.

 

FORWARD-LOOKING STATEMENTS

 

This annual report contains statements which constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.  Certain such forward-looking statements can be identified by the use of forward-looking terminology such as “believe,” “expect,” may,” “are expected to,” “will,” “will allow,” “will continue,” “will likely result,” “should,” “would be,” “seek,” “approximately,” “intend,” “plan,” “project,” “estimate” or “anticipate,” or similar expressions or the negative thereof or other variations thereof of comparable terminology, or by discussions of strategy, plans or intentions.  In addition, all information included herein with respect to future operations, financial condition, financial performance or other financial or statistical matters constitute forward-looking statements.  Those forward-looking statements are necessarily dependent on assumptions, data or methods that may be incorrect or imprecise and that may not be realized.  Such statements appear in a number of places in this annual report, including, without limitation, the information set forth under the headings “Item 3D. Risk Factors,” “Item 4B. Business Overview” and “Item 5. Operating and Financial Review and Prospects,” and include statements regarding our intent, belief or current expectations or those of our directors or our executive officers with respect to:

 

                  general economic, political and business conditions, both in Brazil and in our principal export markets,

 

1



 

                  the declaration or payment of dividends,

 

                  our direction and future operation,

 

                  the implementation of our principal operating strategies, including our potential participation in acquisition or joint venture transactions or other investment opportunities,

 

                  the implementation of our financing strategy and capital expenditure plans,

 

                  the development of solid wood products, or

 

                  the factors or trends affecting the pulp and paper market (including its cyclical nature and our financial condition or results of operations).

 

Investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those in the forward-looking statements, as a result of various factors.  We do not undertake, and specifically disclaim, any obligation to update any forward-looking statements, which speak only as of the date hereof.

 

We make statements in this annual report about our competitive position and market share in, and the market size of, the pulp industry.  We have made these statements on the basis of statistics and other information from third-party sources that we believe are reliable.  We derive this third-party information principally from reports published by the International Pulp Statistical Committee, which includes the American Forest Paper Association, the Canadian Pulp & Paper Association, the Finnish Forest Industry Federation and the Brazilian Pulp and Paper Association, or Bracelpa, and reports published by Hawkins Wright Ltd., or Hawkins Wright.  Although we have  no reason to believe that any of this information or these reports is inaccurate in any material respect, we have not independently verified the competitive position, market share, market size or market growth data provided by third parties or by industry or general publications.

 

2



 

PART I

 

ITEM 1.  IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

 

Not applicable.

 

ITEM 2.  OFFER STATISTICS AND EXPECTED TIMETABLE

 

Not applicable.

 

ITEM 3.  KEY INFORMATION

 

A.                                    Selected Financial Data

 

Our consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America, or U.S. GAAP.  Because we exported approximately 98% of our production in 2004 and operate in an industry that uses the U.S. dollar as its currency of reference, our management believes that the U.S. dollar is the most appropriate currency in which to present our financial statements.  Accordingly, we decided to present our primary U.S. GAAP financial statements in U.S. dollars beginning in 1994.  For this purpose, amounts in Brazilian currency for all periods presented have been remeasured into U.S. dollars in accordance with the methodology set forth in Statement of Financial Accounting Standards No. 52, or SFAS 52.

 

During 1997, the 36-month cumulative rate of inflation in Brazil fell below the 100% threshold, and our management determined the Brazilian economy to have ceased being a highly inflationary economy as of the fourth quarter of 1997. Accordingly, our management reevaluated our economic profile and our operations and determined that the U.S. dollar should remain as our functional currency, in accordance with the criteria established by SFAS 52. Our transition from a highly inflationary environment to a non-highly inflationary accounting environment as of and from January 1, 1998, had no financial reporting effect on our results of operations and financial position, because our reporting currency (which has been, since 1994, the U.S. dollar) was also our functional currency under highly inflationary conditions according to SFAS 52.

 

Pursuant to SFAS 52 as it applies to us, inventories, property, plant and equipment, accumulated depreciation and stockholders’ equity are remeasured at historical rates of exchange, and other assets and liabilities denominated in reais are remeasured at period-end rates. Export sales invoiced in currencies other than the U.S. dollar are remeasured at the applicable exchange rate on the date of sale. Cost of sales, depreciation and other expenses relating to assets remeasured at historical exchange rates are calculated based on the U.S. dollar values of such assets, and other statement of operations accounts are remeasured at the rate prevailing on the date of the charge or credit to income.

 

We publish our financial statements in Brazil in accordance with accounting practices adopted in Brazil, or Brazilian GAAP, which differs in certain significant respects from U.S. GAAP. The principal differences between Brazilian GAAP and U.S. GAAP, as applied to us, are related to disclosure requirements. Our taxes and dividends are determined on the basis of Brazilian GAAP financial statements.

 

During the first quarter of 2001, in an effort to conform our reporting practices to those commonly used in the industry, we changed the classification of freight costs in the statement of income. As a result of this change, ocean freight and insurance charges, which had previously been classified as a reduction to export sales of eucalyptus pulp, together with inland freight charges, previously classified as selling expenses, are now classified as a component of cost of sales.  Additionally, certain administrative expenses were identified as indirectly related to the production process and, beginning January 1, 2001, classified as a component of cost of sales.  Historical information herein with respect to 1999 and 2000 was reclassified accordingly. Therefore, some information may differ from the condensed financial statements published elsewhere.

 

The following table presents our selected financial data as of the dates and for each of the periods indicated.  Our U.S. GAAP financial statements as of December 31, 2002, 2003 and 2004 appear elsewhere herein, together with the

 

3



 

reports of the Independent Registered Public Accounting Firms, PriceWaterhouseCoopers Auditores Independentes, Rio de Janeiro, Brazil (2002 and 2003) and Deloitte Touche Tohmatsu Auditores Independentes Rio de Janeiro, Brazil (2004). The selected financial information at December 31, 2000 and 2001 has been derived from our U.S. GAAP financial statements, not included in this annual report. The selected financial data should be read in conjunction with “Item 5. Operating and Financial Review and Prospects.”

 

 

 

For the year ended December 31,

 

 

 

2000

 

2001

 

2002

 

2003

 

2004

 

 

 

(thousands of U.S. dollars, except number of shares and per share amounts)

 

Statement of Operations Data

 

 

 

 

 

 

 

 

 

 

 

Operating Revenues

 

 

 

 

 

 

 

 

 

 

 

Sales of eucalyptus pulp

 

 

 

 

 

 

 

 

 

 

 

Domestic

 

$

43,601

 

$

23,579

 

$

17,126

 

$

42,401

 

$

66,083

 

Export

 

800,634

 

583,365

 

700,622

 

1,056,498

 

1,256,648

 

Total sales

 

$

844,235

 

$

606,944

 

$

717,748

 

$

1,098,899

 

$

1,322,731

 

Sales taxes and other deductions

 

(63,240

)

(32,589

)

(48,765

)

(95,829

)

(155,618

)

Net operating revenues

 

$

780,995

 

$

574,355

 

$

668,983

 

$

1,003,070

 

$

1,167,113

 

Operating costs and expenses

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

$

412,313

 

$

420,606

 

$

468,875

 

$

592,555

 

$

700,333

 

Selling

 

21,492

 

23,253

 

28,242

 

38,617

 

53,850

 

Administrative

 

22,454

 

22,012

 

22,302

 

22,762

 

31,072

 

Provision for loss on ICMS credit

 

 

 

10,754

 

45,093

 

23,178

 

22,859

 

(Gain)/Loss and provision for loss sale of property, plant and equipment and spare parts inventories

 

4,826

 

9,555

 

1,534

 

4,401

 

6,490

 

Other, net

 

7,152

 

5,252

 

7,434

 

14,383

 

(4,141

)

Total operating costs and expenses

 

$

468,237

 

$

491,432

 

$

573,480

 

$

695,896

 

$

810,463

 

Operating income

 

$

312,758

 

$

82,923

 

$

95,503

 

$

307,174

 

$

356,650

 

Non-operating (income) expenses

 

 

 

 

 

 

 

 

 

 

 

Equity in results of affiliated company

 

$

1,313

 

$

(1,195

)

$

(6,076

)

$

6,844

 

$

11,568

 

Financial income

 

(64,849

)

(54,749

)

(61,611

)

(43,037

)

(56,123

)

Financing expense

 

101,461

 

70,215

 

82,014

 

108,209

 

119,976

 

Loss (gain) on currency remeasurement, net

 

(8,812

)

18,029

 

(14,888

)

(41,955

)

(16,197

)

Other, net

 

(131

)

(214

)

(276

)

(92

)

(67

)

Total Non-operating (income) expenses

 

$

28,982

 

$

32,086

 

$

(837

)

$

29,969

 

$

59,157

 

Income (loss) before income taxes

 

$

283,776

 

$

50,837

 

$

96,340

 

$

277,205

 

$

297,493

 

Income tax expense (benefit)

 

 

 

 

 

 

 

 

 

 

 

Current

 

$

40,461

 

$

35,722

 

$

(23,988

)

$

106,549

 

$

42,746

 

Deferred

 

41,604

 

(2,992

)

8,415

 

22,567

 

27,510

 

Total

 

$

82,065

 

$

32,730

 

$

(15,573

)

$

129,116

 

$

70,256

 

Net income

 

$

201,711

 

$

18,107

 

$

111,913

 

$

148,089

 

$

227,237

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and diluted earnings per share(1)

 

 

 

 

 

 

 

 

 

 

 

Class A Stock

 

$

0.20

 

$

0.05

 

$

0.11

 

$

0.15

 

$

0.23

 

Class B Stock

 

0.20

 

0.02

 

0.11

 

0.15

 

0.23

 

Common Stock

 

0.18

 

0.01

 

0.10

 

0.14

 

0.21

 

Dividends per share

 

 

 

 

 

 

 

 

 

 

 

Class A Stock

 

$

0.06

(2)

$

0.06

(3)

$

0.08

(4)

$

0.11

(5)

$

0.12

(6)

 

 

 

 

 

 

 

 

 

 

$

0.09

(7)

Class B Stock

 

0.06

(2)

0.06

(3)

0.08

(4)

0.11

(5)

0.12

(6)

 

 

 

 

 

 

 

 

 

 

0.09

(7)

Common Stock

 

0.05

(2)

0.06

(3)

0.07

(4)

0.10

(5)

0.11

(6)

 

 

 

 

 

 

 

 

 

 

0.08

(7)

Weighted-average number of shares outstanding (thousands of shares)

 

 

 

 

 

 

 

 

 

 

 

Class A Stock

 

40,903

 

40,651

 

40,395

 

39,819

 

38,074

 

Class B Stock

 

552,889

 

536,512

 

536,768

 

535,969

 

537,711

 

Common Stock

 

454,908

 

454,908

 

454,908

 

454,908

 

454,908

 

Total

 

1,048,700

 

1,032,071

 

1,032,071

 

1,030,696

 

1,030,693

 

 

4



 


(1) Holders of Class B Stock have no dividend preference.  Holders of Class A Stock are entitled to an annual preferential dividend.

(2) Including the dividend declared on April 05, 2000 and paid on April 30, 2000.

(3) Including the dividend declared on March 30, 2001 and paid on April 12, 2001.

(4) Including the dividend declared on April 30, 2002 and paid on May 13, 2002.

(5) Including the dividend declared on April 29, 2003 and paid on May 15, 2003.

(6) Including the dividend declared on April 29, 2004 and paid on May 14, 2004.

(7) Including the interest on stockholders’ equity declared on October 19, 2004 and November 16, 2004 and paid on November 11, 2004 and December 10, 2004, respectively.  The interest on stockholders equity were attributed to the Compulsory Dividend relating to the year 2004, which were declared on  April 29, 2005

 

 

 

At December 31,

 

 

 

2000

 

2001

 

2002

 

2003

 

2004

 

 

 

(thousands of U.S. dollars)

 

Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

18,091

 

$

20,125

 

$

25,474

 

$

66,284

 

$

36,474

 

Other current assets

 

261,815

 

215,199

 

250,487

 

390,459

 

384,529

 

Short-term investments

 

323,032

 

405,493

 

248,455

 

285,991

 

412,110

 

Property, plant and equipment, net

 

1,664,322

 

1,913,191

 

2,000,071

 

2,270,369

 

2,133,896

 

Investment in affiliated company

 

79,698

 

80,893

 

87,107

 

382,318

 

480,940

 

Other assets

 

107,500

 

143,296

 

87,220

 

59,012

 

81,709

 

Total assets

 

$

2,454,458

 

$

2,778,197

 

$

2,698,814

 

$

3,454,433

 

$

3,529,658

 

Short-term debt

 

272,042

 

325,855

 

182,680

 

392,088

 

152,934

 

Other current liabilities

 

55,035

 

99,425

 

55,824

 

121,591

 

121,872

 

Long-term debt

 

278,873

 

537,183

 

611,091

 

979,435

 

1,222,728

 

Other long-term liabilities

 

75,387

 

78,004

 

88,656

 

160,358

 

217,837

 

Stockholders’ equity

 

1,773,121

 

1,737,730

 

1,760,563

 

1,800,961

 

1,814,287

 

Total liabilities and stockholders’ equity

 

$

2,454,458

 

$

2,778,197

 

$

2,698,814

 

3,454,433

 

3,529,658

 

 

Exchange Rates

 

The purchase and sale of foreign currency in Brazil is subject to governmental control.  As of March 4th, 2005 the two then existing foreign exchange markets - the free rate foreign exchange market, also known as the commercial market; and the “floating” rate foreign exchange market - were unified to become one single foreign exchange market  (the “Foreign Exchange Market”). Transactions in the Foreign Exchange Market shall comply with the provisions  set forth in the Resolution 3,265 and the regulations established by the Central Bank of Brazil.

 

The Foreign Exchange Market includes purchase and sale transactions of foreign currency and gold-based foreign exchange trades carried out by institutions authorized to operate on the Foreign Exchange Market by the Central Bank of Brazil.  From March 1995 through January 1999, the Central Bank allowed the gradual devaluation of the real against the U.S. dollar, pursuant to an exchange rate policy that established a band within which the real/U.S. dollar exchange rate could fluctuate.

 

Responding to pressure on the real, on January 13, 1999, the Central Bank widened the foreign exchange rate band. Because the pressure on the real did not ease, on January 15, 1999, the Central Bank allowed the real to float freely. On May 31, 2005, the commercial selling rate was R$2.4038   per US$1.00.  Since January, 1999 the real

 

5



 

exchange rate has been having an erratic trend, where the exchange rate is determined by demand and supply currency flows.

 

The following table shows the commercial selling rate for U.S. dollars for the periods and dates indicated.

 

 

 

Exchange Rate of R$ per US$

 

Year ended December 31,

 

Low

 

High

 

Average(1)

 

Year-End

 

 

 

 

 

 

 

 

 

 

 

1999

 

1.2078

 

2.1647

 

1.8158

 

1.7890

 

2000

 

1.7234

 

1.9847

 

1.8295

 

1.9554

 

2001

 

1.9357

 

2.8007

 

2.3420

 

2.3204

 

2002

 

2.2709

 

3.9552

 

2.9309

 

3.5333

 

2003

 

2.8219

 

3.6623

 

3.0715

 

2.8892

 

2004

 

2.6544

 

3.2051

 

2.8639

 

2.6544

 

 


Source:        Central Bank, PTAX.  PTAX is the average of the exchange rates negotiated in the commercial rate market on a given day.

(1)                                  Represents the average of the exchange rates (PTAX) on the last day of each month during the relevant period.

 

 

 

Exchange Rate of R$ per US$

 

 

 

Low

 

High

 

Month Ended

 

 

 

 

 

December 31, 2004

 

2.6544

 

2.7867

 

January 31, 2005

 

2.6248

 

2.7222

 

February 28, 2005

 

2.5621

 

2.6320

 

March 31, 2005

 

2.6011

 

2.7621

 

April 30, 2005

 

2,5195

 

2,6598

 

May 31, 2005

 

2,3784

 

2,5146

 

 

Source:        Central Bank, PTAX.  PTAX is the average of the exchange rates negotiated in the commercial rate market on a given day.

 

We pay cash dividends and make other cash distributions with respect to the Class B Stock in reais.  Accordingly, exchange rate fluctuations may affect the U.S. dollar amounts received by holders of ADSs on conversion by the depositary of our ADSs, or the Depositary, of such distributions into U.S. dollars for payment to holders of ADSs.  For additional information, see “Item 10D. Exchange Controls.” For information on dividends, see “Item 8A. Consolidated Statements and Other Financial Information—Dividend Policy and Dividends.”

 

B.                                    Capitalization and Indebtedness

 

Not applicable.

 

C.                                    Reasons for the Offer and Use of Proceeds

 

Not applicable.

 

D.                                    Risk Factors

 

Risk Factors Relating to Brazil

 

Brazilian political and economic conditions have a direct impact on our business and the market price of our preferred shares and ADSs.

 

The Brazilian economy has been characterized by volatile economic cycles.  In addition, the Brazilian government frequently, and occasionally drastically, intervenes in the Brazilian economy.  The Brazilian government  has often changed monetary, taxation, credit, tariff and other policies to influence the course of Brazil’s economy.  For example, the Brazilian government has the authority, when a serious imbalance in Brazil’s balance of payments occurs, to impose restrictions on the remittance to foreign investors of the proceeds of their investments in Brazil, and on the

 

6



 

conversion of Brazilian currency into foreign currencies.  The Company’s business, financial condition and results of operations may be adversely affected by changes in policy including tariffs, exchange controls and other matters, as well as factors such as:

 

                  currency fluctuations,

 

                  inflation,

 

                  price instability,

 

                  interest rates,

 

                  tax policy, and

 

                  other political, diplomatic, social and economic developments in or affecting Brazil.

 

Rapid changes in Brazilian political and economic conditions that have already occurred and that might continue will require the Company’s continued emphasis on assessing the risks associated with its activities and adjusting its business and operating strategy.  Future developments in Brazilian government policies or in the Brazilian economy, over which the Company has no control, may reduce demand for the Company’s products in Brazil, and adversely affect the Company’s business, financial condition and results of operations.

 

At the end of 2002, Brazil elected a new president from the Workers’ Party, Luís Inácio Lula da Silva, known as Lula.  In the period leading up to and following his election, there was substantial uncertainty relating to the policies that the new government would pursue, including the potential implementation of macroeconomic policies that differed significantly from those of the prior administration. This initial uncertainty resulted in a loss of confidence in the Brazilian capital markets with a consequent significant devaluation of the real. Up to now, the new government has not departed in any material way from previous and responsible economic and monetary policies, which has caused a subsequent appreciation of the real.   Nevertheless, any substantial negative reaction to possible economic or monetary policy changes by the Brazilian government could adversely affect our business, operations and the market price of our preferred shares and ADSs.

 

Exchange rate instability may adversely affect our financial condition and results of operations and the market price of our preferred shares and ADSs.

