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Latin America Cement & Construction

Sailing with the Wrong Compass: A 1-POSITIVE
Necessary Discussion about P/E and ROE Latin America Cement & Construction
Guilherme Vilazante
Although we acknowledge that P/E and ROE are the most popularly used and almost +55 11 3757 7376
universal valuation metrics, we view them as rather inappropriate references for
valuation and profitability for the Brazilian homebuilders. Reported earnings do not BBSA, São Paulo
reflect the homebuilders’ ability to generate cash (either now or on a recurring basis), Vinicius Mastrorosa
therefore making multiples based on them misleading and untrustworthy, in our view. +55 11 3757 7227
Earnings are distorted by 1) a backward-looking accounting; 2) distortive effects of
BBSA, São Paulo
nominal changes in assets and liabilities in a capital-intensive sector (the principle of
conservatism in accounting makes the asset and liability adjustments take place in
different times and be influenced by different degrees of lumpiness); and 3) the blend of
several harvests of projects launched since 2007. In this report, we discuss these effects
in detail and show how distortive and long-lasting they can be in turning unimportant
events (from a valuation standpoint) into volatile, too high or too depressed earnings
streaks – often leading to the consolidation of ungrounded reputations (positive or
negative) and flawed investment decisions, in a sector with scarce evidence of enduring
competitive advantage among peers.

Despite evidence that such fluctuations in earnings are largely motivated by incidental
factors and that margins will eventually normalize and converge to the mean, the
market tends to attribute these deviations to ingrained and everlasting company traits,
closing its eyes to the fact that super profits will likely be competed away during the
following land acquisition round. Conversely, any bad strategic move that hurts
margins throughout an entire production cycle possibly will not be renewed under the
same terms; companies have a great amount of flexibility to adapt the product mix with
little cost involved, and there is no reason to insist on unprofitable segments in the next
development cycle.

Alas, such a distorted measure, in our view, is the main relative valuation tool, making
stocks often trade at an undue premium on (non-recurring or undue) glories of the
past, or trade at an unjustifiable discount on the extrapolation of a negative event. We
believe that any recommendation based on P/Es and ROEs for Brazilian homebuilders
should be viewed with some caution and should always have its coherence supported
by more thorough analysis, preferably discounted cash flow (DCF) or net-worth

Barclays Capital does and seeks to do business with companies covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.
This research report has been prepared in whole or in part by research analysts based outside the US
who are not registered/qualified as research analysts with FINRA.
Barclays Capital | Br Housing Digest

“In the 3Q10 we accelerate the In our opinion, the pervasive use of earnings (and its derivatives – P/E and ROE) to appraise
construction pace of some the real estate sector should be more seriously considered and challenged. Though
projects in order to be able to convenient (easily available and widely used), we believe earnings do not reflect accurately
deliver more projects than the companies’ ability to generate cash (in the present and on a recurring basis). The ample
previously expected by the end use of P/E multiples makes this discussion even more necessary, as we believe distortive
of the year, so that we could valuation measures can lead to unfounded decisions. Or worse, the excessive focus on next
have higher revenue recognition year’s earnings can motivate companies to take sub-optimal decisions to lessen the impact
in 2010 in the case of the end of on the bottom line in a way the market could perceive as negative (see side quote).
the POC accounting standards
(and consequently the revenue Below we outline what we view as the most frequent distortive factors for
recognition only by key- earnings
delivery)” – CFO of a listed
1) Lagging Revenues Bias: The backward-looking nature of revenues (which reflect
company on the 4Q10 results
launches with a delay of 12-24 months), combined with a long development cycle (at least
conference call.
three years) depresses earnings in the early stages of growth, causing a distortive under-
dilution of SG&A so that healthy incremental launches result in negative earnings in the first
year, depressing margins and ROE.