 

Because a portion of our expenses and a significant portion of our assets and liabilities are denominated in reais and we have U.S. dollar-denominated revenues, debt and other liabilities, we may be adversely affected by foreign exchange rate volatility.    See “—Selected Financial Data—Exchange Rates.”

 

Our operating expenses are substantially denominated in reais and will generally decrease, as expressed in U.S. dollars, as a result of any devaluation of the real.  On the other hand, any appreciation of the real against the U.S .dollar will generally increase operating expenses as expressed in U.S.dollars. If the rate of Brazilian inflation increases more rapidly than the rate of appreciation of the U.S. dollar against the real, then our operating expenses may increase in U.S. dollar terms and, assuming constant U.S. dollar sales prices, our profit margins may decrease. As expressed in U.S. dollars s, any appreciation  of the real may produce exchange losses on unhedged debt denominated in reais. On the other hand, any devaluation of the real may produce exchange gains on unhedged debt denominated in reais.

 

In 2002, the depreciation of the real relative to the U.S. dollar totaled 52%, due in part to the continued economic and political uncertainties in emerging markets and the global economic slowdown.  In 2003, the appreciation of the Real relative to the U.S. dollar was 18.2%. In 2004, the depreciation of the Real relative to the U.S. dollar was 8.1%.  From January 1, 2005 through May 31, 2005, the Real appreciated 9.4%.

 

7



 

Devaluations of the real relative to the U.S. dollar also create additional inflationary pressures in Brazil that may negatively affect us.  They generally curtail access to foreign financial markets and may cause government intervention, including recessionary governmental policies.  See “—Inflation and certain governmental measures to combat inflation may contribute significantly to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets.”  Devaluations also reduce the U.S. dollar value of distributions and dividends on the ADSs.

 

Inflation and certain governmental measures to control inflation may contribute significantly to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets.

 

Brazil has historically experienced extremely high rates of inflation.  Inflation itself, as well as certain governmental measures to control inflation and market speculation about possible future measures, has in the past had significant negative effects on the Brazilian economy.  Our operating expenses are substantially denominated in reais and tend to increase in value with Brazilian inflation because our suppliers and providers generally increase prices to reflect the depreciation of the currency.  As expressed in U.S. dollars, however, these increases are typically offset at least in part by the effect of the appreciation of the U.S. dollar against the real.  If the rate of Brazilian inflation increases more rapidly than the rate of appreciation of the U.S. dollar,  our operating expenses expressed in U.S. dollars may also increase and, assuming constant U.S. dollar sales prices, our profit margins may decrease.  In addition, high inflation generally leads to higher domestic interest rates, and, as a result, our costs of real-denominated debt may increase.   See “Item 5. Operating and Financial Review and Prospects—Brazilian Economic Environment.”

 

We may be impacted by governmental actions affecting the Brazilian markets and economy.

 

The Brazilian government has exercised and continues to exercise substantial influence over many aspects of the private sector.  The Brazilian government owns or controls many companies, including some of the largest in Brazil.  For example, Banco Nacional de Desenvolvimento Econômico e Social – BNDES, which is owned by the Brazilian government, indirectly owned approximately 12.5% of our common stock as of December 31, 2004 and has, through a subsidiary, advanced approximately 17% of our total consolidated indebtedness as of such date.  See “Item 7B. Related Party Transactions.”

 

Developments in other emerging markets may adversely affect the market price of our preferred shares and ADSs.

 

The Brazilian securities markets are, to varying degrees, influenced by economic and market conditions in other emerging market countries.  Although economic conditions are different in each country, investors’ reaction to developments in one country can have an effect on the securities of issuers in other countries, including Brazil.  Developments or conditions in other emerging market countries have, at times, significantly affected the availability of credit in the Brazilian economy and resulted in considerable outflows of funds and declines in the amount of foreign currency invested in Brazil.

 

Developments in the international financial markets, in the future, may adversely affect the Company’s financial condition and its ability to raise capital when needed.  There can be no assurance that the Brazilian securities markets will not continue to be affected negatively by events elsewhere, especially in emerging markets, or that such events will not adversely affect the value of the Company’s preferred shares or ADS.

 

Risks Relating to our Preferred Shares and ADSs

 

Exchange controls and restrictions on remittances abroad may adversely affect holders of ADSs.

 

You may be adversely affected by the imposition of restrictions on the remittance to foreign investors of the proceeds of their investments in Brazil and the conversion of reais into foreign currencies.  The Brazilian government imposed remittance restrictions for a number of months in 1989 and early 1990.  These restrictions would hinder or prevent the conversion of dividends, distributions or the proceeds from any sale of our preferred shares into U.S. dollars and remitting the U.S. dollars abroad.  We cannot ensure that the Brazilian government will not take similar measures in the future.  See “Item 10D. Exchange Controls.”  Holders of the ADSs could be adversely affected by delays in, or a refusal to grant, any required Brazilian governmental approval for conversion of real payments and remittances abroad in

 

8



 

respect of the shares of Class B Stock underlying the ADSs.  In such case, the Depositary will hold the reais it cannot convert for the account of the ADS holders who have not been paid.

 

Exchanging ADSs for the underlying Class B Stock may have unfavorable consequences.

 

The Brazilian custodian for our Class B Stock, or the Custodian, must obtain an electronic certificate of registration from the Central Bank to remit U.S. dollars abroad for payments of dividends, any other cash distributions, or upon the disposition of the shares and sales proceeds related thereto.  If you decide to exchange your ADSs for the underlying Class B Stock, you will be entitled to continue to rely—for five business days from the date of the exchange—on the ADS Depositary’s electronic certificate of registration.  Thereafter, you may not be able to obtain and remit U.S. dollars abroad upon the disposition of the Class B Stock, or distributions relating to the Class B Stock, unless you obtain your own electronic certificate of registration pursuant to Resolution No. 2,689, of January 26, 2000, of the National Monetary Council, known as Resolution 2,689, which entitles foreign investors to buy and sell on the São Paulo stock exchange.  If you do not obtain a certificate of registration under Resolution 2,689, you may not be able to obtain and remit abroad U.S. dollars or other foreign currencies upon the disposition of Class B Stock or distributions with respect thereto, and you will generally be subject to less favorable tax treatment on gains with respect to the Class B Stock.  If you attempt to obtain your own electronic certificate of registration, you may incur expenses or suffer significant delays in the application process.  Obtaining an electronic certificate of registration involves generating significant documentation, including completing and filing various electronic forms with the Central Bank and the Comissão de Valores Mobiliários, or the CVM.  These expenses or delays could adversely impact your ability to remit dividends or distributions relating to the Class B Stock or the return of your capital outside of Brazil in a timely manner.  If you decide to exchange your Class B Stock back into ADSs once you have registered your investment in the Class B Stock, you may deposit your Class B Stock with the Custodian and rely on the Depositary’s certificate of registration, subject to certain conditions.  See “Item 10D. Exchange Controls.”  We cannot assure you that the Depositary’s certificate of registration or any certificate of foreign capital registration obtained by you may not be affected by future legislative or other regulatory changes, or that additional Brazilian restrictions applicable to you, the disposition of the underlying Class B Stock or the repatriation of the proceeds from disposition could not be imposed in the future.

 

The relative volatility and illiquidity of the Brazilian securities markets may adversely affect holders of ADSs.

 

Investments in securities, such as the Class B Stock or the ADSs, of issuers from emerging market countries including Brazil involve a higher degree of risk than investing in securities of issuers from more developed countries.

 

The Brazilian securities market is substantially smaller, less liquid, more concentrated and more volatile than major securities markets in the United States.  These features may substantially limit holders’ ability to sell the preferred shares underlying the ADSs at a price and time at which holders wish to do so.  The São Paulo Stock Exchange (Bolsa de Valores de São Paulo), or BOVESPA, the main Brazilian stock exchange, had a market capitalization of approximately US$341 billion as of December 31, 2004, and an average monthly trading volume of approximately US$419.7 million in 2004.  In comparison, the NYSE had a market capitalization of US$19.8 trillion as of December 31, 2004, and an average monthly trading volume of approximately US$46.1 billion for 2004.

 

There is also significantly greater concentration in the Brazilian securities market than in major securities markets in the United States.  The ten largest companies in terms of market capitalization represented approximately 47.5% of the aggregate market capitalization of BOVESPA as of December 31, 2004.  The top ten stocks in terms of trading volume accounted for approximately 45.3% of all shares traded on BOVESPA.

 

Because we are subject to specific rules and regulations as a Brazilian company, holders of our ADSs have fewer and less well defined shareholders’ rights than investors in U.S. companies.

 

Our corporate affairs are governed by our by-laws and the Brazilian corporate law, which differ from the legal principles that would apply if we were incorporated in a jurisdiction in the United States, such as Delaware or New York, or in certain other jurisdictions outside Brazil.  In addition, your rights or the rights of holders of the preferred shares

 

9



 

under the Brazilian corporate law to protect your interests relative to actions taken by our board of directors or the holders of common shares may be fewer and less well defined than under the laws of other jurisdictions outside Brazil.

 

Although Brazilian law imposes restrictions on insider trading and price manipulation, the Brazilian securities markets are not as highly regulated and supervised as the securities markets in the United States or certain other jurisdictions.  For example, certain provisions of the U.S. Sarbanes-Oxley Act of 2002 that apply to U.S. companies do not apply to us.  In addition, rules and policies against self-dealing and regarding the preservation of shareholder interests may be less well developed and enforced in Brazil than in the United States, potentially disadvantaging holders of our preferred shares and ADSs.  When compared to Delaware general corporation law, the Brazilian corporate law and practice have less detailed and less well established rules and judicial precedents relating to the review of management decisions under duty of care and duty of loyalty standards in the context of corporate restructurings, transactions with related parties and sale-of-business transactions.  In addition, shareholders must hold 5% of the outstanding share capital of a corporation to have the necessary standing to bring shareholders’ derivative suits.  Shareholders ordinarily do not have standing to bring a class action.

 

Also, in accordance with Brazilian corporate law and our by-laws, holders of our preferred shares, and therefore of our ADSs, are not entitled to vote at meetings of our shareholders except in limited circumstances.  See “Item 10B. Memorandum and Articles of Association.”

 

You may not be able to exercise preemptive rights.

 

You may not be able to exercise the preemptive rights relating to the Class B Stock underlying the ADSs  unless a registration statement under the Securities Act is effective with respect to those rights or an exemption from the registration requirements of the Securities Act is available.  We are not obligated to file a registration statement with respect to the shares relating to these preemptive rights, and we cannot assure investors that we will file any such registration statement.  Unless we file a registration statement or an exemption from registration applies, investors may receive only the net proceeds from the sale of their preemptive rights by the Depositary, or if the preemptive rights cannot be sold, they will be allowed to lapse.

 

We are incorporated under the laws of Brazil.  All of our directors and executive officers, and the experts named in this annual report, reside outside the U.S. Substantially all of our assets, and our directors’ and officers’ assets and such experts’ assets are located outside the U.S. As a result, it may not be possible for investors to effect service of process within the U.S. upon us or our directors, executive officers or such experts, or to enforce against them or us, judgments obtained in U.S. courts based upon the civil liability provisions of the federal securities laws of the U.S. In addition, we have been advised by our Brazilian counsel, that there is doubt that the courts of Brazil will enforce against us, our officers, directors and experts named herein, judgments obtained in the U.S. based upon the civil liability provisions of the federal securities laws of the U.S. or will enter judgments in original actions brought in Brazilian courts based upon the federal securities laws of the U.S.

 

Risk Factors Relating to Aracruz and the Pulp Industry

 

The market prices for our products are cyclical.

 

The prices we are able to obtain for our pulp depend on prevailing world prices for market pulp.  Worldwide pulp prices have historically been cyclical, subject to significant fluctuations over short periods of time, due to a number of factors, including:

 

                  worldwide demand for pulp products,

 

                  worldwide production capacity,

 

                  the strategies adopted by major pulp producers, and

 

10



 

                  the availability of substitutes for our products.

 

All of these factors are beyond our control.  After reaching a peak in the middle of 1995, market pulp prices continued to fall through the first quarter of 1999, due primarily to a significant drop in demand, although market prices began to increase beginning in the second quarter of 1999 and continued to increase through the second half of 1999 and early 2000.  In the second half of 2000, market prices of pulp were flat for the whole period.  Weak demand and excess inventories in the hands of pulp producers caused eucalyptus pulp list prices to fall at the end of March 2001.  Market conditions remained difficult through 2002, with Europe being the most challenging market.  In 2002 the average list price of BEKP in North America decreased 8% compared to the average list price in 2001; this was primarily due to the slowdown in the growth of the major economies which began in 2001 that continued to negatively impact the global demand for paper throughout 2002.  Global product availability was limited due to pulp production curtailments as a result of inventory adjustments, maintenance and bad weather conditions in the Northern Hemisphere. At the same time, pulp demand remained relatively stable in the majority of the markets, except in Asia and especially in China, where demand was above levels of the previous year. Consequently, global pulp inventories were driven down to below the historic level. In 2003, shipments of BEKP increased the most when compared to other grades. From January to November 2003, deliveries grew 14%, mainly to Asia and Western Europe. This compares with relatively flat shipments of northern hardwood and a 9% decline in southern hardwood. Over the course of the fourth quarter, an increase of approximately 300,000 tons in the aggregate stocks (5.5 million tons at the end of December) put pressure on pulp prices, resulting in a $10 – $20/ton erosion of list prices in December. In 2003 the average list price for BEKP was US$ 540/t. In 2004, shipments of BEKP grew by 11%. A more favorable economic situation, strong growth in demand for printing and writing paper, and the increase in the production of tissue paper were the main factors leading to this strong growth. In 2004, the average list price for BEKP (North America delivered) was US$ 559/t. Demand for BEKP continued strong through the first quarter of 2005 as expected, with shipments registering an increase of 7% until February 2005. This strong demand has permitted the implementation of price increase, the average list price for BEKP (North America delivered) in the first quarter of 2005 was US$ 595/t.

 

The Company has long term supply contracts with various customers and no assurance can be given that the prices for pulp or paper will stabilize or not decline further in the future, or that demand for the Company’s products will not decline in the future.  As a result, no assurance can be given that the Company will be able to operate its production facilities in a profitable manner in the future.  The Company’s results of operations would be materially adversely affected if the price of its product were to decline significantly.  See also “Item 4B. Business Overview—Market Overview.”

 

We face significant competition, which may adversely affect our market share.

 

The pulp industry is highly competitive.  In the international pulp markets, we compete with larger competitors that have greater financial strength, higher production capacities and access to cheaper sources of wood.

 

In addition, most markets are served by several suppliers, often from different countries.  Many factors influence our competitive position, including plant efficiencies and operating rates in relation to our competitors, and the availability, quality and cost of wood, energy, chemicals and labor.  To the extent that pulp from other hardwoods can be substituted for the more expensive bleached eucalyptus kraft market pulp, we also compete with producers in the broader segment of the pulp market.  Some of our competitors in this market have greater financial, marketing and other resources, larger customer bases and greater breadth of product offerings than we do.  If we are unable to remain competitive with these producers in the future, our market share may be adversely affected.  See “Item 4B. Business Overview—Competition.”

 

We may be adversely affected by the imposition and enforcement of more stringent environmental regulations that would require us to spend additional funds.

 

The Company is subject to stringent environmental laws and regulations in Brazil on the national, state and  local levels.  Changes in environmental laws and regulations or changes in the policy of enforcement of existing environmental laws and regulations could adversely affect it.  The Company’s operations are supervised by governmental agencies that are responsible for the implementation of pollution control laws and policies.  These agencies could take

 

11



 

action against the Company if it failed to comply with applicable environmental regulations.  These actions could include the imposition of fines and revocation of licenses and concessions.

 

Although changes in laws and regulations apply only prospectively under Brazilian law, it is possible that the relevant legislatures and/or governmental agencies will impose additional regulations or seek a more stringent interpretation of existing laws and regulations that would require the Company to spend additional funds on environmental matters or limit the Company’s ability to operate as it currently does.  In addition, such actions by such governmental bodies could impose additional costs to be borne by the Company when it renews existing licenses or applies for new ones.

 

Actions by federal or  state legislature may adversely affect our operations.

 

In September 2001, the legislature of the State of Espírito Santo, where we own approximately 167,800of forest and other land, passed a law temporarily restricting the plantation of eucalyptus forests for purposes of pulp production within the state.  In June 2002, this law was declared to be unconstitutional by a provisional decision of the Brazilian Federal Supreme Court, and injunctive relief was granted in response to suits brought by the National Confederation of Industry and by the National Brazilian Confederation of Agriculture and Cattle Raising.  The Company believes that such provisional decision will be upheld by the court’s definitive decision on the merits. However, there can be no assurance that such definitive decision will be favorable to the Company or that similar laws will not be enacted  that would impose a limitation or restriction on plantation of eucalyptus or that would affect our licenses or permits.

 

On March 13, 2002, the Espírito Santo legislative assembly created an investigating commission (Comissão Parlamentar de Inquérito) to investigate the legality of our permits and the acquisition of our properties from the date  we began our operations in Espírito Santo.  As the procedures in the investigation were not concluded within the prescribed time period for such a type of investigation, the commission was terminated without issuing a final report.  The Company is confident that it has obtained all necessary permits and that all our property was legally acquired strictly in accordance with all laws and regulations. However, we cannot be certain that a governmental entity will not initiate similar or other investigations in the future that would cause us to incur significant expense and divert management’s attention.

 

In May 2003 the Human Rights Commission of the Brazilian House of Representatives (“Câmara dos Deputados”) created a Working Group to discuss the alleged violation of economic, social, cultural and environmental rights in the eucalyptus plantations in the State of Espírito Santo. Among other issues, several complaints involving the Company were discussed. Representatives of the Company participated in a Public Hearing and presented to the Commission extensive reports, information, evidence, technical studies and governmental and judicial decisions that demonstrate that the complaints were unjustified. The Working Group was terminated without issuing a final report.  However, the Company cannot be certain that a governmental entity will not initiate similar or other investigations in the future that would cause the Company to incur significant expense and divert management’s attention.

 

If we are unable to manage potential problems and risks related to acquisitions and alliances, our business and growth prospects may suffer.  Some of our competitors may be better positioned to acquire other pulp and paper businesses.

 

                                          The Company, as part of its business strategy, recently made a major acquisition by purchasing Riocell and may acquire other businesses in Brazil or elsewhere. In addition, the Company has made a significant joint venture investment in Veracel and may enter into other similar arrangements or alliances with third parties.   Our management is unable to predict whether or when any prospective acquisitions or alliances will occur.  Our ability to continue to expand successfully through acquisitions or alliances depends on many factors, including the availability of businesses for sale.  Acquisitions and similar joint ventures or other arrangements have significant risks: we could fail to successfully integrate the operations, services and products of any acquired company;

 

                                          we could fail to select the best partners or fail to effectively plan and manage any alliance strategy;

 

                                          the acquisitions could increase our costs;

 

                                          our management’s attention could be diverted from other business concerns; and

 

12



 

                                          we could lose key employees of the acquired company.

 

Our failure to integrate any new businesses or manage our investment in Veracel or any new alliances successfully could adversely affect our business and financial performance. Furthermore, the world pulp industry is undergoing consolidation, and many companies compete for acquisition and alliance opportunities in our industry.  Some of our competitors have greater financial and other resources than we do. This may reduce the likelihood that we will be successful in completing acquisitions and alliances necessary for the expansion of our business or cause such acquisition or alliances to be possible only on less favorable terms. In addition, any major acquisition we consider may be subject to regulatory approval. We may not be successful in obtaining required regulatory approvals on a timely basis or at all.

 

We are controlled by a few shareholders.

 

Approximately 96.5% of our voting stock is owned by four principal shareholders, who have the ability to control the election of our board of directors and our direction and future operations, including decisions regarding acquisitions and other business opportunities, the declaration of dividends in excess of the requirements under our by-laws and Brazilian corporate law, and the issuance of additional shares and other securities.  See “Item 7A. Major Shareholders.”

 

Dependence on Few Customers

 

The Company’s marketing strategy is to develop long-term relationships with customers that will purchase the Company’s production year after year.  In 2004, the Company’s ten largest customers accounted for approximately  72% of its sales (by volume) and the two largest customers accounted for 44% of the Company’s sales (by volume). See “Market Overview — Markets and Customers”.  The Company believes that the loss of either of these customers would have a material adverse effect on the Company’s results of operations.

 

Various other risks could have a material adverse effect on our financial results.

 

Our operations are subject to various other risks that affect our forests and manufacturing processes, including fire, port closings, disease and factory explosions. To date, the Company’s experience with such hazards has not had a material adverse effect on the Company. However, in the future, such hazards could have a negative effect on the Company’s financial results.

 

ITEM 4.  INFORMATION ON ARACRUZ

 

A.                                    History and Development of Aracruz

 

We conduct our operations under our legal and commercial name, Aracruz Celulose S.A.  We are a corporation (sociedade anônima), with unlimited duration, organized under the laws of the Federative Republic of Brazil.  As a Brazilian corporation, we operate under the provisions of the Brazilian corporate law.  Our headquarters and main operating unit  are located at Rodovia Aracruz - Barra do Riacho, kilometer 25, Municipality of Aracruz, State of Espírito Santo, Brazil, and its telephone number is 55-27-3270-2122.  Our principal office is located at Rua Lauro Müller, 116, 40th floor, 22299-900 Rio de Janeiro, State of Rio de Janeiro, Brazil, and its telephone number is 55-21-3820-8111. Our management has recently decided to relocate our principal office to the city of São Paulo, State of  São Paulo. Such decision is under implementation and is expected to be concluded early in the second half of 2005. Our agent for service of process in the United States is CT Corporation, 111 Eighth Avenue, New York, NY 10011.  We maintain an Internet website at www.aracruz.com.br.  Information contained on our website is not part of this annual report.

 

Aracruz Florestal S.A., or AFSA, our predecessor, was incorporated in 1967, for an unlimited duration, to plant eucalyptus forests.  AFSA became a subsidiary of Aracruz in 1972 when Aracruz was incorporated, and on July 20, 1993, AFSA was merged into Aracruz.

 

We commenced pulp production operations in September 1978 , using a single production line (“Fiberline A”) with a nominal production capacity (i.e., the production capacity for which the mill was designed) of approximately 400,000 tons of pulp per year. In early 1991, we completed an expansion plan, known as the 1991 Expansion Project,

 

13



 

which added a second production line (“Fiberline B”). This increased the  nominal capacity  of the Barra do Riacho Unit to approximately 1,025,000 tons per year.  In 1994, we increased our effective production capacity to 1,070,000 tons through system upgrades and productivity gains. From October 1995 to December 1998, we implemented the Modernization Project, which increased the Barra do Riacho Unit  nominal capacity to 1,240,000 tons per year, as well as our production efficiency.

 

We own 51% of Portocel Terminal Especializado de Barra do Riacho S.A., the company that operates the port terminal of Barra do Riacho, since January 1985. The remaining 49% of Portocel is owned by Cenibra, another pulp manufacturer and one of our competitors. From the privatization of the port terminal in 1985 until 2005 Portocel increased its storage capacity from 45,000 to 150,000 tons.

 

In 1997 we acquired all ownership interests of Gutchess International Inc. in Tecflor Industrial S.A. (currently known as Aracruz Produtos de Madeira S.A., or APM), a joint venture between Gutchess International Inc. and we created in 1997 for the production of solid wood products. In October 2004 we sold two thirds of our shares in APM to Weyerhaeuser do Brasil Participações Ltda., a subsidiary of Weyerhaeuser Corporation. APM’s domestic sales policy remained unaltered and its overseas sales  continued to be Weyerhaeuser’s responsibility. We currently own one third of the shares of  APM.   See “—Business Overview—Aracruz Produtos de Madeira.

 

In June 2000, our board of directors approved another expansion of the nominal production capacity of the Barra do Riacho Unit  by 700,000 tons per year, known as the Fiberline C Expansion Project. The Fiberline C Expansion Project involved the addition of a new pulp line and certain other modifications to existing equipment at the Unit in order to further improve our cost-effectiveness. Construction began in the second semester of 2000, and the plant began operations at the end of May 2002, reaching full capacity in 2003. See “—Business Overview—Fiberline C Expansion Project.” The production volume resulting from the Fiberline C Expansion Project required an increase in the Company’s forest base of approximately 65,200 hectares of eucalyptus plantations. To meet this demand, in June 2000, the Company acquired Terra Plana, with assets comprised of 19,000 hectares of land appropriate for planting eucalyptus trees. From July 2000 through December 31, 2001, the Company acquired approximately 44,000 additional hectares of land in a number of separate transactions. Additionally, in September 2002, Bahia Sul and the Company signed, jointly with Companhia Vale do Rio Doce and its wholly owned subsidiary, Florestas Rio Doce S/A, a contract for the acquisition of equal stakes by Bahia Sul and the Company of forest assets comprising approximately 40,000 hectares of lands and eucalyptus-planted forests. The Company also entered into a three-year wood supply contract for with Veracel to provide a total of up to 3.85 million cubic meters wood for the Fiberline C Expansion Project until the new plantations reach maturity for harvesting. This contract terminated in the first half of 2004. During 2004, we were able to meet approximately 62% of our wood fiber requirements from our own eucalyptus forests. In 2005 we expect to meet approximately 84% of our wood requirements from our own eucalyptus forests.

 

 On October 10, 2000, we acquired a 45% stake in Veracel, a joint venture to grow eucalyptus trees on plantations and to build a pulp mill. On January 31, 2003, the Company acquired an additional 5% stake in Veracel, bringing its total stake to 50%. The remaining 50% interest in Veracel is owned by Stora Enso OYJ (“Stora Enso”).  Veracel grows eucalyptus on plantations in the State of Bahia, which has diversified the sources of the Company’s supply of wood for the Barra do Riacho Unit. This equity investment in Veracel achieved two objectives:  (i) a guaranteed supply of wood for the Fiberline C Expansion Project during the first three years of the new production unit’s operation and (ii) the opportunity to expand the Company’s business in the future from an operational base in Bahia that can potentially replicate its accomplishments in the State of Espírito Santo.  In May 2003, the Company and its joint venture partner decided to invest an additional US$940 million in Veracel to build a 900,000-ton capacity mill (the “Veracel Mill”) for the production of BEKP in the State of Bahia. Construction of the Veracel Mill was started at the beginning of the second half of 2003, and the  mill start up was in  May 2005. As of  March 31, 2005, a total of US$824 million had been committed to the project.

 

The Veracel pulp mill, from the cornerstone to the start-up at the beginning of May 2005, took 22 months to be completed. The mill has a nominal production capacity of 900,000 tons per year of bleached eucalyptus pulp. The output of the new plant will be sold in its entirety to the controlling shareholders, in the same proportion as their shareholdings (50% each). Production in 2005 is forecasted at 360,000 tons of pulp, half of it (180,000 tons) going to the Company. Of this amount, the Company expects to sell about 130,000 tons in 2005, with the balance being used to build inventory. In

 

14



 

2006, with the initial learning phase completed, the plant should attain full capacity. Transportation of the pulp from the Belmonte terminal in Bahia to the Portocel port terminal, in the state of Espírito Santo, a distance of approximately 450 km, will be carried out using sea-barges

 

The Veracel mill is expected to have the world’s lowest production cost for bleached eucalyptus market pulp, due to its modern equipment, low average forestry operations radius (50 km) and high forest productivity, and will be one of the largest single-line pulp production facilities of its type in the world. The project makes use of modern equipment, control systems and processes to preserve the quality of the environment.

 

Because of its location - distant from large urban centers - Veracel’s mill will contribute to the creation of jobs and income in a region where there are currently few opportunities. During the construction phase of the project, up to 12,000 direct and indirect jobs were generated. See “—Business Overview—Acquisition of Veracel” and Note 4 to the consolidated financial statements.

 

On May 30, 2003, the Company acquired all of the capital stock of Riocell S.A. (“Riocell”), a major producer of BEKP, from Klabin S.A. for an adjusted purchase price of US$567 million. Riocell owned and operated a mill (the “Riocell Mill”) with a capacity of approximately 400,000 tons per annum and owned approximately 40,000 hectares of eucalyptus plantations. On January 7, 2004, Riocell was merged into the Company and the Riocell Mill and related forestry assets are now operated as the Company’s Guaíba Unit.  See “ Business — Guaíba Unit”.

 

Capital Expenditures

 

The Company’s capital expenditures for 2004, 2003 and 2002 were US$94.5 million, US$118.7 million and US$260.7 million, respectively.

 

The table below sets forth a breakdown of our most significant capital expenditures for the periods indicated:

 

 

 

For the years ended December 31,

 

 

 

2004

 

2003

 

2002

 

 

 

(in US$ millions)

 

Fiberline C Expansion Project

 

 

US$

55.8

 

US$

185.3

 

Siviculture and other forestry investments

 

US$

52.7

 

41.4

 

39.5

 

Forests (includes land purchase)

 

15.4

 

10.1

 

15.4

 

Improvements/industrial investments

 

20.9

 

3.2

 

9.4

 

Other

 

5.5

 

8.2

 

10.8

 

Total

 

US$

94.5

 

US$

118.7

 

US$

260.7

 

 

The US$160.8 million decrease in capital expenditures in 2002 compared to 2001 were primarily due to investments in the Fiberline C Expansion Project.

 

During the year 2003, we invested approximately US$118.7 million, of which US$55.8 million was devoted to the Fiberline C Expansion Project, US$3.2 million was devoted to ongoing industrial investments, US$51.5 million was devoted to silviculture and other forestry investments and US$8.2 million was devoted to other projects.

 

During the year 2004, we invested approximately US$94.5 million, of which US$68.1 million was devoted to silviculture and other forestry investments, US$17.9 million was devoted to ongoing industrial investments, US$3.0 million was devoted to Guaíba Unit optimization and US$5.5 million was devoted to other projects.

 

During 2005, the Company expects to invest approximately  US$132 million relates to industrial, forestry and other investments. Funding for these investments will derive mostly from the Company’s own cash generation.

 

15



 

B.                                    Business Overview

 

General

 

We are the world’s largest producer of bleached hardwood kraft market pulp. We produce eucalyptus pulp, which is a high-quality variety of hardwood pulp used by paper manufacturers to produce a wide range of products, including premium tissue, printing and writing papers, liquid packaging board and specialty papers. Eucalyptus pulp’s distinguishing characteristics are its softness, opacity, porosity, and suitability for printing. “Market pulp” is the pulp sold to producers of paper products, as opposed to pulp produced by an integrated paper producer, for use in paper production facilities. “Kraft” pulp is pulp produced in a chemical process using sulphate.

 

During 2004, we produced approximately 2,497,000 tons of BEKP, a 11% increase from 2003 when we had produced approximately 2,250,000 tons of BEKP, which was a 36% increase as compared to 2002 when it had produced approximately 1,656,000 tons of bleached eucalyptus pulp. Pulp sales for 2004 were approximately 2,450,000 tons, a 14% increase as compared to 2,149,000 in 2003, which had represented a 36% increase when compared to 2002 pulp sales of 1,585,000 tons. Export pulp sales in both the years 2003 and 2004 were approximately 98% of total sales.  See “—Markets and Customers” and “—Competition.”

 

From 1979 to 2004 the Aracruz’s pulp production volume had a compound annual growth rate of 9.1% p.a., and the Company expects to reach  in 2006 a total pulp production volume of  3,060,000 tons (including 50% of Veracel pulp production volume).

 

Our production facilities at Barra do Riacho unit consist of a eucalyptus pulp mill which has three production lines (Fiberlines A, B and C). The Fiberlines A and B have each two bleaching, drying and a total of five baling lines for both Fiberlines. The Fiberline C which began production in May 2002 has one bleaching  line, one drying line and  three baling lines.  We also have a pulp mill in our Guaíba Unit which has a single production unit with one bleaching line, one drying line and one baling lines. The Guaiba Unit industrial facilities are currently being upgraded with the purpose of increasing its production capacity. See “Business Overview - Guaiba Unit”.

 

We own approximately 414,600  hectares of forest and other land in the States of Espírito Santo, Bahia, Minas Gerais and Rio Grande do Sul, of which over 252,400 hectares are planted with eucalyptus forests. The Barra do Riacho Unit is located approximately 1.5 kilometers from the port facilities at Barra do Riacho, of which 51% are owned by us.  The Guaiba Unit is located approximately 160 nautical miles from the Rio Grande port and the pulp is transported from the mill thereto by barge through the lake Lagoa dos Patos. See “—History and Development of Aracruz” above.

 

We believe that we are one of the lowest-cost producers of bleached kraft market pulp in the world. Our low production costs relative to some of our competitors are due to a number of factors, including:

 

                  economies of scale,

 

                  advanced forestry techniques in managing the planting processes,

 

                  the comparatively short harvest cycle of our trees, and

 

                  lower energy and chemical costs.

 

During 2004, we were able to meet almost approximately 62% of our wood fiber requirements from our own eucalyptus forests.  Climate and soil conditions in Brazil enable us to harvest our eucalyptus trees in only seven years after plantation, while harvest cycles for other types of hardwood trees in the southern United States, Canada and Scandinavia can range from 25 to 70 years.  Harvest cycles for our principal non-Brazilian competitors in the eucalyptus pulp market, which are located in Spain, Portugal and Chile, are approximately eight to ten years.  See “—Raw Materials—Wood” and “—Competition.”  We internally produce approximately 97% of our electrical energy requirements, mainly from by-products of our pulp production process, and recycle the greater part of the chemicals used at the Units.  See “—Raw Materials—Energy.”

 

16



 

Business Strategy

 

The key elements of our mission statement are:

 

                  Leveraging our competence in renewable forestry uses,

 

                  Developing products that add value for our customers,

 

                  Creating development opportunities for our employees, and

 

                  Observing the principles of sustainable development.

 

In 2004, the Company made progress in the implementation of its strategy of combining sustainable growth with continuous efforts to boost operational excellence. Our strategic objective is to substantially increase Aracruz’s share of the global hardwood pulp market over the coming years and to continue to be one of the lowest cost producers in the sector, adding value for shareholders and other stakeholders.

 

The following ongoing projects implement our business strategy:

 

                  Economies of scale resulting from new capacity increases. Following the Modernization of Fiberlines A and  B, and the Excellence Project, both carried out in 1998, which improved Aracruz’s operational efficiency and enabled the Company to reduce costs, and the Fiberline C Expansion Project, which in the middle of 2002 increased our nominal production capacity to over 2,000,000 tons per year, Aracruz continued to deliver growth through the acquisition from Klabin S.A., in 2003, of Riocell , with its nominal production capacity of  approximately 400,000 tons of bleached eucalyptus market pulp and 40,000 tons of printing and writing paper, and through the Veracel project, a pulp mill for the production of bleached eucalyptus kraft market pulp in Eunápolis, in the state of Bahia, with a nominal capacity of 900,000 tons per year, which started up in May 2005.Those Projects rely on our technology advances and benefits from our existing overhead and management structure, which has absorbed the new activity  without significant additional fixed costs. These enhancements will enable us to reduce pulp costs and improve quality levels in the new production unit. “

 

                  Improvements in forestry technology using advanced genetic techniques, which will result in an increase in the forest yield. As a result of the ongoing forest improvement program, we planted new eucalyptus clones in 2004 that display greater pulp potential productivity per hectare as well as wood quality that is better suited to the requirements of our customers. The performance of these clones was monitored throughout the year and those presenting the best adaptation to Aracruz’s environmental conditions will be used on a large scale as of 2005. We made progress in forest sustainability, especially regarding the most effective use of water and nutrients, soil conservation and maintenance of biodiversity

 

                  Optimization of transportation logistics.  Transportation of wood to the mills comprises a large portion of the cost of our pulp production. Improve in transportation logistics and costs are a priority for the Company.  At the end of 2002, we improved the logistics of our rail transportation. We also launched our Multimodal Transportation Systems—Maritime and Rail—, the main objective of which is to enhance logistics and further integrate our Mill-Port-Forest system. In 2004, coastal shipping delivered 13% of the total wood consumed at the Barra do Riacho Unit. With the entry into service of another tug and barge next year, the annual shipping capacity is expected to reach 3.4 million tons, representing 42% of total wood transportation. Each barge has a wood-carrying capacity of 5,000 tons. As well as optimizing transport costs, their use eliminated some 40,000 truck journeys along the BR 101 highway in 2004, reducing traffic on the road and cutting emissions of greenhouse gases as a result of lower fossil fuel consumption

 

                  Improve business process management with state-of-the-art information technology in order to improve efficiency and reduce costs. We use mySAP.com(R) platform supplied by SAP to control, simplify and integrate our business process within all our sites and also to implement connectivity with our customers

 

17



 

and suppliers. We are currently making improvements in all our applicable systems in order to comply  with Sarbanes-Oxley demands.

 

                  Increase of competitiveness.  The competitiveness of our business operations, combined with our significant cash generation capabilities, has led us to evaluate from time to time various future strategic alternatives, including further increase of current pulp operations either through acquisitions or expansion of existing capacity, and/or further acquisitions of additional forests.

 

Fiberline C Expansion Project

 

The Fiberline C, our third pulp operational unit, began operations at the end of May 2002, after being completed in 17 months (two months ahead of schedule) at a lower cost than originally budgeted.

 

With nominal capacity of 700,000 tons per year as of December 31, 2003, the cost of the new line was US$477 million (net of ICMS tax). The volume of production during year 2004 by the Fiberline C totaled 780,000 tons, an increase of  11% over nominal capacity. In January 2005, the facility reached a monthly production record of 72,078 tons.