2) Conservatism Principle Bias: Reported earnings encompass both profit from operations
and changes in net value of assets and liabilities; however, the second component is
dominant, non-operating, volatile, distorted, and unbalanced. The principle of conservatism
in accounting (and the lengthy production cycle) turns changes on the liability side into
one-off negative adjustments (triggering exaggerated reactions), while gains on the asset
side can inflate margins artificially for several quarters (creating an undue reputation of
excellence, in our view).

3) Wrong Attribution Bias: In addition to the biases described above, the bottom line is a
blend of several harvests of projects since 2007 (quite an unsteady period), which further
contributes to the deviation of the reported earnings from the mean for several quarters.
Despite the ample evidence that such deviations are motivated by incidental factors and
that margins will eventually normalize during the following cycles, the market tends to
attribute such performance to skill (or lack of skill), and P/E adoption perpetuates such
deviations, creating artificial champions and laggards without, in our view, a material basis.

The “Wrong Attribution Bias” becomes even more distorting given the high dependency of
margins on the quality of the budgeting process. A flawed budgeting (not frequent or not
accurate enough) can distort margins significantly throughout the cycle, making a company
that takes longer to identify a cost overrun seem more profitable for years (e.g., Cyrela in
4Q10; see our 16 March, 2011 “Cyrela’s Guidance Cut: Will other homebuilders follow suit?
We don’t think so” for more details).

On the next pages we describe each of the mentioned biases and provide examples.

Drawback 1: The Lagging Revenues Bias

We believe that one of the most striking drawbacks for earnings (ROEs and P/Es) is the
material underestimation of margins during the early stages of growth. To illustrate this
distortion we have created a didactic example. The percentage of completion (POC)
methodology for revenue recognition, combined with a three-year construction cycle,
quarterly earnings release, and a certain level of fixed costs, amplifies the operating leverage
effect, which compresses ROEs and margins for at least three years after growth wanes.

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Example 1: Why is ROE of little use in the early stages of growth?

A start-up company launches R$1 billion per year, with a 30% gross margin, zero income
tax and no SG&A. Revenues from a unit launched will be recognized following the POC
(20% in the first year, 40% in the second, and 40% in the third year after the launches). To
finance this venture, the company raises R$600mn in equity. Please see in Figure 1 the ROE
distortion that weak revenue recognition causes during the first couple of years, depressing
the asset turnover component.

Figure 1: Start-up Example 1

Year 0 Year 1 Year 2 Year 3 Year 4

Launches - 1,000 1,000 1,000 1,000

Sales - 1,000 1,000 1,000 1,000
Revenues - 200 600 1,000 1,000
Gross Mg 30% 30% 30% 30% 30%
Gross Profit - 60 180 300 300
Net Margin 0% 30% 30% 30% 30%
BV 600 660 840 1,140 1,140
ROE 0.0% 9.1% 21.4% 26.3% 26.3%
Source: Barclays Capital Research

What multiple would one be willing to pay for a company with a 9% ROE versus a peer with
a 21% ROE? The challenge is that we are referring to the same company, but with one year
ahead in completion. The numbers used in this example are not far from reality. This
example show us that 1) earnings do not reflect the company’s ability to generate cash on a
recurring basis (in the first year earnings amount to R$60mn, and the company will
generate R$300mn per year on a recurring basis two years later); and 2) ROE is a polluted
valuation measure until a couple years after a company stops growing.

To make the example above more realistic, let’s assume that our company incurs some
SG&A: with this additional fixed-cost component, the slow ramp-up of revenues under POC
amplifies the operating leverage, illustrating how inappropriate the reported earnings can be
as a proxy of the ROE.

Example 2: Why is P/E of little use in the early stages of growth? The
operating leverage effect
Watch out for the effect of SG&A of R$120mn (12% of launches) over earnings and
margins (please see Figure 2). Needless to say, in years 1 and 2 earnings are significantly
downplaying the company’s ability to generate cash in year 3.