 

The new production volume resulting from the Fiberline C Expansion Project required an increase in our forest base of approximately 65,200 hectares of eucalyptus plantations, which were acquired between June 2000 and December 2004 through separate transactions. Additionally, in September 2002, Bahia Sul and we signed, jointly with Companhia Vale do Rio Doce and its wholly owned subsidiary, Florestas Rio Doce S/A, a contract for the acquisition of equal stakes by Bahia Sul and us of  forestry assets comprising approximately 40,000 hectares of gross lands that include around 28,000 hectares of eucalyptus-planted forests.

 

In order to meet the expected increase in production arising from the Fiberline C Expansion Project, we built a port facility in Caravelas, State of Bahia, and expanded our port facility in Barra do Riacho, State of Espírito Santo.

 

Acquisition of Veracel

 

On October 10, 2000, we entered into two stock purchase and sale agreements pursuant to which we acquired a 45% stake in Veracel, a joint venture between Stora Enso OYJ and Odebrecht to grow and manage eucalyptus plantations and to build a pulp mill. One agreement, for the amount of approximately US$72 million, was entered between the Company and Odebrecht for the acquisition of 40% of the total outstanding capital stock of Veracel. The other agreement, for the amount of approximately US$9 million, was entered between the Company and Stora Enso Treasury Amsterdam B.V. for the acquisition of an additional 5% of the total outstanding capital stock of Veracel. On January 31, 2003, Odebrecht sold its 10% stake in Veracel to Stora Enso OYJ and us. We acquired shares representing 5% of the total outstanding capital stock of Veracel for US$9.7 million, resulting in 50% stake for each shareholder. This equity investment in Veracel achieved two objectives: (i) a guaranteed supply of wood for the Fiberline C Expansion Project during the first three years of the new production unit’s operation and (ii) the opportunity to grow our business in the future from an operational base in Bahia that can potentially replicate our accomplishments in the State of Espírito Santo.

 

Under both stock purchase and sale agreements, we have agreed to indemnify the relevant counterparty for certain liabilities and/or damages which such counterparty may incur as a result of a breach by us of the representations and warranties or a default by us under a covenant under those agreements.

 

In May 2003, Stora Enso and we approved the construction of Veracel’s pulp mill for the production of  BEKP in Eunápolis, in the State of Bahia. The mill will have a nominal capacity of 900,000 tons per year, and the overall investment is budgeted at US$1.24 billion Veracel will be one of the largest and most advanced single-line pulp mill in the world.

 

The Veracel Project has obtained commitments for long-term direct funding from development banks in the amount of approximately US$650 million, being US$500 million from BNDES and US$150 million from the European Investment Bank (EIB) and the Nordic Investment Bank (NIB).  The funding of the Veracel Project is expected to consist of 50% equity and 50% loans from Brazilian and international development agencies. The Company is a several guarantor

 

18



 

of 50% of the indebtedness incurred by Veracel, including indebtedness in connection with the financing of the Veracel Project. Stora Enso is a several guarantor of the other 50% of such indebtedness. At December 31, 2004 the outstanding amount of such indebtedness guaranteed by the Company was approximately US$251.6  million.

 

The construction of the mill was started at the beginning of the second half of 2003, and the operational start-up was  in May 2005.  The project was carried out under an EPC (Engineering, Procurement and Construction) concept and requires the prior implementation of a qualification program to enable the local workforce to take part in the construction of the pulp mill. The equipment and services necessary for the project were  contracted mostly from Brazilian suppliers.

 

In connection with the acquisition of the 45% equity participation in Veracel, on October 10, 2000, we, Stora Enso and Odebrecht, together known as the Veracel Shareholders, and Veracel entered into a shareholders’ agreement, or the Original Veracel Shareholders’ Agreement, which sets forth, among other things, certain agreements among the parties with respect to the management and operation of Veracel and the transfer of the common shares of Veracel.  The Original Veracel Shareholders’ Agreement has a term of 20 years from its date and can be automatically extended for successive 20-year terms thereafter unless notice is given by any party to the Original Veracel Shareholders’ Agreement. The Original Veracel Shareholders’ Agreement will terminate automatically if the ownership by any of the Veracel Shareholders of common shares of Veracel exceeds 50%. The Original Veracel Shareholders’ Agreement provides that Veracel will at all times during its term have a board of directors comprised of five members, of which (i) two will be elected from individuals appointed by Stora Enso, (ii) two will be elected from individuals appointed by us and (iii) one will be elected from individuals appointed by Odebrecht. The directors elected by us (acting jointly) and the directors elected by Stora Enso (acting jointly) will each have the right, without any action by any other directors, to request the removal of any incumbent officer of Veracel.  The Original Veracel Shareholders’ Agreement also provides that neither we nor Stora Enso may transfer (which includes the creation of liens) any of their respective common shares of Veracel other than (i) prior to the decision to build Veracel’s pulp mill, or the Implementation Decision, and (ii) if the Implementation Decision is made, after the second anniversary of the start-up of Veracel’s pulp mill. We each have a right of first refusal if the other party wishes to transfer all of its common shares of Veracel before the Implementation Decision.  Under the Original Veracel Shareholders’ Agreement, Odebrecht may not transfer any of its common shares of Veracel other than (i) on or prior to December 31, 2002, if there has been no Implementation Decision, (ii) following the Implementation Decision, (iii) after the start-up date of Veracel’s pulp mill (if it is built) or (iv) after the second anniversary of the start-up of Veracel’s pulp mill (if it is built), provided that, in the case of the conditions described in (i), (ii) and (iii), Odebrecht will have the right to transfer all of its common shares of Veracel to the other shareholders of Veracel, for different prices, in accordance with the terms set forth in the Veracel Shareholders’ Agreement.  Any of the Veracel Shareholders may transfer its common shares of Veracel to an affiliate, subject to certain limitations, or with the prior written consent of each of the other Veracel Shareholders. The Original Veracel Shareholders’ Agreement also requires that each person or entity who acquires shares of Veracel pursuant to the provisions thereof become a party to such agreement. The Original Veracel Shareholders’ Agreement provides that, under certain circumstances, the Veracel Shareholders may be required to make capital contributions to Veracel, on a pro rata basis. The Original Veracel Shareholders’ Agreement also provides that we, so long as neither we nor any of our subsidiaries is a shareholder of Veracel, shall not acquire (or caused to be acquired) any interest in real property in Veracel. The same covenant applies to Veracel with respect to real property in our core area.

 

In connection with the further acquisition by us and by Stora Enso, on equal basis, of the stake then held by Odebrecht in Veracel on January 31, 2003 and as a consequence of the Implementation Decision adopted by the remaining shareholders, the Original Veracel Shareholders’ Agreement was amended. According to the amended agreement, or the Veracel Shareholders’ Agreement, the board of directors of Veracel is to be comprised of four members, of whom two will be elected from individuals appointed by Stora Enso, and  two will be elected from individuals appointed by us. The Original Veracel Shareholders’ Agreement provides that if any of the shareholders, known as the Defaulting Shareholder, fails to comply with any of its obligations regarding Veracel’s funding needs in connection with the business plan, the Investment Plan and Capital Contributions, the other shareholder (the Calling Shareholder) shall have the right to require the Defaulting Shareholder to transfer all (but not less than all) of its shares to the Calling Shareholder at a discounted market value calculated according to the provisions of the Original Veracel Shareholders’ Agreement. The Original Veracel Shareholders’ Agreement governs the management and operation of Veracel.

 

19



 

Guaíba Unit

 

On June 30, 2003 the Company announced that it had acquired Riocell S.A. (“Riocell”) from Klabin S.A., which operated the Riocell Mill situated in Guaíba, Rio Grande do Sul, in the south of Brazil, for an adjusted purchase price of US$567 million. As a consequence, Riocell was included in the Financial Information of the Company at and for the year ended December 31, 2003 included herein. On January 7, 2004, Riocell was merged into the Company  and is now operated as the Guaíba Unit of the Company.

 

The nominal production capacity of the Guaíba Unit is approximately 400,000 tons of BEKP and 40,000 tons of printing and writing paper, equipped with advanced environmental protection resources. The Guaíba Unit has approximately 65,787  hectares of forest and other land and 8,287  hectares of plantations are kept in association with third parties. The average distance of the wood supply to the mill is approximately 85 kilometers.

 

The Guaíba unit is now fully integrated into Aracruz: human resources, information technology, systems and processes. Several synergies were obtained mainly in logistics, sales and operations.

 

During the second half of 2004, the project to upgrade the Guaíba Unit’s industrial facilities was approved involving an investment of US$34 million. The project will improve product quality, reduce costs and increase production by 30.000 tons per year.

 

Aracruz Produtos de Madeira

 

As part of our earlier strategy of diversification into other forest product businesses, we established a joint venture with the Gutchess International group of the United States in 1997 to create a new company, Tecflor Industrial S.A., for the production of solid wood products.  In 1998, we acquired all ownership interests of Gutchess International Inc. in Tecflor Industrial S.A., now called Aracruz Produtos de Madeira S.A., or APM, which then became our wholly owned subsidiary.  APM’s high-tech hardwood lumber sawmill, which is located in the State of Bahia, was commissioned in the first quarter of 1999 and started sales during the third quarter of 1999.  APM manufactures and markets Lyptus®, a new  concept renewable, high-grade hardwood lumber produced using eucalyptus trees, computer-optimized sawing technology and advanced drying and finishing processes.  The sawmill has a nominal production capacity of 44,000 cubic meters per year.  As of April 30, 2005, APM had nominated 11 sales representatives in major furniture markets in Brazil and was supplying an industrial customer base of nearly 150 manufacturers.

 

Having consolidated the production process and trained its workforce during the preceding two years, in 2001 APM sought to expand the presence of its Lyptus® brand of high-quality sawn wood in domestic and international markets while ensuring that its quality standards were maintained. In 2001, APM established a commercial partnership with the U.S.-based Weyerhaeuser Co., or Weyco, one of the largest forestry companies in the world, for the exclusive distribution of Lyptus® in the North American markets.  This new partnership arrangement gave APM access to over 70 Weyco points of sale in the U.S. and Canada, increasing the presence of Lyptus® in one of the largest markets in the world for high-quality hardwood.  The first shipments to Weyco took place in the months of May and August 2001.  We have expanded the 2001 agreement with Weyco of the U.S. to extend sales of Lyptus® to the European and Asian markets, thus assuring the presence of the product in over 100 points of distribution in those regions.

 

The initial impact of this agreement was to increase Lyptus® sawn wood exports from 4.2% in 2001 to 10.6% in 2002, in addition to  47,223m2 of Lyptus® flooring.  In 2002 and 2003, 15% and 23,5%, respectively, of total production was exported. In 2004, 30% of total production was exported, and export sales accounted for 61% of the revenues  of APM.

 

Consistent with the strategies set forth above, in October 2004 we sold two thirds of our shares in APM to Weyerhaeuser do Brasil Participações Ltda., a subsidiary of Weyco, for a total purchase price of US$ 18,6 million. We currently own one third of the shares of  APM and have certain voting rights as set forth in APM Shareholders’ Agreement.

 

20



 

The Board of Directors of APM approved in February 2004 a 5 year business plan, which comprises the expansion of the sawmill nominal production capacity to 95,000 cubic meters per year and investments in the amount of up to US$ 10,3 million, of which US$ 1,35 million have been committed for 2005.

 

Market Overview

 

General

 

Wood pulp is the principal raw material used in manufacturing paper and paperboard.  Whether or not a specific type of wood pulp is suitable for a particular end-use depends on the type of wood used to make the pulp, as well as the process used to transform the wood into pulp.  Hardwood pulp is produced using hardwood trees, such as oak, eucalyptus, aspen, birch and acacia trees.  Hardwood pulp has short fibers and is generally better suited for manufacturing coated and uncoated printing and writing papers, tissue and specialty papers.  Softwood pulp is produced using softwood trees, such as pines.  It has long fibers and is generally used to add strength to the paper.  We do not produce softwood pulp.

 

The pulp manufacturing process also can determine a pulp’s suitability for particular end-uses.  Chemical pulp refers to pulp made using chemical processes to dissolve the lignin and other organic materials holding the wood fibers together.  Among the various chemical processes, the most common is the “kraft” process, which is used by us to produce our pulp.  The kraft process helps to maintain the inherent strength of the wood fibers and thus produces a pulp especially well suited for manufacturing printing and writing papers, specialty papers and tissue papers.  Pulp producers may sell their pulp in the worldwide market or use it internally to manufacture various types of papers.

 

Bleached pulp is used for a variety of purposes, including printing and writing papers, specialty papers and tissues.  Unbleached pulp, which is brown in color, is used in the production of wrapping papers, corrugated containers and other paper and cardboard transportation materials.

 

As a result of the variety of wood types and processes used to produce pulp, which have evolved significantly over time, the pulp market has become increasingly specialized in terms of technical characteristics.  Many of the physical and chemical properties most valued by printing and writing paper manufacturers and other bleached pulp consumers, such as opacity and brightness, are exhibited by hardwood and, particularly, eucalyptus pulp.  In addition, the increasing specialization of paper manufacturers has resulted in many such manufacturers developing their own customized mix of pulp inputs, also known as furnish, for use in their paper manufacturing.  Furthermore, as more paper manufacturers have come to appreciate the technical characteristics of hardwood pulp and to rely on a significant hardwood pulp component in their furnish, the market for hardwood pulp has grown more rapidly than the market for softwood pulp.  Within the hardwood segment, bleached eucalyptus kraft market pulp has demonstrated the highest annual rate of growth in demand from 1994 to 2004. Over the same ten-year period, the annual rate of growth in demand for bleached eucalyptus pulp was estimated at 6.9%, while the annual rate of growth in demand for hardwood pulp during the same period was estimated at 4.6% and the market for softwood for the same period was estimated at a 2.5% annual rate.

 

Eucalyptus is only one of many types of hardwood used to make pulp.  Eucalyptus trees generally grow straight and have few branches.  This allows for dense growth, easy harvesting and less need for pruning.  Since 1980, eucalyptus kraft market pulp has steadily increased as a percentage of the total worldwide production of bleached hardwood kraft market pulp (from 29% in 1980 to approximately 44% in 2004) primarily due to its high quality, and because of properties, such as its softness, opacity and printability.

 

International Markets

 

From 1992 to 2004, the worldwide production capacity of bleached hardwood kraft market pulp is estimated to have grown an average of approximately 4.3% per year, from 13.2 million tons to 22 million tons.  The start-up of new or expanded production facilities has increased the total worldwide capacity for bleached hardwood kraft market pulp by approximately 3.9 million tons from 2000 to 2004.  Worldwide demand for bleached hardwood kraft market pulp is strongly influenced by the demand for paper and board products, which correlates to world GDP growth.  Demand for bleached hardwood kraft market pulp has grown in recent years, increasing from 11.5 million tons in 1992 to 20.8 million tons in 2004.  Consumption of market pulp is concentrated mainly in Europe, North America and Asia.  In 2001, demand

 

21



 

for bleached hardwood kraft market pulp amounted to approximately 7.1 million tons in Europe, 2.6 million tons in North America and 6.4 million tons in Asia, 42%, 16% and 38%, respectively, of the world’s total demand.  In 2002, demand for bleached hardwood kraft market pulp amounted to approximately 7.9 million tons in Europe, 2.8 million tons in North America and 6.6 million tons in Asia, 44%, 15% and 36%, respectively, of the world’s total demand. In 2003, demand for bleached hardwood kraft market pulp amounted to approximately 8.4 million tons in Europe, 2.7 million tons in North America and 7.5 million tons in Asia, 43%, 14% and 39%, respectively, of the world’s total demand.  In 2004, demand for bleached hardwood kraft market pulp amounted to approximately 9 million tons in Europe, 2.7 million tons in North America and 8 million tons in Asia, 43%, 13% and 40%, respectively, of the world’s total demand.   In 2001, we supplied approximately 475,000 tons or 7% of the total European demand, approximately 480,000 tons or 18% of the total North American demand, and approximately 306,000 tons, or 5%, of the total Asian demand.  In 2002, we supplied approximately 637,000 tons, or 8%, of the total European demand, approximately 623,000 tons or 23% of the total North American demand, and approximately 280,000 tons, or 4%, of the total Asian demand. In 2003, we supplied approximately 765,000 tons or 9% of the total European demand, approximately 690,000 tons or 26% of the total North American demand, and approximately 470,000 tons or 7% of the total Asian demand. In 2004, we supplied approximately 1,004,000 tons or 11% of the total European demand, approximately 833,000 tons or 30% of the total North American demand, and approximately 540,000 tons or 7% of the total Asian demand.

 

The market pulp industry is highly competitive and is also sensitive to changes in industry capacity, producer inventories and cyclical changes in the world’s economies, all of which may significantly affect pulp prices and thereby our profitability.  The price of pulp generally increases as economies expand around the world.  Strong demand during most of the 1980s caused the market price per ton of bleached eucalyptus kraft market pulp delivered in the United States by us to peak in 1989 at US$775 per ton.  A global recessionary environment and a substantial increase in worldwide pulp supply during the early 1990s led to a sharp decline in the prices of market pulp, reaching US$410 per ton in December l993, the lowest price level since 1983.  Prices began to increase in the second quarter of 1999 through the second half of 1999.  In 1999, the average price per ton of bleached eucalyptus kraft market pulp delivered in the United States was US$522, an increase of approximately 1.3% as compared to 1998.  In 2000, prices continued increasing during the first half of the year, led mainly by the strong demand in Europe.

 

However, in the second half of 2000, prices remained stable.  The average  price per ton of bleached eucalyptus kraft market pulp delivered in the United States was US$665, an increase of approximately 27% as compared to 1999.

 

While the Company’s volume of pulp sales during 2002 was higher than in 2001 or 2000, the price of pulp declined throughout 2002.  The Company’s average list price decreased 8.2% in 2002 compared with the average in 2001, primarily due to the slowdown in the growth of the major economies, which began in 2001 and continued to negatively impact the global demand for paper throughout 2002.

 

The high level of the world pulp inventories witnessed at the beginning of the year caused prices to fall to their lowest levels by the end of the first quarter of 2002. From then on, the recovery in demand, coupled with expectations of renewed growth in the world economy during the second half of 2002 and underpinned by improved control over supply, prompted consecutive increases in the price of eucalyptus pulp, which reached US$510 per ton delivered to the United States in the third quarter of 2002.

 

Despite the satisfactory performance of the main consumer markets, high quality tissue and printing and writing papers, the price of pulp still was depressed throughout 2003.

 

In the beginning of 2004 prices were still under pressure, but with the pick up of paper demand and adequate inventories, prices were able to reach its peak by June and July at US$ 595 (North America delivered) . In the middle of third quarter the absence of the Chinese buyers in the market once more depressed prices which ended 2004 at US$555 North America delivered.

 

The pick up in demand in the beginning of 2005, combined with pulp mill closures have permitted the implementation of price increase in the first quarter of the year which reached list price of US$ 615 per ton (North America delivered)  by  the end of March 2005.

 

22



 

The following chart shows, for the periods indicated, average annual prices for BEKP produced by us as compared to northern hardwood (NBHK) and southern hardwood (SBHK) prices:

 

BEKP -NBHK - SBHK List Prices

North America Delivered (US$/ton)

 

 

(Note: prices are expressed as simple arithmetic average for the year)

 

Sources: For all eucalyptus pulp prices and for 2000 southern and northern hardwood pulp prices, the Company’s databank; for 2001 northern and southern hardwood pulp prices, Hawkins Wright 2001; for 1988-99 southern and northern hardwood pulp prices, Hawkins Wright, November 2000.  For 2002, 2003, 2004 and First Quarter 2005 eucalyptus prices, the Company’s databank, and for southern and northern hardwood pulp prices, Hawkins Wright, December 2002, 2003 and 2004.

 

Domestic Market

 

In 2004, we supplied approximately 50,000 tons of the aggregate domestic demand for bleached eucalyptus kraft market pulp, compared to 36,000 tons in 2003. In the first quarter of 2005, the Company supplied 9,479 tons of the aggregate domestic demand for BEKP, compared to 5,903 tons supplied for the same period in 2004. Demand for bleached hardwood kraft market pulp in Brazil decreased from 530,740 tons in 1998 to 511,760 tons in 1999, due to the adverse economic situation in Brazil during most of 1999.  See “Item 5. Operating and Financial Review and Prospects—Brazilian Economic Environment.”  However, in 2000, the Brazilian economic scenario improved and the demand for bleached hardwood kraft market pulp reached 517,000 tons, an increase of 1% compared to 1999.  In 2001, the demand for bleached hardwood kraft market pulp reached 489,000 tons, a 5% decrease compared to 2000, primarily due to the energy rationing in Brazil, which had a negative impact on paper production.  In 2002, the demand for bleached hardwood kraft market pulp reached 512,000 tons, a 5% increase compared to 2001, primarily due to the paper production growth, mainly on the tissue segment (8.4%). In 2003 demand grew by 2% compared to 2002, reaching 520,579 tons, reflecting an increase in the tissue and printing and writing segments. In 2004 demand remained almost flat reaching 518,742 tons, still reflecting a positive scenario in the paper segment which started in 2003.

 

23


 


 

The six largest Brazilian producers of bleached hardwood kraft market pulp are:

 

                  Aracruz Celulose S.A.,

 

                  Celulose Nipo-Brasileira S.A., or Cenibra,

 

                  Votorantim Celulose e Papel S.A,

 

                  Suzano Bahia Sul Celulose S.A.,

 

                  Jarí Celulose S.A., and

 

                  Lwarcel Celulose e Papel

 

Together the six largest Brazilian producers accounted for 71% of total domestic sales in 2004, with us accounting for 10% of total domestic sales.  In the first three months of 2005, the six largest Brazilian producers accounted for 70% of the total domestic sales, with us accounting for 7%. Our domestic sales volume of bleached hardwood kraft market pulp was 2% of its total sales volume in 2002 and 2003 as compared to 3% in 2001, and for the first quarter of 2004 its domestic sales volume of bleached hardwood kraft market pulp was 1% as compared to 2% in the same period in 2002, as a result of our increase in sales in international markets and other producers increasing their own share of the Brazilian market.  See “—Competition.”  Although domestic pulp prices are affected to a certain degree by general economic conditions in Brazil, domestic pulp prices have been, and are expected to continue to be, correlated with international pulp prices.

 

Eucalyptus Forests

 

At December 31, 2004, we owned approximately 414,600 hectares of forest and other land in the Brazilian States of Espírito Santo, Bahia, Minas Gerais and Rio Grande do Sul, of which over 252,400  hectares are planted with eucalyptus forests. The average distance from our forest areas currently in use to the mills at Barra do Riacho Unit is 207 kilometers, while this distance at Guaíba Unit is 82 kilometers.  Because of the cost of transportation, the average distance from the forest to the mill has an important effect on our cost structure, and we have sought to reduce the distance in various ways, including by accelerating the substitution of cloned trees with higher productivity near the mills, as discussed in “—Raw Materials—Wood.”  We are always evaluating opportunities for acquiring land with forest closer to the mills in order to reduce the distance, and the associated costs, of hauling wood between the forest and the mills as well as any system of logistics that could reduce the cost of transportation, such as transportation by barges using our port facility in the state of Bahia.  See “—Business Strategy”.  Of the 414,600 hectares owned by us, approximately 252,400 hectares are currently used for the planting of trees to supply pulp production and solid wood production, approximately 133,000  hectares are reserved for preservation, approximately 17,900 hectares have been used in the construction of roads and the remainder is used for research and development and other activities.  Brazilian law requires that 20% of our land, at any given time, either remain uncultivated with eucalyptus trees or planted with indigenous species.

 

Throughout 2004, one of our principal objectives was to increase the Forestry Partners Program, for the establishment of new plantations to ensure the future supply of wood for our mills.  During 2004, we established approximately 18,000 additional hectares of eucalyptus plantation through this program.

 

At Barra do Riacho Unit we have a tree nursery capable of producing approximately 43 million seedlings per year and a research facility are located nearby as well. At Guaiba Unit our tree nursery is capable of producing 6,5 million in 2004 and there is a expectation  of expansion in 2005 to up to 10 million.

 

In 2004, we supplied  9,4 million cubic meter wood to our pulp mills, of which 6,3 million cubic meter came from our own eucalyptus forests  and 3,1 million cubic meters of wood were purchased from the market, including approximately 563,000  cubic meters  purchased through the Forestry Partners Program.

 

24



 

Raw Materials

 

Wood

 

We rely exclusively on planted eucalyptus trees to meet our pulp wood requirements.  Eucalyptus is a short-fibered hardwood that grows back from the stump after being cut, with each tree capable of regenerating twice.  Eucalyptus trees are among the fastest growing trees in the world.  Climate and soil conditions in Brazil allow for approximately seven-year eucalyptus tree harvest rotations as compared to eight to ten-year harvest rotations in Spain, Portugal and Chile.  As part of our growth strategy, we have sought to eliminate the need for external sources of wood and to maximize both the yield and quality of fiber grown on our timberlands through the application of advanced forestry technology.

 

We pioneered the use of cloned seedlings from rooted cuttings, a method also known as vegetative  propagation, to carry out large-scale planting of eucalyptus trees.  Our method of cloning results in trees whose fibers are more homogeneous, which we believe results in a more streamlined industrial process and higher-quality pulp.  Today, approximately 82% of our eucalyptus forests are grown from this type of seedling, considering our two operational Units (Barra do Riacho and Guaíba).  Rather than growing from seeds, clones are the “offspring” of  asexual propagation.  By means of this type of generation, the descendant receives the entire genetic code of the  original tree.  Accordingly, the risk of disease and pests can be lessened by choosing parent trees better adapted to the region.  Other benefits of vegetative propagation include less bark per cubic meter of wood and “self-pruning” trees  with fewer branches.

 

In terms of forestry productivity, the results indicate that a typical plantation  of ours grows 40 - 42 cubic meters of pulpwood per hectare per year,  and a typical eucalyptus tree grows an average of approximately three inches per week and will grow to a height of 90 feet in seven years, at which point it is harvested.

 

Through the development of cloned trees selected on the basis of certain characteristics, the Company was able to reduce its wood consumption per ton of pulp produced from 3.9 solid cubic meters under bark in 1985 to 3.5 solid cubic meters in 2004.  The optimal time to harvest the Company’s trees is  six to seven years from the time of planting.

 

Energy

 

Reducing our need for outside sources of energy and chemicals is an important component of our low-cost production strategy.  At the Barra do Riacho Unit approximately 97% and 98% of our electrical energy needs in 2003 and 2004, respectively, were met by burning by-products generated from the pulp production process compared with 79% in 1999.  At the Guaíba Unit approximately 95% and  89% of our electrical energy in 2003 and 2004, respectively, were generated  internally using methods similar to the ones used in Barra do Riacho Unit. The remainder of our energy needs was met through purchases of electricity, fuel oil and natural gas from third sources.

 

Chemicals

 

We use several chemicals in the pulp bleaching process.  Until December 1999, we maintained and operated an electrochemical plant on the same site as the mill at Barra do Riacho Unit to produce some of the chemicals used in the pulp bleaching process, specifically chlorine, caustic soda and sodium chlorate.

 

On December 16, 1999, we entered into a series of transactions with Canadianoxy Chemicals Ltd. for the transfer of our electrochemical plant to a subsidiary of Nexen Inc., or Nexen, a Canadian company formerly known as Canadian Occidental Petroleum, for approximately US$61 million.  Nexen, with head offices in Calgary, Canada, is a major producer of sodium chlorate.  Its principal shareholder is Occidental Petroleum Corporation, which owns approximately 80% of its share capital.  The transfer closed on December 17, 1999.  The sale of the electrochemical plant, located adjacent to the mill in Barra do Riacho Unit, is part of our strategy to concentrate on our core business, transferring the production of chemicals to a specialized producer.  We built the plant during the construction of the pulp mill in 1979.  We subsequently expanded the plant in 1991.  At the time of the sale, the electrochemical plant had the capacity to produce approximately 36,000 tons per year of sodium chlorate, 36,000 tons per year of caustic soda and 32,000 tons per year of chlorine.  The plant also produces hydrochloric acid and sodium hypochlorite (liquid bleach).

 

25



 

Under the terms of the purchase agreement, we have agreed to indemnify Nexen for certain liabilities relating to:  (i) the manufacturing of electrochemical products prior to the sale, (ii) any legal proceedings that relate to the manufacture of the electrochemical products in which the basis of the claim occurred prior to the sale and (iii) any misrepresentation by us in connection with the purchase agreement.  Our indemnity obligations expire, with respect to tax, labor, product liability and environmental matters, upon the passage of the relevant statute of limitations and, with respect to other matters, three years from the closing of the sale. As part of the sale of the electrochemical plant, we and two subsidiaries of Nexen entered into a successively renewable contract for the reciprocal supply of raw materials, services and products over a 25-year period.  The agreement obligates us to provide a continuous supply of raw materials, primarily water and steam, to the electrochemical plant, and the plant to provide bleaching chemicals to us, at competitive prices.  The agreement includes clauses of performance incentives, such as sharing of productivity gains, preference prices and “take-or-pay” obligations pursuant to which we are committed to purchase from the electrochemical plant a volume of chemical products projected for six years from the date of the agreement.  If, in a given year, we purchase volumes of chemical products in excess of the minimum agreed to volume, our obligations to purchase may be reduced in subsequent years.  For the take-or-pay quantities, we will pay unit prices which equal cost plus a margin as determined in the contract.  See Note 2 of the consolidated financial statements.  The agreement also may not be assigned by a party without the consent of the other party and includes provisions relating to:  (i) the extension of the agreement for an additional 10-year period upon the agreement of both parties not less than two years prior to the expiration of the initial 25-year term, (ii) the suspension of service by each party, (iii) the termination of service and (iv) the termination of the agreement by a party upon 18 months’ notice that such party intends to permanently cease operation at its facility.  In the event of termination of the agreement or a proposed sale by Nexen, the agreement provides that we have the right of first negotiation for the acquisition of the electrochemical plant.  As a result of the sale, we no longer have responsibility for the electrochemical plant and, accordingly, any interruption of the operations of the electrochemical plant could require us to seek alternative sources in the market for certain chemicals essential to our production of pulp.

 

The chemicals used in the pulp bleaching process in the Guaiba Unit, specially chlorine, caustic soda, sodium chlorate,  hydrochloric acid and chlorine dioxide, are also produced in an electrochemical plant located on site. The nominal capacities of such electrochemical plant are, respectively, 23.605 ton/year of caustic soda, 20.949 ton/year of chlorine, 9.900 ton/year of sodium chlorate, 9.000 ton/year of hydrochloric acid and 5.760 ton/year of chlorine dioxide.

 

Water

 

 Water is required in the pulp production process and in the cultivation of seedlings.  Water is primarily provided by several rivers, which feed into a 35 million cubic meter reservoir on the mill site in Barra do Riacho Unit. In the Guaiba Unit the water is provided by the Guaiba River, beside the mill.  The reservoir in the Barra do Riacho Unit holds enough water to supply the mill’s needs for a five-year period in the event of a drought (based on statistical information regarding periods of very low rainfall).  In the Barra do Riacho Unit wastewater undergoes a two-stage purification treatment process before it flows into the ocean, and in Guaíba Unit we have a four stage purification process before it flows into the Guaíba River.

 

Beginning in the latter half of 1998, the State of Espírito Santo experienced a severe drought which reduced our water supply and caused us to pursue alternative long-term sources of water to meet our current operating needs as well as any foreseeable expansion plans.  As a result, in May 1999, we, together with the municipal governments of Aracruz and Linhares, a neighboring city, began a project of public interest to obtain water from the Rio Doce river through an existing  system of canals and rivers.  The project was completed in June 1999 and now provides water for the local communities and for the industrial and chemical districts of the Municipality of Aracruz as well as for irrigation of agricultural activities in the northern region of the State of Espírito Santo.  During 2000 and the beginning of 2001, we made the necessary adjustments in the mill to receive the water supply from Rio Doce.  The project was approved by federal, state and local authorities.  Despite the low average rainfall during 2003, the use of water from the Rio Doce river enabled us to obtain all of our water supply requirements. In 2004 due to high average rainfall, we decided to temporarily close our  Rio Doce river access.

 

26



 

The Units

 

Our principal pulp mill, located in the State of Espírito Santo, is the largest bleached hardwood kraft market pulp production facility in the world.  From 1991 to 1998, we successfully increased this mill’s nominal capacity from 1,025,000 tons of pulp per year to 1,240,000 tons of pulp per year. This mill’s third production unit, known as the Fiberline C Expansion Project, began production in May 2002, increasing the nominal production capacity of the mill to approximately 2,000,000 tons of pulp per year

 

We also have a pulp mill in our Guaíba Unit which production capacity is of approximately 400,000 tons of BEKP per year, and is expected to be increased to up to 430,000 tons per year in 2005, after full implementation of the project to upgrade the Guaíba Unit’s industrial facilities. - See “B - Business Overview - Guaiba Unit”.

 

The Company’s total production in 2004 was 2,497,000 versus  2,250,000 tons in 2003 tons  (comprising the Barra do Riacho Unit  and the Guaíba Unit) , representing approximately 11% of the total worldwide bleached hardwood kraft market pulp production capacity. In the first quarter of 2005, the Company’s pulp production was 661,000 tons, compared to 628,000 tons in the same period last year.

 

In 1994, we increased our effective production capacity to 1,070,000 tons through system upgrades and productivity gains.  From 1995 to 1999, we invested in the Modernization Project, increasing the nominal production capacity of that mill to 1,240,000 tons of pulp per year.  After the Fiberline C Expansion Project  the nominal capacity increased to 2,000,000 tons, our total production in 2002 was 1,656,000 tons (1,272,000 tons in 2001) 2,031,000 tons in 2003 and 2,093,000 tons in 2004, representing approximately 8% of the total worldwide bleached hardwood kraft market pulp production capacity.

 

The production facilities in the State of Espírito Santo and  Rio Grande do Sul consist of large receiving yards for the logs, debarking, chipping and digesting equipment, packaging and warehousing facilities capable of holding 109,000 tons of pulp and a fully computerized control system that continuously monitors the entire production process.  The Barra do Riacho Unit and the Guaiba Unit mills’ pulp systems have, respectively,  five steam turbines and three steam turbines, and generators that provide a continuous power supply for that system.  Fuel for the generation of steam is mainly provided by waste products from the pulp production process.  External backup power supplies are also available on sites.  In Barra do Riacho Unit a tree nursery capable of producing approximately 43 million seedlings per year and a research facility are located nearby. At Guaiba Unit our tree nursery is capable of producing 6,5 million in 2004 and there is a expectation  of expansion in 2005 to up to 10 million.   The Barra do Riacho Unit electrochemical plant, which was transferred in December 1999 to Nexen and that provides most of the chemicals used in the pulp bleaching process, is located within the boundaries of the production facility. The Guaíba Unit also has an electrochemical plant located within its boundaries. For a discussion of the sale of our electrochemical plant to Nexen, see “—Raw Materials—Chemicals.”

 

Pulp Production

 

When operating at full capacity, the Barra do Riacho Unit mill can process over 23,000 solid cubic meters of timber each day and the Guaiba Unit mill can process 6,700  solid cubic meters of timber each day.   The logs are either debarked in the forest or debarked at the mills using tumbling drums and then cut into chips, which are transferred by conveyors system to the digesters where they are mixed with chemicals and heated under pressure.  During this chemical cooking process, the lignin and cellulose are separated.  Once removed, the lignin is used as fuel to produce steam and electrical energy for the milling process.  The used chemicals are removed at various stages of the production process and recycled within the plant.  The cellulose fibers are then washed, bleached using bleaching chemicals (which are produced on site), filtered, pressed and dried.  The dried pulp is then cut into sheets, packed into bales and transported by truck to domestic destinations, for exportation.  Barra do Riacho Unit is served by a private port which is administered by Portocel (a company where we own 51% of the stocks)  located approximately 1.5 kilometers from the mill, for shipments abroad. At Guaíba Unit a barge terminal is located in the Guaíba River, beside the mill, and the pulp is transported by barges to Rio Grande Port for shipment abroad.  See “—Transportation.”

 

27



 

In 2004 we have produced two types of pulp:

 

                  Standard Pulp (only in Barra do Riacho Unit); and

 

                  ECF Pulp.

 

Standard Pulp is pulp bleached with regular levels of chlorine.  Standard Pulp is in high demand in North America and Asia.  Although most of the production is represented by ECF Pulp, the production of Standard Pulp is still relevant because there is high demand for such pulp.  During 2004, we produced approximately 36,792  tons of Standard Pulp, as compared to 79,536 in 2003 and 203,848 in 2002.In the first quarter of 2005, the Company produced 2,500tons of Standard Pulp, as compared to 11,516 tons and 38,784 tons in the same period of 2004 and 2003, respectively.  ECF Pulp, or Elemental Chlorine Free Pulp, is pulp bleached with lower levels of chlorine.  ECF Pulp is in high demand in Europe, where our customers have preferred pulp that is bleached with little or no chlorine due to the environmental concerns relating to the pulp production process, particularly the bleaching process (although recently we have detected a shift in environmental concerns away from the bleaching process to forestry management and efficient control).  We first produced ECF Pulp in November 1990.  During the period from 1991 to 1994, we equipped the Barra do Riacho Unit mill so that it would have the capacity to produce enough ECF Pulp to meet the growing demand for ECF Pulp.  From 1993 to 1997, we produced 75% ECF pulp.  Commencing in 1998, with the completion of the Modernization Project, we were  to produce 100% ECF pulp.  See “—The Units.”  .During 2004, approximately 98% of Barra do Riacho Unit  production, or 2,050,218 tons, was comprised of ECF Pulp as compared to 1,860,060  tons during 2003 and 1,372,172  tons during 2002. In the first quarter of 2005 the Barra do Riacho Unit  produced 552,352  tons of ECF Pulp, as compared to 500,638 tons and 433,864 tons in the same period of 2004 and 2003, respectively.  During 2004 the production of ECF in Guaiba Unit was approximately 401,000 tons as compared to 378,000 tons in 2003.