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Barclays Capital | Br Housing Digest

Figure 2: Start-up Example 2

Year 0 Year 1 Year 2 Year 3 Year 4

Revenues - 200 600 1,000 1,000

Gross Margin 30% 30% 30% 30% 30%
Gross Profit - 60 180 300 300
(-) SG&A (12% of Launches) - (120) (120) (120) (120)
Net Profit - (60) 60 180 180
Net Margin 0% -30% 10% 18% 18%
BV 600 540 600 780 780
ROE 0.0% -11.1% 10.0% 23.1% 23.1%
Source: Barclays Capital Research.

The main takeaway from the examples above is that earnings significantly downplay the
company’s ability to generate cash until the third year after a slowdown in volumes. We
believe the “Lagging Revenues Bias” is the most often overlooked, and is especially unfair to
start-up developers (or even large ones during a strong ramp-up period), making them
seem less profitable than an equally efficient but more sluggish peer.

The positive about this bias is that it can easily be adjusted. For example, Brookfield has a
launches guidance of R$5billion for 2011 (mid range). Those launches will come down to
revenues along the construction cycle, and revenues will converge to launches volume. A
good proxy for earnings can be achieved by replacing revenues for launches in 2011,
combined with a reasonable net margin (15% is a good level in our opinion), then check the
potential distortion from the Lagging Revenues Bias. In our example, the 2011 adjusted
earnings for Brookfield would reach R$750mn (15% of R$5bn of launches), 74% above our
earnings estimate for 2011 (downward biased by lagging revenues). See Figure 3 below to
identify the stocks where this distortion is more patent.

Figure 3: Launches-Revenue Gap

10,000 9,500



5,400 35%
5,500 5,000 4,850
4,350 41%
99% 38%

2,500 2,200

Brookfield Rossi PDG Tecnisa Gafisa MRV Cyrela Even

3Q10 Rev Ann 2011E Launches

Source: Barclays Capital Research and Companies’ Info.

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Example: Rossi 2009

Rossi is a very telling example, in our view. In March 2009, the company was viewed as a
poor operator with sub-par margins (EBITDA margin of 8.6% and ROE of 5.5% in the
previous year, well behind competitors). It caused the stock to trade at a 46% discount to its
peers on a P/BV adjusted basis at that time.

However, a more accurate analysis of the Rossi situation would point out that most of the
margin performance could be attributed to under-dilution of SG&A and financial expenses
driven by temporarily depressed earnings: 12-month trailing revenues were 33% bellow the
12-month trailing launches. Revenues eventually caught up sales/launches, and Rossi’s
margins have converged to the sector’s average. Currently Rossi’s margin is pretty close to
its peers, and the discount on valuation has narrowed significantly.

Figure 4: Rossi’s Launches vs. Revenue

900 25%


700 24%

400 115%



- 5%
2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10

Launches (left axis) Revenues (left axis) EBITDA Mg (right axis)

Source: Barclays Capital Research and Company’s Info.

Another case to illustrate the confusion that backward-looking revenues recognition can
create was observed in 2007/2008. At that point smaller homebuilders (start-up companies
at the time) were posting lower margins (when compared to large and more diversified
players). This pattern has given rise to the notion that homebuilding was a “big guys”
business, that smaller companies were uncompetitive and that the fate of smaller
companies was to be incorporated. With hindsight, it is easy to verify that such low margins
(and ROEs too) were largely caused by under-dilution of SG&A, and, as revenues caught up
to sales, operating margins have regressed to the mean. See Figure 7 on page 8 for the
evolution of margins for the companies in our coverage universe.

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Barclays Capital | Br Housing Digest

Drawback 2: The Conservatism Principle Bias

Assets and liabilities adjustments are dominant over the operating

component of earnings
As mentioned, reported earnings encompass both 1) profit from operations and 2) changes
in net value of assets and liabilities. However, the second component is non-operating,
volatile, dominant, unbalanced, and crippled by a lengthy cycle and the conservative GAAP.
Earnings have to accommodate nominal changes in assets and liabilities in a capital
intensive, multi-indexed and largely inflation-hedged business. However, the conservatism
principle makes the asset and liability sides of the adjustments (which are sizable but
usually offset one another) take place in different moments and under different degrees of
lumpiness, playing havoc with earnings and contributing to make it a poor proxy of
companies’ ability to generate cash. For more detail please refer to our BR Housing Digest:
“About Inflation and Margins: Don’t Overreact Now, Don’t Overpay Later” dated October
21, 2010.

Liability impact: Short-run margin volatility, limited impact on valuation

The principle of conservatism in accounting determines that any nominal change that
impacts liabilities (including inflation adjustments), must be expensed right away in the
income statement, which tends to cause downward volatility in reported margins.
Sometimes an immaterial event such as a small cost overrun (over the three-year cycle)
tend to be amplified by the accounting rules that require that all the profit unduly accrued in
the past is deducted from the revenues in a single quarter through a one-off deduction from
revenues (e.g. MRV in 4Q10, see “MRV 4Q10 Results – Has the Decline in Margins Started?”
dated March 24, 2011 for more details). Such an adjustment can be significant as a typical
mid-income production cycle usually takes three years. We estimate that a 1p.p. cost
overrun can hurt margins by 6p.p. in the quarter if it is recognized in the middle of the
construction cycle and by 12p.p. if identified at the end of the project. Such episodes of
volatility, though occasional and with limited impact on the valuation, erode the confidence
of investors in reported earnings and usually take a disproportionate toll on stock prices.

Figure 5: Cost Overrun: Mid-Cycle Recognition Figure 6: Cost Overrun: End-Cycle Recognition

40% 40%

35% 35%
34% 34%

30% 30%

25% 25%
Return (Area): 34/100 Return (Area): 34/100 23%

20% 20%
1Q 2Q 3Q 4Q 5Q 6Q 7Q 8Q 9Q 10Q 11Q 12Q 1Q 2Q 3Q 4Q 5Q 6Q 7Q 8Q 9Q 10Q 11Q 12Q

Source: Barclays Capital Research. Source: Barclays Capital Research.

Rossi 1Q08 results and Cyrela 2Q10 (and more recently “Cyrela 4Q10 Results – Sizeable
(pre-announced) Budget Revision Hurting Reported Margins” dated March 28, 2011) are

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Barclays Capital | Br Housing Digest

examples of such episodes; in the six months after the unexpected miss in margins the
stocks have underperformed the index by 15% and 17%, respectively.

Assets effects – Non-recurring gains on assets can unduly swell margins for
a long time
The same principle in accounting determines that an asset gain can only be reflected on the
statements when its materialization is beyond reasonable doubt. Therefore, economic gains
over assets (especially appreciation of land or units in inventory), instead of being recorded
when the economic gain takes place, will only be reflected in the results when the inventory
is depleted (land is developed or units are sold). Therefore, an occasional one-off gain from
assets appreciation (such as an unexpected hike in units’ price) tends to swell margins for
several quarters in a somewhat smooth pattern. The problem is that the use of P/E
extrapolates these lagging and swollen margin gains, treating them as recurring results for
several quarters and creating false champion reputations.

Example: MRV 2009 and PDG 2010

When the government low-income package was announced in March 2009, no other
company was as well positioned as MRV in the segment. They had a large inventory of both
land (three years of launches) and units (more than 13 months of sales, 80% of which fit in
the low-income program). This excessive inventory on the eve of the MCMV package (in
4Q08), allowed the company to take advantage of a 15%+ increase in real prices observed
in low income units with a cost basis fixed in 2008 levels, bringing this windfall directly to
the gross margins of the units sold after 1Q09; this is possibly behind MRV’s superior
margin over this time.

PDG has recently gone through a similar situation: in May 2010 PDG acquired Agre, a
company focused on the mid-high income segment with high exposure to the southeast
region, more concentrated in São Paulo city, with an inventory of units of R$1.5bn and
landbank of R$18bn (potential sales value). During 2010, house prices rose by more than
20% in the mid-high income segment, especially in the large cities where Agre operates
(São Paulo and Rio), directly impacting the company’s margins: PDG’s EBITDA margin rose
from 22% in 3Q09 to 28% in 3Q10.