 

Transportation

 

Wood from the forest areas is transported by truck  and  by  sea barges (owned by independent contractors) to the mills for processing into pulp.  The average distance from our forest areas currently in use to the mills at Barra do Riacho Unit is 207 kilometers, while this distance at Guaíba Unit is 82 kilometers.

 

The pulp produced for export at Barra do Riacho mill is transported by truck from the mill to the port of Barra do Riacho (Portocel), which is located approximately 1.5 kilometers from the mill site. This port is used almost exclusively to hold and load pulp and provides us with convenient access to ocean transport vessels.  The port is a modern facility that currently has the capacity to handle approximately 4,000,000 tons of pulp per year.  The port includes a warehouse capable of holding approximately 140,000 tons of pulp.

 

We own 51% of Portocel, the company that operates the port of Barra do Riacho.  The remaining 49% of Portocel is owned by Cenibra, another pulp manufacturer and one of our competitors.  We do not own any ships for transportation of our pulp.

 

Our integrated, coastal wood shipment project was completed in December 2002.  It involves a system of sea-going barges and tugboats and two port terminals that link the extreme south of Bahia to the north of Espírito Santo. The port complex of Portocel, adjacent to the mill at Barra do Riacho Unit, is to begin receiving wood from plantations in southern Bahia via an alternative transportation system that is more efficient than truck-based highway shipments.  Another improvement to our wood transportation operations was the construction and start-up of a nearly 4km-long rail spur used for unloading wood shipments directly at the mill’s yard. The first phase of the operation between Caravelas and Portocel, with annual capacity for transporting 1.7 million cubic meters of wood, began at the end of 2002.

 

At the Guaíba mill, the pulp is exported through the port of Rio Grande. The pulp is transported by barge  through the lake Lagoa dos Patos and the distance from the mill to the port is 160 nautical miles. To load the barges there is a terminal facility integrated to the mill.

 

28



 

Markets and Customers

 

Our principal markets are in North America, Europe, Asia and Brazil. Our export sales are performed through our foreign subsidiaries in Hungary and Panama. See - “Organizational Structure - Significant Subsidiaries”. The relative geographic distribution of our sales by volume and percentages of total production were as set forth below:

 

 

 

2000

 

2001

 

2002

 

2003

 

2004

 

1Q2005

 

 

 

Tons

 

% of
Total

 

Tons

 

% of
Total

 

Tons

 

% of
Total

 

Tons

 

% of
Total

 

Tons

 

% of
Total

 

Tons

 

% of
Total

 

Europe

 

594.6

 

47

%

475.3

 

37

%

637.0

 

40

%

813.7

 

38

%

1,014.4

 

41

%

262.5

 

44

%

North America

 

433.5

 

34

 

479.8

 

37

 

623.2

 

39

 

767.8

 

36

 

831.3

 

34

 

215.5

 

36

 

Asia

 

180.8

 

14

 

306.2

 

23

 

280.1

 

18

 

509.0

 

23

 

533.1

 

22

 

102.6

 

17

 

Latin America

 

9.0

 

1

 

3.6

 

0

 

17.6

 

1

 

21.4

 

1

 

21.6

 

1

 

2.2

 

1

 

Total Exports

 

1,217.9

 

96

%

1,264.9

 

97

%

1,557.9

 

98

%

2,111.9

 

98

%

2,400.4

 

98

%

582.8

 

98

%

Brazil

 

54.7

 

4

 

36.4

 

3

 

27.0

 

2

 

37.1

 

2

 

49.6

 

2

 

9.5

 

2

 

Total

 

1,272.6

 

100

%

1,301.3

 

100

%

1,584.9

 

100

%

2,149.0

 

100

%

2,450.0

 

100

%

592,3

 

100

%

 

The average net prices per ton of eucalyptus pulp for 2000, 2001, 2002, 2003, 2004 and first quarter of 2005 were US$611, US$438, US$418, US$453, US$458 and US$482, respectively.

 

In 2004 and 2003, approximately 2% of our sales volume was sold in the domestic market (2% in 2002).In  the first quarter of 2005, approximately 2% of the Company’s sales was sold in the domestic market compared to 1% in the same period of 2004.

 

One of our marketing strategies is to develop long-term relationships with customers that will purchase our production year after year.  Stable long-term relationships permit us to reduce our marketing expenses, to better understand our customers’ needs, and to take advantage of our competitive strengths, including the consistency of our pulp and our efficient logistic and technical support to our clients.  In 2004, our ten largest customers accounted for approximately 72% of our sales and our two largest customers accounted for approximately 44% of our sales (75% and 46%, respectively, in 2003 and 71% and 44%, respectively, in 2002).  These customers include leading North American tissue manufacturers and leading global manufacturers of printing and writing paper. In 2003,2004 and for the first quarter of 2005, demand for our pulp has been in line with our production capacity; however, we cannot guarantee that such balance between demand and production capacity will happen in the future.    We believe that the loss of either of our two largest customers could have a material adverse effect on our results of operations. We have long-term sales contracts with some of our customers, including several of our largest customers.  These contracts generally provide for sales of specified amounts of pulp at prices announced from time to time by us, which are in line with the prevailing market prices for pulp sold to customers in the geographic area of the purchaser under the contract.  Early termination is provided for in the contracts in the event of a material breach, the insolvency of one of the parties or force majeure events of extended duration.  Certain sales contracts include provisions that permit us to reduce the quantities to be shipped if sales to the purchaser and our affiliates would exceed a specified percentage of our annual production capacity.

 

We have sought to diversify our sales among different market segments, such as consumer products (for example, tissue paper), specialty papers and high quality printing and writing papers.  Producers of these products, as opposed to producers of commodity papers, value the consistency of our pulp as well as the reliability of our service.

 

29



 

The following table shows the breakdown by end uses of our pulp production in  2000, 2001, 2002, 2003 and 2004.

 

 

 

2000

 

2001

 

2002

 

2003

 

2004

 

Tissue

 

51

%

51

%

57

%

55

%

55

%

Printing, and Writing Paper

 

28

 

28

 

29

 

26

 

22

 

Specialty Papers(1)

 

19

 

20

 

13

 

18

 

22

 

Cartonboard

 

2

 

1

 

1

 

1

 

1

 

 

 

100

%

100

%

100

%

100

%

100

%

 


(1)                                  Includes liquid packaging board, carbonless paper, base paper for laminated paper and coated wood-free specialties.

 

Competition

 

While we compete with other producers of bleached hardwood kraft market pulp, our most direct competitors are other producers of eucalyptus pulp due to the special characteristics of this fiber.  To a lesser degree, all producers of hardwood pulp compete with producers of softwood pulp and with other raw materials, such as recycled paper.

 

Competition is based primarily on quality (particularly consistency of product), service, price and reliability.  We and other Brazilian eucalyptus pulp producers have significant cost advantages over producers in other regions.  See “—Raw Materials—Wood.”  We, however, do not generally compete on the basis of price alone.  Instead, we emphasize quality, reliability and stable long-term relationships with customers.

 

If demand for recycled paper increases in the future, demand for pulp could be adversely affected.  While no assurance can be given, we believe that increases in demand for recycled paper would not materially affect our results of operations, at least in the near future, because (i) it is more costly to produce recycled paper using current technology due to the high costs of sorting out wastes and de-inking the recycled fiber, and (ii) customers are predominantly manufacturers of higher-quality paper products such as premium tissue paper, coated papers and specialty papers, which are less likely to use recycled fibers for their products.

 

Bleached Eucalyptus Kraft Market Pulp (BEKP)

 

We are the largest producer and exporter of bleached eucalyptus kraft market pulp in the world.  Our main competitors in this market are located in Brazil, Portugal, Chile and Spain and are listed by country (without any priority as to order) in the following table:

 

Producer

 

Country

 

Cenibra

 

Brazil

 

Suzano Bahia Sul Celulose S.A.

 

Brazil

 

Jari Celulose S.A.

 

Brazil

 

Votorantim Celulose e Papel S.A.

 

Brazil

 

Empresa de Celulose e Papel de Portugal SGPS, S.A. (Portucel)

 

Portugal

 

Celulose Beira Industrial S.A.

 

Portugal

 

CMPC Papeles S.A.

 

Chile

 

Celulosa Arauco y Constituicíon SA.

 

Chile

 

Empresa Nacional de Celulosas S.A.

 

Spain

 

Grupo Rottneros (Miranda mill)

 

Spain

 

 

Management estimates that the five major producers of bleached eucalyptus kraft market pulp in the world (i.e., Aracruz, Cenibra, Empresa Nacional de Celulosas S.A., Portucel, and Votorantim Celulose e Papel S.A) currently account for 57% of the total world production capacity of bleached eucalyptus kraft market pulp.  Management estimates that in 2004, we accounted for 26% of the world production capacity of bleached eucalyptus kraft market pulp, 5% of the world production capacity of chemical market pulp and 11% of the world production capacity of bleached hardwood kraft market pulp.

 

30



 

Bleached Hardwood Kraft Market Pulp

 

To the extent that pulp from other hardwoods can be substituted for the slightly more expensive bleached eucalyptus kraft pulp, we also compete with producers of pulp from other hardwoods.  Such competition is based more on cost and less on quality or suitability of the pulp for use in higher quality paper products.  Although bleached hardwood kraft market pulp is produced in most regions of the world, the dominant producers are located in North America, Latin America, Western Europe and the Scandinavian countries (Finland, Norway and Sweden), which in 2004 are estimated to have accounted for 70% in the aggregate, and 21%, 28%, 13% and 8%, respectively, of the world’s total bleached hardwood kraft market pulp production capacity. Producers in the United States sold approximately, 2,527,000 tons during 2002, 2,347,000 tons during 2003 and 2,352,000 in 2004 while Brazilian producers sold approximately 3,927,000 tons, 4,767,000 tons and 5,237,000 respectively, in such periods.  Several of our competitors in this market are larger than we are and may have greater economic and other resources than we do.

 

Worldwide production capacity for bleached hardwood kraft market pulp grew approximately 4.59% per  year from 1994 to 2004, totaling 21.9 million tons, and is expected to grow at an annual rate of 4.7% during the period of 2004 to 2008 (or approximately 5.7 million tons in total during this period).  Approximately 84% of this growth in capacity is expected to occur in Latin America, where bleached eucalyptus kraft market pulp capacity is expected to grow from approximately 6.2 million tons in 2004 to approximately 10.9 million tons in 2008.  Mixed tropical hardwood market pulp capacity in Indonesia is expected to increase from 3.2 million tons in 2004 to 3.3 million tons in 2008.Worldwide demand for bleached hardwood kraft market pulp is expected to grow by 3.8% per year from 2005 through 2008, adding 2.6 million tons to the current demand.

 

Environmental and Other Regulatory Matters

 

Our mill and forestry operations are subject to federal, state and local laws, regulations and permit requirements relating to the protection of the environment.  Law No. 6,938, dated August 31, 1981 established strict liability for environmental damage, mechanisms for enforcement of environmental standards and licensing requirements for activities that are effectively or potentially damaging to the environment.  Environmental laws and regulations also govern the conduct of forest operations and the protection of Brazilian fauna and flora.  A violation of environmental laws and regulations may result in fines and penalties which may be material.  Law No. 9,605, dated February 12, 1998 provides that individuals or entities whose conduct or activities cause harm to the environment are subject to criminal and administrative sanctions and are liable for any costs to repair the damages resulting from such harm.  Criminal sanctions for individuals and entities that commit environmental crimes range from fines to imprisonment (individuals) or dissolution (legal entities).  In addition, Law No. 9,605 also establishes that the corporate structure of a company may be disregarded if the structure impedes the recovery for harm caused to the environment.  We are not aware of any successful assertion of claims against shareholders under this provision of Law No. 9,605.

 

The States of Espírito Santo and Rio Grande do Sul require local manufacturing concerns to obtain various permits including operating permits for manufacturing facilities.  Pursuant to state laws, state authorities are empowered to regulate a company’s operations by prescribing company-specific environmental standards in such company’s operating permit. The operating permits require that we maintain certain emissions, effluent and waste disposal standards.

 

On February 10, 1998, the State of Espírito Santo issued to us a two-year operating permit for Fiberlines A and B at Barra do Riacho Unit, which was renewed for an additional five years commencing on February 10, 2000.  This operating permit  is currently under renewing process and remains valid until such process is concluded. On July 01, 2002 the State of Espírito Santo issued to us a four -year operating permit for Fiberline C at Barra do Riacho Unit, which is valid until July 2006. During 2002, supplemental environmental licenses were obtained for Fiberline C Expansion Project relating to our industrial installations.

 

On January 15, 2003 the State Rio Grande do Sul issued to us an operating permit for Guaíba Unit, valid until October 2003 and later extended to July 24, 2004. This operating permit, already including the expansion of the production capacity deriving from the upgrade of Guaiba Unit’s industrial facilities, is currently under renewing process and remains valid until such process is concluded.  We have also been granted supplemental environmental licenses  relating to our industrial installations in Guaiba Unit.

 

31



 

Beginning in March 1997, we became subject to an environmental audit every three years in the State Espírito Santo.  The audit is conducted by subcontracted auditors, approved by the Environmental Secretary of the State of Espírito Santo, or SEAMA.  The audit was not carried out in 2000, since SEAMA has not published the result of the 1997 audit.  The 2000 audit was conducted in June 2001. The most recent audit was conducted in November 2004.  In the State Rio Grande do Sul we became subject to an environmetal audit every  year, since the year 2002. The audit is conducted by subcontracted auditors, approved by the Brazilian Environmental Institute, or IBAMA. The audit has been regularly carried since 2002 and the most recent audit was conducted in October 2004.

 

Our forestry activities are regulated by the Brazilian federal government and the governments of the States of Espírito Santo, Minas Gerais, Bahia and Rio Grande do Sul. Our operating permit for our forest operations in Espírito Santo was renewed for a six-year period commencing on October 4, 2004. Since 2000, the Company has obtained from the environmental state agencies from the states Espírito Santo, Minas Gerais and Bahia 20 implementation and operational permits for implanting 269   projects accounting for 58,367 hectares of eucalyptus plantations.  The remaining area is going to have operational permits during 2005. The terms and conditions for the issuance of forest operating permits in the state Rio Grande do Sul are currently being defined by the local environmental state agency. We are engaged in this process so as to obtain our relevant forest operating permits in Rio Grande do Sul in due course.

 

 We also entered into contracts with farmers in the State of Espírito Santo, Minas Gerais, Bahia and Rio Grande do Sul pursuant to which the farmers have agreed to grow trees for sale to us.  See “Eucalyptus Forests”. Regarding our operating permit for the Forestry Partners Program, the licensing process for renewing it is under negotiation and we expect to conclude it  during 2005.

 

Plantings may be undertaken only pursuant to a plan presented to and approved by the appropriate governmental authorities.  In accordance with federal law, at least 20% of our landholdings, at any given time, must be preserved uncultivated or planted with indigenous species.  We currently exceed this requirement, since such land accounts for approximately 32% of our total landholdings. In September 2001, the legislature of the State of Espírito Santo, where we own approximately 167,800 hectares   of forest and other land, passed a law temporarily restricting the plantation of eucalyptus forests for purposes of pulp production within that State. This law was declared to be unconstitutional by a provisional decision of the Brazilian Supreme Federal Court and injunctive relief was granted in response to suits brought by the National Confederation of Industry and by the National Confederations of Acquisitions and Cattlle Raising.  The Company believes that such provisional decision will be upheld by the count’s definitive decision on the merits.   However, there can be no assurance that such definitive decision will be favorable to the Company nor that other similar laws will not be enacted that would impose a limitation or restriction on plantation of eucalyptus or that would affect our licenses or permits.

 

On March 13, 2002 the State of Espírito Santo legislative assembly created an investigating commission (Comissão Parlamentar de Inquérito) to investigate the legality of our permits and the acquisition of our properties since we began operating in the State of Espírito Santo.  As the investigative procedures were not concluded within the prescribed term for such type of investigation, the commission was terminated without issuing a conclusive report.  We are confident that all our permits and acquisition documents are strictly in accordance with all laws and regulations.

 

We believe that we are in compliance in all material respects with all applicable environmental regulations.  In addition, environmental considerations are fundamental to our development of new technologies.  Our integrated pest management relies on biological control of pests and diseases.  Soil and plant nutrients are continuously monitored to guarantee an adequate balance.  At the Mill, methods for the evaluation of environmental effects of effluents on receiving detriments have been developed and used.  The origins of pulp and effluent toxicity have been studied, considering all possible sources, from the raw material (wood) to bleaching effluents.  In addition, environmental quality is considered in the development of new technologies and products.  Pulp products are continuously evaluated in terms of their possible effects on the quality of effluents in our customers’ paper machines as well.

 

In 1996, the State of Bahia granted us a permit for the location of our sawmill, APM.  In 1998, the State of Bahia granted an operating permit for APM, valid until August 2003.  In June 2003, the State of Bahia renewed APM’s operating permit, valid until June 2007. See “—Business Strategy.”

 

32



 

As part of the licensing process in connection with the Fiberline C Expansion Project, we contracted independent consultants to prepare the required environmental impact assessment reports.  Those reports were discussed in public hearings (two in Bahia and one in Espírito Santo) in 2000 as well as during six public meetings with communities in both states.  There was ample discussion at each meeting of the environmental and social questions involved.  The results of the discussions were taken into consideration by the government regulatory agencies in their technical analyses and their subsequent approval of the permits.

 

We also obtained 269 projects permits for forest plantations, of which 56 were incorportaed in operating licenses issued by the Espírito Santo Agriculture, Cattle-Raising and Forest Protection Institute (IDAF), 197 were projects incorporated in installation licenses issued by the Bahia Environmental Resources Center (CRA-BA) and 16 projects approved for operating licenses by the Minas Gerais State Forestry Institute (IEF-MG).

 

In addition, the following licenses were obtained in 2004:

 

                  Simplified Permit for bark landfill: issued by Caravelas Municipality, administrative rule 121; and

 

                  Operation License for eucalyptus plantations in Minas Gerais State: administrative rule IEF 157 and 158.

 

In October 2003, the Bureau Veritas Quality International (“BVQI”) approved  CERFLOR (the Brazilian System of Forest Certification) certification of 95,300 hectares covering all of the Company’s own plantations in the State of Bahia.The certificate emitted by INMETRO (National Institute of Metrology) was received in March 2004.   We initiated this certification process in August 2003, including pre-audit, initial audit and a certification audits.  The certification audit was publicized through local radio stations and newspapers as well as the sending out of letters to more than 600 persons or entities. Five public meetings were held in respect of the Certification, with the presence of more than 300 persons. In October 2004 it took place the first annual monitoring audit for the maintenance of CERFLOR certification in Bahia. The certification was maintained and a new public report is being prepared by BVQI.

 

The CERFLOR Certification  for plantations in Espírito Santo State (93.501 hectares) was approved  by BVQI in May 2005. The certification process was initiated in November 2004 with the realization of six  public meetings and an initial audit. The certification audit was held in January 2005. The audit report was made available for the public on the internet for  90 days.  The certificate emitted by INMETRO (National Institute of Metrology) was received in June 2005.

 

All of the Company’s own plantation areas in the State of Rio Grande do Sul (Guaíba Unit) are certified by the Forestry Stewardship Council (FSC), totaling 58,800 hectares.

 

Insurance

 

We believe that our insurance coverage of our production facilities and forests is in line with Brazilian market and international pulp industry standards.

 

In 2003, the Company received the Highly Protected Risk (HPR) seal of approval from FM Global. The certification, which is renowned worldwide in the field of insurance, attests to the Company’s low risk of interruption of its operations as result of an industrial accident. The Company is the first Brazilian company to earn the certificate from FM Global, the world’s largest property risk insurance company and leader in the field of risk management and loss prevention.

 

C.                                    Organizational Structure

 

Significant Subsidiaries

 

Our operations are conducted by Aracruz Celulose S.A., as the controlling and principal operating company.  The following table sets forth the significant subsidiaries owned directly or indirectly by us and our ownership interest in each of them as of December 31, 2004:

 

33



 

 

 

As of December 31, 2004*

 

 

 

Total Capital

 

Voting

 

 

 

(in percentages)

 

(in percentages)

 

Portocel Terminal Especializado de Barra do Riacho S.A.(1)

 

51

%

51

%

Mucuri Agroflorestal S.A.(1)

 

100

%

100

%

Aracruz Produtos de Madeira S.A. (formerly named Tecflor Industrial S.A.)(1)

 

33,33

%

33,33

%

Veracel Celulose S.A.(1)

 

50

%

50

%

Aracruz Trading S.A.(2)

 

100

%

100

%

Aracruz Celulose (USA), Inc.(3)

 

100

%

100

%

Aracruz (Europe) S.A.(4)

 

100

%

100

%

Aracruz Trading Hungary Ltd.(5)

 

100

%

100

%

Riocell Trade (6)

 

100

%

100

%

Ara Pulp - Com. de Importação e Exportação, Unipessoal Ltda(7)

 

100

%

100

%

 


(1)

Incorporated in Brazil.

(2)

Incorporated in the Republic of Panama.

(3)

Incorporated in the United States under the laws of the State of Delaware.

(4)

Incorporated in Switzerland.

(5)

Incorporated in Hungary

(6)

Incorporated in England

(7)

Incorporated in Portugal

 

D.                                    Property, Plant and Equipment

 

In December 1999, we moved our headquarters from Rio de Janeiro to the City of Aracruz in the Brazilian coastal State of Espírito Santo, where our main production unit is located.  We maintain offices in Rio de Janeiro for our financing, administrative and trading activities. Relocation of these executives’ offices to São Paulo is being implemented and expected to be concluded early in the second half of 2005.

 

Our principal production facilities consist of a eucalyptus pulp mill located in Aracruz, State of Espírito Santo, which has three production units, each with three production lines.  When operating at full capacity, this mill can process over 23,000 solid cubic meters of timber each day. We also have one mill in Guaíba, State of Rio Grande do Sul that has one production unit, with one production line.  When operating at full capacity, this mill can process over 6,700 solid cubic meters of timber each day.

 

As of December 31, 2004, we had an aggregate principal amount outstanding of approximately US$231.2 million under certain loans granted to us by BNDES, which loans are secured by liens on our industrial site in the Municipality of Aracruz.  See “Item 7B. Related Party Transactions.”

 

We own approximately 414,600 hectares of land in the Brazilian States of Espírito Santo, Bahia, Minas Gerais and Rio Grande do Sul, of which approximately 252,400 are planted eucalyptus forests.  See “—Business Overview—Eucalyptus Forests.” The pulp mill in Barra do Riacho Unit is located approximately 1.5 kilometers from the port facilities at Barra do Riacho, of which 51% are owned by us. We have a terminal facility integrated to the Guaiba Unit mill that is used to load the barges that transport the pulp to Rio Grande port.

 

See “—Environmental and Other Regulatory Matters” for the environmental rules and regulations affecting our operations.

 

ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements, including the respective notes thereto, included elsewhere in this annual report, and in conjunction with the discussion of the method of presentation of financial information under Item 3.

 

34



 

Overview

 

We are the world’s largest producer of bleached hardwood kraft market pulp. During 2004, we produced approximately 2,497,000 tons of bleached eucalyptus pulp, a 11% increase from 2003 when we had produced approximately 2,250,000 tons of bleached eucalyptus pulp, and a 36% increase as compared to 2002 when we had produced approximately 1,656,000 tons of bleached eucalyptus pulp.  In 2003, eucalyptus accounted for approximately 41% of the total worldwide production capacity of bleached hardwood kraft market pulp. In each of 2004 and 2003, sales to customers located outside Brazil, especially in North America, western Europe and Asia, accounted for approximately 98% of the Company’s sales volume.

 

Pulp sales for 2004 were approximately 2,450,000 tons, a 14% increase as compared to 2,149,000 in 2003, which had represented a 36% increase when compared to 2002 pulp sales of 1,585,000 tons.  In 2004, the Company sold US$1,167.1 million of eucalyptus pulp compared to US$1,003.1 million in 2003 and US$669 million in 2002.

 

The Company’s volume and price of pulp sales during 2004 were higher than in 2003.  The Company’s average list price increased by approximately 4% in 2004 compared with the average in 2003.

 

The primary factors affecting our results of operations are:

 

                  prevailing world market prices for pulp;

 

                  the amount of pulp produced and sold by us;

 

                  our costs of production, which principally consist of the costs of materials (primarily wood and chemicals) and depreciation; and

 

                  the relationship between the real, the currency in which approximately  50% of our cash operating cost and expenses (operating expenses net of depreciation and amortization of property, plant and equipment and net of forest depletion) are incurred, and foreign currencies, principally the U.S. dollar, in which more than 95% of our sales are made.  See “—Brazilian Economic Environment—Effects of Inflation and Currency Exchange Fluctuations.

 

The prices that we are able to obtain for our pulp depend upon prevailing world market prices, which historically have been cyclical, with prices subject to significant fluctuations over relatively short periods of time.  See “Item 4B. Business Overview—Market Overview—International Markets.”

 

We believe that we are one of the lowest cost producers of bleached kraft market pulp in the world.  Our relatively low production costs are due to economies of scale, advanced forestry techniques, a comparatively short regional harvest rotation and low energy and chemical costs.  See “Item 4B. Business Overview—General.”

 

Recently Issued Accounting Pronouncements under U.S. GAAP

 

In November 2004, the FASB issued SFAS No. 151, Inventory Costs - an amendment of ARB No. 43. This Standard requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to be recognized as current period charges. Additionally, it requires that allocation of fixed production overhead costs be allocated to inventory based on the normal capacity of the production facility. The provisions of this Standard apply prospectively and are effective for us for inventory costs incurred after January 1, 2006. While we believe this Standard will not have a material effect on our financial statements, the impact of adopting these new rules is dependent on events that could occur in future periods, and as such, an estimate of the impact cannot be determined until the event occurs in future periods.

 

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets an amendment of APB No. 29.  This Statement amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. The Statement specifies that a nonmonetary exchange has commercial substance if the future cash flows of the

 

35



 

entity are expected to change significantly as a result of the exchange.  This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.  Earlier application is permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after the date this Statement is issued.  Retroactive application is not permitted.  Management will apply this Statement in the event exchanges of nonmonetary assets occur in fiscal periods beginning after June 15, 2005.

 

In September 2004, the FASB issued FSP EITF Issue 03-1-1, which delayed the effective date of paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Paragraphs 10-20 of EITF Issue No. 03-1 give guidance on how to evaluate and recognize an impairment loss that is other that temporary.  Application of these paragraphs has been deferred pending issuance of proposed FSP EITF Issue 03-1a.  Management has concluded that EITF Issue No. 03-01 is not applicable to its current operations since it does not have any investments classified as available-for-sale or held-to-maturity, or other investments carried at cost.

 

At its March 31, 2004 meeting, the Emerging Issues Task Force (EITF) reached final consensus on EITF Issue No. 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share.  Typically, a participating security is entitled to share in a company’s earnings, often via a formula tied to dividends on the company’s common stock.  The issue clarifies what is meant by the term participating security, as used in Statement 128. When an instrument is deemed to be a participating security, it has the potential to significantly reduce basic earnings per common share because the two-class method must be used to compute the instrument’s effect on earnings per share.  The consensus also covers other instruments whose terms include a participation feature.  The consensus also addresses the allocation of losses.  If undistributed earnings must be allocated to participating securities under the two-class method, losses should also be allocated.  However, EITF 03-6 limits this allocation only to situations when the security has (1) the right to participate in the earnings of the company, and (2) an objectively determinable contractual obligation to share in net losses of the company.

 

The consensus reached in EITF 03-6 is effective for fiscal periods beginning after March 31, 2004 (effectively the second fiscal quarter for calendar year-end companies).  EPS in prior periods must be retroactively adjusted in order to comply with the consensus decisions reached in EITF 03-6. The Company does not expect that this consensus will have any impact on its calculation of Basic and Diluted EPS.

 

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”. This statement replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle.  The Statement applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. Contrary to Opinion 20 that previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle, this Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.  When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than being reported in an income statement.  When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable.

 

This Statement carries forward without change the guidance contained in Opinion 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate.  This Statement also carries forward the guidance in Opinion 20 requiring justification of a change in accounting principle on the basis of preferability.

 

This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued.  Management will apply this statement in the event that exchanges of nonmonetary assets occur in fiscal periods beginning after December 15, 2005.

 

36



 

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations – an interpretation of FASB Statement No. 143”.  This interpretation clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity.  The Interpretation was issued in order to minimize the diverse accounting practices that have developed with respect to the timing of liability recognition for legal obligations associated with the retirement of a tangible long-lived asset when the timing and (or) method of settlement of the obligation are conditional on a future event.  This Interpretation clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation when it is incurred if the liability’s fair value can be reasonably estimated.

 

The Interpretation is effective no later than the end of the fiscal years ending after December 15, 2005 (December 31, 2005 for calendar-year enterprises).  Management has previously evaluated the application of FASB Statement No. 143 to its operations and concluded that no material effects would be expected.  Management will consider this Interpretation in 2005 in the event a conditional asset retirement obligation arises.

 

Discussion of Critical Accounting Policies and Estimates

 

In connection with the preparation of the financial statements included in this annual report, we have relied on variables and assumptions derived from historical experience and various other factors that we deemed reasonable and relevant. We are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses during the reporting periods and require the disclosure of contingent assets and liabilities as of the date of the financial statements.   The Company’s consolidated financial statements therefore include estimates concerning such matters as the selection of useful lives of property, plant and equipment, provisions necessary for asset impairments, contingent liabilities, employee postretirement benefits and other similar evaluations. Although we review these estimates and assumptions in the ordinary course of business, the portrayal of our financial condition and results of operation often requires our management to make judgments regarding the effects of matters that are inherently uncertain on the carrying value of our assets and liabilities.  Actual results may differ from those estimated under different variables, assumptions or conditions.  Note 1 of the Consolidated Financial Statements includes a summary of the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements.  In order to provide an understanding about how management forms its judgments about future events, including the variables and assumptions underlying the estimates, and the sensitivity of those judgments to different variables and conditions, we have included below a brief discussion of the more significant accounting policies and methods used by us.

 

General

 

The financial statements were prepared in accordance with U.S. GAAP, which in certain respects differ from the accounting principles we apply when preparing financial statements in accordance with Brazilian GAAP.

 

We have reported in U.S. dollars since 1994 when the US Securities and Exchange Commission permitted foreign registrants to report in U.S. dollars rather than in the currency of the country in which they are incorporated.  The U.S. dollar amounts have been remeasured from Brazilian reais (R$) in accordance with the criteria set forth in Statement of Financial Accounting Standards Nº 52 “Foreign Currency Translation” (“SFAS 52”).  The Board of Directors and management have historically considered the U.S. dollar as our functional currency as this has been, and remains in our opinion, the currency in which we principally operate as well as being our primary unit of economic measure.  Accordingly, our management has concluded that our functional currency is and will continue to be the U.S. dollar.

 

Deferred Taxes

 

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities.  We regularly review the deferred tax assets for recoverability and establish a valuation allowance, as required, based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences.  Although the realization of net deferred tax assets is not assured, management believes that, except where a valuation allowance has been provided, such realization is more

 

37



 

likely than not to occur.  The amount of deferred tax asset considered realizable could, however, be reduced if estimates of future taxable income during the tax loss carryforwards period are reduced.

 

Legal Contingencies

 

We are currently involved in certain legal proceedings.  As discussed in note 16 to our financial statements, we have accrued our estimate of the probable costs for the resolution of these claims.  This estimate has been developed in consultation with outside legal counsel handling our defense in these matters and is based upon an analysis of potential results, assuming a combination of litigation and settlement strategies.  We do not believe these proceedings will have a material adverse effect on our financial position.  It is possible, however, that future results of operations could be materially affected by changes in our assumptions and the effectiveness of our strategies with respect to these proceedings.

 

Allowance for doubtful receivables

 

The Company has established a policy with respect to granting of credit to its clients and makes permanent follow-up of accounts receivables open balances. Historically, the Company has not incurred in material bad debt losses. In December 31, 2004 the Company accounted for US$ 496,000 as allowance for doubtful receivables.

 

Impairment testing of goodwill

 

The Company annually evaluates the carrying value of goodwill during and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal  factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. When evaluating whether goodwill is impaired, the Company compares the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying amount, including goodwill. The fair value of the reporting unit is estimated using a discounted cash flows approach. The Company’s evaluation of goodwill completed during the year resulted in  no impairment losses.

 

Brazilian Economic Environment

 

The Brazilian economy has been characterized by frequent and occasionally drastic intervention by the Brazilian government and volatile economic cycles.  The Brazilian government has often changed monetary, taxation, credit, tariff and other policies to influence the course of Brazil’s economy.  For example, the Brazilian government has the authority, when a serious imbalance in Brazil’s balance of payment occurs, to impose restrictions on the remittance to foreign investors of the proceeds of their investments in Brazil, and on the conversion of Brazilian currency into foreign currencies.  Furthermore, in late September 1999, a court in the state of Minas Gerais ruled that the representatives of the board of directors of the minority foreign private partners of Companhia Energética de Minas Gerais, a privatized electric utility in that state, could no longer have veto power over corporate actions.  Also in late September 1999, Brazil’s Federal Supreme Court ruled that pension taxes on retired federal employees and pensioners, as well as the increase of pension taxes charged to active employees, are unconstitutional.  Changes in monetary, taxation, credit, tariff and other policies could adversely affect our business, as could inflation, currency and interest rate fluctuations, social instability and other political, economic or diplomatic developments, as well as the Brazilian government’s response to such developments.

 

Rapid changes in Brazilian political and economic conditions that have already occurred and that might continue will require continued emphasis on assessing the risks associated with our activities and adjusting our business and operating strategy.  Future developments in Brazilian government policies, including changes in the current policy and incentives adopted for financing the export of Brazilian goods, or in the Brazilian economy, over which we have no control, may materially adversely affect our business.  See “Item 3D. Risk Factors—Risk Factors Relating to Brazil.”

 

Brazilian economic conditions may be affected negatively by events elsewhere, especially in emerging markets.  For instance, the Argentine government’s default on certain of its debt obligations, the devaluation of the Argentine peso and terrorist attacks such as those of September 11, 2001 present causes for concern relating to Brazil’s economic

 

38



 

stability.  Instability in the Brazilian financial markets caused by developments in the international financial markets may adversely affect our financial condition and, specifically, our ability to raise capital when needed and the market price of the preferred shares and ADSs.  See “Item 3D. Risk Factors—Risk Factors Relating to Brazil.”

 

The Tax reform recently approved by the Brazilian government has resulted so far in Law No. 10.833/03, extending to Brazil’s Social Security Financing Contribution (Contribuição para o Financiamento da Seguridade Social – “COFINS) the “non-cumulative regime” already mandatory since 2002 for contributions made to Social Integration Program (Programa de Integração Social e de Formação do Patrimônio do Servidor Público “PIS/PASEP), as per Law No. 10.637/02. Law No. 10.833/03 also provided an increase in the tax rate for COFINS now at 7.6% on revenues of Brazilian companies (the rate was formerly 3%). Since the tax is not assessed on export transactions, the Company as a result of the non-cumulative regime, presented a PIS and Cofins credit position, lowering the tax burden for the fiscal  year ended in 2004, in spite of the increase in tax rates.

 

Effects of Inflation and Currency Exchange Fluctuations

 

Until July 1994, Brazil had for many years experienced high and generally unpredictable rates of inflation and steady devaluation of its currency relative to the U.S. dollar.  The following table sets forth Brazilian inflation as measured by the Indice Geral de Preço-Mercado, the General Market Price Index or IGP-M, and the devaluation of Brazilian currency against the U.S. dollar for the periods shown:

 

 

 

1999

 

2000

 

2001

 

2002

 

2003

 

2004

 

Inflation (General Market Price Index)

 

20.1

%

9.8

%

10.4

%

25.3

%

8.7

%

12.4

%

Devaluation (R$v. US$)

 

48.0

%

9.3

%

18.7

%

52.3

%

(18.2

)%

(8.1

)%

 

Inflation and exchange rate variations have had, and may continue to have, substantial effects on our financial condition and results of operations.

 

 Inflation and exchange rate variations affect our monetary assets and liabilities denominated in reais.  The value of such assets and liabilities as expressed in U.S. dollars declines when the real devalues against the U.S. dollar and increases when the real appreciates.  In addition, many financial instruments denominated in reais are indexed for inflation.  In periods of devaluation of the real, we report (a) a remeasurement loss on real-denominated monetary assets, which is offset, at least in part, by monetary indexation of real-denominated financial instruments and (b) a remeasurement gain on real-denominated monetary liabilities, which is offset, at least in part, by the monetary indexation of real-denominated financial instruments.

 

  At December 31, 2004, approximately 86% of our cash and cash equivalents and short-term investments were invested in Real denominated deposits and financial assets.  See “—Liquidity and Capital Resources—Financial Strategy.”