We have strong reasons to believe that both companies’ margins should converge to the
sector’s average. In our view, any change (negative or positive) in the market has adjusted
shortly after the benefit was granted: competition soon worked to compensate more
expensive houses. Land prices have more than doubled in some regions, especially in the
MCMV space where the competition has stiffened a lot since 2009 on the back of lower
barriers to entry (induced by the package).

Therefore, if the statements were to recognize the economic gains from land appreciation,
inventory would be marked to market, MRV and PDG would have recognized a sizable one-
off gain when land prices in the segments they operate went up, their cost base would be
marked to market, and thus their margins would be lower than they are right now.

However, the large inventory of land held by the two companies (PDG with a lot of old plots
of land inherited from Agre and MRV that 35% of what was launched in 2010 still used
lands acquired before MCMV) combined with the POC accounting rule, will likely contribute
to maintaining their margins artificially above their peers for several quarters more.

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Drawback 3: The Wrong Attribution Bias

In addition to the two distorting effects described above, the current bottom line is a blend
of several harvests of projects since 2007 (production cycle spans four years). Volumes and
margins are unevenly, temporarily and sometimes strongly impacted by events such as the
hike in prices of low income (2009) and mid/high income (2010) levels, cost overruns
(projects launched in 2007/2008), the quasi-interruption in launches that companies went
through during the credit crisis of 2008, and one-off events such as acquisitions, equity
offerings, and financial gains from financing buyers.

Reported earnings are, therefore, composed of so many resulting forces that work for such
a prolonged time (another contribution of lagging accounting) that, whenever a deviation
occurs, we lack the means to determine whether this deviation is incidental or idiosyncratic,
concentrated on few projects or extensive, temporary or long lasting, financial or
operational, deliberate or unintentional – making it hard to decide how to treat it from the
valuation standpoint.

Historical series analysis suggests a pattern of convergence to the mean for margins,
indicating that deviations are more likely attributable to one-off, ephemeral events 1 than to
skill-related factors; this trend has become especially clear after 4Q10 when two of the most
profitable companies in the past, MRV and Cyrela, have announced downward revisions
(significant in Cyrela’s case), signalling that part of the historical margin advantage owes
more to inaccurate budgeting than to superior operating skills. Indeed, anecdotal and
numeric evidence suggests that there is no such a thing as premium developers, although
the spread in multiples suggests that the market has a diverse opinion (please refer to our
BR Housing Digest “Margins of the Same Feather Should Trade Together” dated April 26,

Figure 7: Historical EBITDA Margin (deviation around the mean)







1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10


Source: Barclays Capital Research.

Regression to the mean is one of the strongest clues to identifying a system where incidental factors prevail over
intrinsic skill, for a very interesting read about the subject we suggest Michael Mauboussin’s article “Untangling Skill
and Luck” dated July 15, 2010.

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Assuming our opinion about the drivers of deviation is accurate, the market should not be
paying a premium or applying a discount, as the deviation drivers are likely short-lived and
have little impact on valuation (despite the strong influence over next year’s margin). The
most likely outcome, in our view, is that their margins will converge to the mean whenever
these effects of these one-off events phase out.

Understanding the “Wrong Attribution Bias”

Despite the evidence that such fluctuations are motivated by unintended and incidental
factors, and that margins will eventually normalize, the market tends to attribute these
deviations to ingrained and everlasting traits of companies, closing its eyes to the fact that
super profits will likely be competed away during the following land acquisition round (as
observed with the low income segment in the aftermath of the MCMV package in 2009;
please see our report “MRV: Why we are less bullish about the stock?” dated August 16,
2010). Conversely, any bad strategic move that hurts margins throughout an entire
production cycle possibly won’t be renewed under the same terms – companies have a
great amount of flexibility to adapt the product mix with little cost involved, and there is no
reason to insist on unprofitable segments during the next cycle. We name this trend the
“Wrong Attribution Bias”. Gafisa’s foray in the N and NE regions (that has likely hurt
margins between 2008 and 2011), and Cyrela’s reputation of higher profitability vs. their
peers (before sizable margin cuts in 2010 on the back of budget revisions) are eloquent
examples of victim and beneficiary of the “Wrong Attribution Bias”