 

A.                                    Operating Results

 

Results of Operations for the Year Ended December 31, 2004 Compared with the Year Ended December 31, 2003

 

The table below shows a summary of the Company’s income statement for the years 2002, 2003 and 2004:

 

 

 

US$ thousands

 

Income statement

 

2002

 

2003

 

2004

 

Net sales

 

668,983

 

1,003,070

 

1,167,113

 

Operating Cost and expenses

 

573,480

 

695,896

 

810,463

 

Operating income

 

95,503

 

307,174

 

356,650

 

Non-operating (income) expenses

 

(773

)

29,932

 

59,148

 

Income tax expense (benefit)

 

(15,573

)

129,116

 

70,256

 

Minority interest in losses (earnings) of subsidiary

 

64

 

(37

)

(9

)

Net income

 

111,913

 

148,089

 

227,237

 

 

39



 

Net operating revenues in 2004 were US$1,167.1 million, US$164.0 million higher than last year, mainly as a result of higher pulp sales volume ($136.4 million), higher pulp prices ($10.6 million) and higher paper sales ($17.6 million). In 2004 total cost of pulp, paper and sawn wood sales totaled $700.3 million, compared to $592.6 million in 2003. The cost of pulp sales in 2004 was $666.3 million, compared to $569.2 million in the previous year, mainly due to higher sales volumes. Production cost per ton in 2004 was $228, compared to $226 in the previous year. Cash production cost in 2004 was $151 per ton, against $144/ton in the previous year, mainly due to higher chemical cost and packaging, sustainment projects related to the maintenance of productive capacity and Brazilian currency appreciation against the US dollar.

 

Cash production cost is an important management information, since it expresses the actual production costs exclusive of non-cash items, such as depreciation and amortization. By adjusting non-cash items out of production cost, the management has an accurate view of cost items that impact the company’s cash flow. The following tables set forth the impacts of each of these items in the Company’s cash production cost, as well as the reconciliation of some non GAAP information to GAAP measures:

 

 

 

US$ per ton

 

Cash Production Cost

 

 

 

2003

 

144

 

Higher chemical cost and packaging

 

2

 

Sustainment projects

 

3

 

Brazilian currency appreciation against the US dollar

 

2

 

2004

 

151

 

 

Non-GAAP information Reconciliation

 

 

 

FY03

 

FY04

 

 

 

US$
million

 

Volume
000/ tons

 

US$
per ton

 

US$
million

 

Volume
000/ tons

 

US$
per ton

 

Cost of sales

 

481.0

 

2,149.0

 

224

 

560.8

 

2,450.0

 

229

 

Pulp inventories on Beginning of the period

 

(37.2

)

(165.7

)

225

 

(67.9

)

(273.4

)

248

 

Guaiba unit acquisition

 

(6.7

)

(29.4

)

227

 

 

 

 

Pulp for paper production

 

4.0

 

22.3

 

181

 

8.6

 

42.1

 

203

 

Other

 

(1.1

)

 

 

(1.3

)

 

 

Pulp inventories on end of the period

 

67.9

 

273.4

 

248

 

70.1

 

277.8

 

252

 

Pulp Production cost

 

507.9

 

2,249.6

 

226

 

570.3

 

2,496.5

 

228

 

Depreciation and depletion in the production cost

 

(183.6

)

 

(82

)

(192.3

)

 

(77

)

Cash production cost

 

324.3

 

2,249.6

 

144

 

378.0

 

2,496.5

 

151

 

 

40



 

Adjusted EBITDA at December 31st, 2004 was US$ 596 million (51% margin), US$ 56 MM higher than last year, mainly due to higher sales volume as a result of the acquisition of Riocell (Guaiba Unit) in July 2003 and higher prices. Adjusted EBITDA in 2003 was US$ 539 million (54% margin). We use adjusted EBITDA as one criterion for evaluating our performance relative to that of our peers. We believe that adjusted EBITDA is useful for that purpose because comparisons based on other measures, such as net income or cash flows from operating activities, include elements that vary from company to company depending on where they are located or on their capital structure.  We also use  adjusted EBITDA in the determination of a portion of the compensation for our employees.  We do not present adjusted EBITDA as an alternative measure of operating results or cash flow. Adjusted EBITDA does not represent net income or cash flows from operating activities, as these terms are defined by generally accepted accounting principles.   Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Adjusted EBITDA is a measure that approximately represents the cash generation of the company, that is adjusted by the company (“Adjusted EBITDA”) by provisions and other non-cash items to better represent the cash generation. See table below:

 

Adjusted EBITDA:

 

 

 

Year Ended December 31,

 

In millions of US$

 

2000

 

2001

 

2002

 

2003

 

2004

 

Net income

 

201.7

 

18.1

 

111.9

 

148.1

 

227.2

 

Financial income

 

(64.8

)

(54.7

)

(61.6

)

(43.0

)

(56.1

)

Financial expenses

 

101.4

 

70.2

 

82.0

 

108.2

 

120.0

 

Income tax expense (benefit)

 

82.1

 

32.7

 

(15.6

)

129.1

 

70.3

 

Equity in results of affiliated companies

 

1.3

 

(1.2

)

(6.1

)

6.8

 

11.6

 

Loss (gain) on currency remeasurement, net

 

(8.8

)

18.0

 

(14.9

)

(41.9

)

(16.2

)

Other, net

 

(0.1

)

(0.2

)

(0.2

)

(0.1

)

(0.1

)

Operating income

 

312.8

 

82.9

 

95.5

 

307.2

 

356.7

 

Depreciation and depletion

 

168.0

 

162.6

 

171.5

 

191.5

 

206.9

 

EBITDA

 

480.8

 

245.5

 

267.0

 

498.7

 

563.6

 

Non-cash charges

 

10.9

 

22.8

 

53.6

 

40.4

 

32.2

 

Provision (reversal) for labor indemnity

 

2.3

 

(1.2

)

1.0

 

1.5

 

1.4

 

Provision for loss on ICMS credits

 

 

10.7

 

45.1

 

23.1

 

22.9

 

Provision (reversal) for loss on inventory

 

1.3

 

(0.1

)

1.2

 

(1.2

)

(0.3

)

Provision for a tax contingency

 

 

 

1.4

 

10.3

 

1.3

 

Fixed asset write-offs

 

1.6

 

8.9

 

1.1

 

1.9

 

0.3

 

Amortization of prepaid expenses

 

2.3

 

1.2

 

1.2

 

 

 

Loss on the sale of obsolete spare parts

 

0.8

 

0.7

 

0.5

 

2.5

 

1.0

 

Loss on the sale of affiliated company

 

 

 

 

 

5.1

 

Allowance for doubtful accounts

 

 

 

0.9

 

2.3

 

0.5

 

Other

 

2.6

 

2.6

 

1.2

 

 

 

Adjusted EBITDA

 

491.7

 

268.3

 

320.6

 

539.1

 

595.8

 

 

Sales and distribution expenses were $53.8 million, $15.2 million higher than in the previous year, mainly due to a 14% higher sales volume, changes in the geographical sales mix, and higher terminal expenses.

 

Administrative expenses were $31.1 million, $8.3 million higher than in 2003, mainly due to greater services expenses, such as consulting services and legal fees, and the local currency’s appreciation against the dollar.

 

41



 

Other operating expenses came to $25.2 million, $16.8 million lower than in the previous year, mainly due to a lower provision for fines relating to tax contingencies, of $9.0 million; a lower allowance for doubtful accounts, of $1.8 million; smaller losses on the sale of obsolete spare parts, of $1.5 million; lower fixed asset write-offs, of $1.5 million; and $6.4 million of tax credits for PIS/Cofins on depreciation, partially offset by the non-cash impact of a $ 5.1 million accounting loss from the sale of 2/3 ownership in Aracruz Produtos de Madeira S.A. (APM).

 

The Financial and Currency remeasurement results amounted to $47.7 million, $24.5 million higher than in the previous year, mainly due to increased financial expenses and a lower currency re-measurement gain, partially offset by increased financial income (see chart below).

 

The increase in interest on financing was mainly due to a 16% increase in the average balance of gross debt in 2004 compared to 2003. The increased financial income was mainly due to gains on hedging transactions against the local currency (R$), which also covered the 50% hedging needs of Veracel’s balance sheet exposure (Aracruz’s equity interest).

 

(US$ million)

 

2004

 

2003

 

Financial Expenses

 

120.0

 

108.2

 

Interest on financing

 

93.8

 

79.4

 

Taxes (PIS/COFINS and CPMF)

 

11.9

 

24.4

 

Interest on fiscal contingency provisions

 

12.2

 

15.6

 

Other

 

2.1

 

(11.2

)

Financial Income

 

(56.1

)

(43.0

)

Currency re-measurement

 

(16.2

)

(42.0

)

Total

 

47.7

 

23.2

 

 

In 2004, the Brazilian currency (R$) appreciated 8.1% against the US dollar, compared to an appreciation of 18.2% in the previous year. The closing exchange rate on December 31, 2004 was R$2.6544 per US dollar.

 

Income taxes in Brazil comprise federal income tax and social contribution (which is an additional federal income tax).   The statutory rates applicable for federal income tax and social contribution for the years ended December 31, 2002, 2003 and 2004 are presented as follows:

 

Federal income tax rate

 

25.0

%

Social contribution (*)

 

9.0

%

Composite tax rate

 

34.0

%

 

Income tax and social contribution amounted to an expense of $70.3 million, against $129.1 million in the previous year. Tax charges are calculated based on the Brazilian GAAP results, and consequently influenced by the exchange rate variation’s effect on monetary assets and liabilities denominated in US dollars. The positive impact of the exchange rate variation for 2004 on the Brazilian GAAP results was lower than in the previous year. The taxes were also reduced in 2004 as a result of payments of Interest on Shareholders’ Equity, which are deductible for tax purposes.

 

The amounts reported as income tax expense in the consolidated statements of income are reconciled to the statutory rates - See Note 4.1 to our 2004 Consolidated Financial Statements.

 

42



 

As a result of all of the above-described factors, net income in 2004 totaled US$227.2 million, compared to US$148.1 million in 2003.

 

Results of Operations for the Year Ended December 31, 2003 compared with the Year Ended December 31, 2002

 

Net operating revenues in 2003 were US$1,003.1 million, compared to US$669.0 million in 2002.  The US$334.1 million increase was primarily due to a US$235.7 million increase in pulp sales volume and US$76.3 million increase in the average prices of pulp. In 2003, total cost of pulp and sawn wood sales was US$592.6 million, compared to US$468.9 million in 2002.  This increase was mainly due to a US$162.6 million increase in the sales volumes, offset by a US$50.3 million decrease in production costs, mainly due to lower depreciation and depletion.  Production costs per ton in 2003 were US$226, compared to US$238 in 2002.  Cash production cost in 2003 was US$144 per ton as against US$138 per ton in 2002, mainly due to higher wood costs as a consequence of purchased wood volume and longer average distance from the forest to the mill.

 

Selling expenses were US$38.6 million in 2003, compared to US$28.2 million in 2002, mainly due to higher sales volume.

 

Administrative expenses were US$22.8 million, compared to US$22.3 million in 2002, mainly due to the local currency appreciation against the dollar.

 

Other operating expenses, net, totaled US$42.0 million in 2003, compared to US$54.1 million in 2002, mainly due to a lower provision of US$21.9 million for loss of the ICMS tax credit, partially offset by a higher provision for fines on tax contingencies of US$8.9 million.

 

Financial income in 2003 was US$43.0 million, compared to US$61.6 million in 2002.  The difference was mainly due to lower interest rates and lower interest on tax credits, given the reduction in the amount of credits.

 

Financial expense was US$108.2 million in 2003, compared with US$82.0 million in 2002, as demonstrated in the table below:

 

(US$ million)

 

2003

 

2002

 

Interest on financing

 

79.4

 

61.5

 

Taxes (PIS/COFINS and CPMF)

 

24.4

 

17.1

 

Interest on fiscal contingency provisions

 

15.6

 

8.2

 

Other

 

(11.2

)

(4.8

)

Total

 

108.2

 

82.0

 

 

Currency re-measurement resulted in a net gain of US$42.0, compared with US$14.9 million in 2002, the differences arising from fluctuations in the exchange rate of reais versus dollars. The closing exchange rate on December 31, 2003 was US$1 = R$2.8892.

 

Income tax totaled US$129.1 million in 2003, compared with income tax credit of US$15.6 million in 2002.  Given the fact that tax charges are calculated based on Brazilian GAAP results, the increase was mainly due to the profits in local currency, a record for the Company.

 

As a result of all of the above-described factors, net income in 2003 totaled US$148.1 million, compared to US$111.9 million in 2002.

 

43



 

B.                                    Liquidity and Capital Resources
 

At December 31, 2004, we had total debt outstanding of US$1,375.7 million, an increase of 0.3% over total debt outstanding at December 31, 2003 of US$1,371.5 million.   At March 31, 2005, the Company’s total debt outstanding decreased to US$1,373.6 million, primarily due to exchange rate variation.

 

The Company’s working capital is sufficient for the Company’s present requirements.

 

The breakdown of our total debt outstanding at December 31, 2004 and December 31, 2003 is set forth in the table below:

 

 

 

At December 31,

 

 

 

2003

 

2004

 

 

 

(millions of U.S. dollars)

 

SHORT-TERM DEBT

 

 

 

 

 

Current portion of long-term debt

 

 

 

 

 

Local currency

 

41.1

 

43.2

 

Foreign currency

 

226.6

 

98.1

 

Short-term debt instruments

 

 

 

 

 

Local currency

 

1.1

 

3.8

 

Foreign currency (ACC/ACE)

 

117.2

 

0

 

Accrued finance charges

 

 

 

 

 

Local currency

 

0.9

 

1.0

 

Foreign currency

 

5.2

 

6.9

 

Subtotal

 

392.1

 

153.0

 

LONG-TERM DEBT

 

 

 

 

 

Local currency

 

169.8

 

148.5

 

Foreign currency

 

809.6

 

1,074.2

 

Subtotal

 

979.4

 

1,222.7

 

TOTAL DEBT

 

1,371.5

 

1,375.7

 

 

At December 31, 2004, our outstanding debt in local currency totaled US$196.5 million and was comprised primarily of loan agreements with Banco Nacional de Desenvolvimento Econômico e Social—BNDES. BNDES is a major shareholder of the Company.

 

At December 31, 2004, the Company’s outstanding debt exclusive of accrued interest was approximately US$783.5 million based on fixed interest rates, US$350.4 million based on Libor, US$38.5 million based on a basket of currencies and US$195.4 million based on TJLP.

 

The Company does not have any significant financial covenant under its debt instruments that may substantially affect the Company’s operations or financial condition.

 

At December 31, 2004, our long-term debt maturities were as follows:

 

 

 

Maturing in

 

 

 

2006

 

2007

 

2008

 

2009

 

2010 and
beyond

 

Total

 

Long-term debt

 

 

 

 

 

 

 

 

 

 

 

 

 

(in millions of US$)

 

256.8

 

336.8

 

264.9

 

137.0

 

227.2

 

1,222.7

 

 

44



 

At December 31, 2004, we had cash, cash equivalents and securities of US$450.2 million, an increase of US$97.9 million from US$352.3 million at December 31, 2003.  The equivalent of US$419.3 million was invested in local currency instruments and US$30.9 million was invested abroad, mostly in U.S. dollar time deposits with leading financial institutions.  At March 31, 2005, the Company had cash, cash equivalents and time deposits of US$520.5 million.

 

Net debt (gross debt less cash holdings) reached US$925.5 million at December 31, 2004 as compared to US$ 1,019.2 million at December 31, 2003.  The decrease was mainly due to cash generated from operations, partly offset by capital expenditures of US$94.5 million, investments in affiliate company of US$99.0 million and dividends / interest on shareholders’ equity of US$198.7 million, paid to shareholders.

 

Net debt (gross debt less cash holdings) reached US$1,019.2 million at December 31, 2003 as compared to US$ 519.9 million at December 31, 2002.  The increase was mainly due to capital expenditures of US$118.7 million, acquisition and investments in affiliate company of US$673.4 million and dividends of US$109.3 million, paid to shareholders, partly offset by cash generated from operations.

 

Net debt (gross debt less cash holdings) reached US$519.9 million at December 31, 2002 as compared to US$ 437.4 million at December 31, 2001.  The increase was mainly due to capital expenditures of US$260.7 million, and dividends of US$73.8 million, paid to shareholders partly offset by cash generated from operations.

 

Our short-term debt consists primarily of trade financing in the form of export sales advances, or ACC, discounted export accounts receivables, or ACE, and prepayments for exports and Euro-commercial paper borrowings, all denominated in foreign currency.  ACC and ACE are forms of financing available from Brazilian financial institutions or Brazilian branches of foreign financial institutions at a fixed rate with a maturity of up to 360 days prior to shipment of pulp for export, in the case of ACC, and with a maturity of up to 180 days after shipment of pulp for export, in the case of ACE.  Prepayments for exports are a form of financing available from importers or foreign financial institutions at a fixed rate with maturity of either up to 180 days or more than one year, in each case prior to the shipment. As of December 31, 2004 there is no outstanding principal amount of such short-term trade financing as a consequence of our effort to improve our debt maturity.  As of December 31, 2003, the outstanding principal amount of such short-term trade financing was US$117.8 million at an average annual interest rate of 1.7% and an average month-end balance of US$181.1 million during 2003. As of December 31, 2002, the outstanding amount of such short-term trade financing was US$7.5 million at an average annual interest rate of 4.7% and an average month-end balance of US$24.6 million during 2002.The Company’s long-term debt consists primarily of U.S. dollar-denominated debt issued outside Brazil in the amount of US$1,172.3 million at December 31, 2004 and loans from BNDES, one of the Company’s principal shareholders, denominated in Reais and in foreign currencies.  At December 31, 2004, the Company had loans from BNDES with an aggregate principal amount outstanding of R$620.9 million (US$233.9 million) (as compared to R$765.7 million (US$263.3 million) at December 31, 2003), which represented approximately 17% of the Company’s total indebtedness at such date.  At  December 31, 2004, of the total aggregate principal amount of the BNDES debt, US$195.4 million was denominated in Reais and adjusted by the Taxa de Juros de Longo Prazo (the Long-term Interest Rate or “TJLP”), and US$38.5 million was adjusted by a currency basket.

 

In February 2002, the Company, through Aracruz Trading S.A., signed a financing agreement with a special-purpose entity (SPE) under which such entity received and advanced to the Company US$ 250 million, as an issuance of Senior Secured Export Notes. In August 2003, a second tranche of Senior Secured Export Notes was issued, in the amount of US$ 400 million under the same securitization program established in February 2002. In May 2004, a third tranche of Senior Secured Export Notes was issued, in the amount of US$ 175 million under the same securitization program.  In return, the Company securitized the financing by selling to the SPE 95% of its current and future export accounts receivables. In June 2003 this obligation was reduced to 80% of such receivables. In February 2004, Aracruz Trading Hungary Ltd. was included in the securitization program, in addition to Aracruz Trading S.A. Each month the collections in excess of contractual funding requirements are transferred to Aracruz Trading S.A and Aracruz Trading Hungary Ltd.  The table below summarizes the terms of the three tranches under the securitization programs:

 

45