Throw the hindsight mirror away, handle P/E with care

P/E is, in our opinion, the main conduit of the three “biases” we mentioned in this report, as
it amplifies the deviation, multiplying the noise component of the earnings (either positive
or negative, but almost always relevant) by 7, 8, 9 or 10x, by our estimates; perpetuating
such deviations, creating artificial champions and laggards without a material basis. We
favour DCF analysis, which we feel is much less challenging than many might think (we
have built a simplified model whose utilization we recommend: please see “BREATH:
BarCap’s Rather Easy Appraisal Tool for Homebuilders” dated January 5, 2011). Secondarily
we favour the use of net worth multiples P/BV and P/LV as more stable and accurate
metrics for relative valuation (please see the “Liquidation Value and Book Value Multiples
Report – 3Q10 edition” dated November 17, 2010).

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I, Guilherme Vilazante, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of
the subject securities or issuers referred to in this research report and (2) no part of my compensation was, is or will be directly or indirectly
related to the specific recommendations or views expressed in this research report.


For current important disclosures, including, where relevant, price target charts, regarding companies that are the subject of this research report,
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Materially Mentioned Stocks (Ticker, Date, Price)
Brookfield (BISA3.SA, 30-Mar-2011, BRL 8.24), 1-Overweight/1-Positive
Cyrela (CYRE3.SA, 30-Mar-2011, BRL 15.27), 2-Equal Weight/1-Positive
Gafisa (GFSA3.SA, 30-Mar-2011, BRL 10.10), 1-Overweight/1-Positive
MRV (MRVE3.SA, 30-Mar-2011, BRL 12.88), 3-Underweight/1-Positive
PDG (PDGR3.SA, 30-Mar-2011, BRL 9.07), 1-Overweight/1-Positive
Rossi (RSID3.SA, 30-Mar-2011, BRL 13.71), 1-Overweight/1-Positive
Guide to the Barclays Capital Fundamental Equity Research Rating System:
Our coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2-Equal Weight or 3-Underweight (see definitions
below) relative to other companies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (the “sector
coverage universe”).
In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-
Negative (see definitions below). A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors
should carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone.
Stock Rating
1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month
investment horizon.
2-Equal Weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-
month investment horizon.
3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month
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1-Positive - sector coverage universe fundamentals/valuations are improving.
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3-Negative - sector coverage universe fundamentals/valuations are deteriorating.
Below is the list of companies that constitute the "sector coverage universe":

Latin America Cement & Construction

Brookfield (BISA3.SA) Cyrela (CYRE3.SA) Even (EVEN3.SA)

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Barclays Capital | Br Housing Digest


Rossi (RSID3.SA) Tecnisa (TCSA3.SA)

Distribution of Ratings:
Barclays Capital Inc. Equity Research has 1710 companies under coverage.
43% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Buy rating; 52% of
companies with this rating are investment banking clients of the Firm.
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companies with this rating are investment banking clients of the Firm.
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companies with this rating are investment banking clients of the Firm.
Guide to the Barclays Capital Price Target:
Each analyst has a single price target on the stocks that they cover. The price target represents that analyst's expectation of where the stock will
trade in the next 12 months. Upside/downside scenarios, where provided, represent potential upside/potential downside to each analyst's price
target over the same 12-month period.
Barclays Capital offices involved in the production of equity research:
Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London)
New York
Barclays Capital Inc. (BCI, New York)
Barclays Capital Japan Limited (BCJL, Tokyo)
São Paulo
Banco Barclays S.A. (BBSA, São Paulo)
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Barclays Bank PLC, Hong Kong branch (Barclays Bank, Hong Kong)
Barclays Capital Canada Inc. (BCC, Toronto)
Absa Capital, a division of Absa Bank Limited (Absa Capital, Johannesburg)

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