BPI EQUITY RESEARCH Telcos Brazil Telecoms
The Holy Grail of Brazilian Telecoms 6th October 2014
4 Have we reached the boiling point? Oi hiring BTG Pactual and news that TIM has Brazil hired Bradesco to study the possibility of buying each other leads to the conclusion that we are on the verge of consolidation in the sector. Moreover, the press is rumouring about the step down of Oi CEO which could speed up TEF vs. PTC vs. Eurostoxx Telco the process. We estimate annual savings of BRL 1.8bn and a net value accretion 251 of BRL 16.3bn under a TIM+Oi merger scenario. This compares with the current combined Op.CF and Mkt Cap of both companies of BRL 2.7bn and BRL UFG 231 44.5bn, respectively! Still the control of Oi is yet to be clarified as the migration to Novo Mercado and the merger between preference and ordinary shares have not been completed. Moreover, Oi's strategic importance in the wireline communications 211 Fvsptupyy and its status of national champion make unviable an operation without the Ufmdp authorities blessing, and would be odd to see a move before the end of the elections. 91
4 Oi priced for perfection? Under the assumptions set in our last note "PT: New 71 terms approved" issued on the 9th of September, and assuming PT can monetize QUD the entire value of the call option, PT is trading between a discount of 13.5% 51 and a premium of 7.9%, excluding any holding discount that we believe is Tfq-24 Kbo-25 Nbz-25 Tfq-25 owed. Oi, on its hand, is trading at 15.1x Op.CF15 at a premium to TEF Brazil (11.2x). Adding BRL 1.4bn annual savings from potential consolidation to Oi Source: Bloomberg. OpCF would lead Oi to trade in line with Vivo. This amount of savings represents 79% of the synergies of our TIM+Oi merger scenario. The M&A scenarios seem to be holding the stock up and any disappointment on that front is likely to impose a massive correction. If it is confirmed that Oi's CEO steps down we would also expect a negative reaction.
4 Back to acquisition mode: TEF seems to have returned to acquisition mode and the recent deals (DTS and GVT) do not seem cheap enough to avoid resurfacing old concerns. The possibility of a bid for TIM Brazil that could go up to BRL 40bn, o.w. TEF would have to contribute 1/3 seems to be getting less likely, though. We continue optimistic on TEF core markets (Spain, Brazil, Germany and UK) but the EBITDA keeps a negative trend in all of TEF core operations. The lag in operational recovery, acquisition risks and a balance sheet in the debt plus hybrids upper limit sustain our negative stance.
Summary of Recommendations
Market Price YE15 LfL Recommendation PE EV/EBITDA DY (E/share) (4th Oct) PT chg. New Old 15F 15F 15F PTC (1) 1.56 UR - UR UR 27.6 5.7 3.7% TEF 12.00 12.20 0% Reduce Reduce 15.5 5.7 3.3% (1) Oi's multiples with bloomberg consensus estimates. Source: BPI Equity Research.
Analyst Available on our website: Pedro Pinto Oliveira www.bpiequity.bpi.pt, BPI Online, [email protected] Phone 351 22 607 3194 and Bloomberg at NH BPD Equity Research 4 Telcos Brazil 4 October 2014
INDEX
3 Brazilian telecoms top down analysis
7 Wireline access lacking quality and alternatives
11 Pay-TV - Several trying but only a few succeeding
13 Mobile is king
19 Is consolidation the solution?
22 Synergies: The holy grail of the industry
24 Wrapping Up
2 Equity Research 4 Telcos Brazil 4 October 2014
BRAZILIAN TELECOMS TOP DOWN ANALYSIS
The telecom sector in Brazil has recorded an accumulated growth of 251% since 2000 in local currency which compares with a lethargic growth in Europe in the same period (up 20% with a negative trend since 2006) justifying the focus European players (PT, TEF, TI and Vivendi) have been giving to the country. But not everything is rosy about Brazilian Telecoms. A reality check reveals that the telecom sector has been losing weight in the overall economy with net revenues as a % of GDP dropping from 3.9% in 2011 (peak) to 2.8% in 2013 despite the growing penetration in most of the telecommunications segments.
Telecommunication services net revenues in Brazil (BRL bn) 271/1 6/1%
5/1% 231/1
4/1% 91/1 3/1%
51/1 2/1%
1/1 1/1% 2I2 3111 3112 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124 Broadband penetration 2012 Upubm$ofu %$HEQ (% population)
Source: TeleBrasil and BPI Equity Research. VL
VTB Moreover, deflating the telecom sector growth we can observe that in 4 out of the last 5 years the sector has recorded negative growth in real terms. From one side this Qpsuvhbm reflects the tough competitive environment, but also the difficulties Telecom Dijob operators have to work in high inflation environments given the hurdles to pass
through price increases in the industry. Csb{jm
1% 21% 31% 41% 51% Gross revenues yoy evolution (%) Pay-Tv penetration 2012 (% 31% homes) zpz$(opnjobm)
26% VL
21% VTB
6% Qpsuvhbm
Dijob 1% zpz$(sfbm) Csb{jm -6% 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124 1% 61% 211%
Source: TeleBrasil and BPI Equity Research. Source: Oi.
3 Equity Research 4 Telcos Brazil 4 October 2014
Another point that has been penalizing the industry and favouring the decreasing 3G penetration 2012 weight of net revenues in the overall economy is the growing burden of tributes (% population) (taxes, rates and contributions). In fact we believe the weight of tributes are a key element to understand the industry in Brazil (1) (probably the economy as well as VL tributes are also present in other areas of the economy) and draws attention the VTB fact that tributes are more than double of comparable countries in Latin America, Brazil among the countries with higher tax burden North America and Europe placing Qpsuvhbm in telecommunications in the world! The main reason is the (2) ICMS that charges 25% of the gross revenues (in some States goes up to 35%) and does not allow Dijob deduction of ICMS supported with expenses, contrarily to what happens with VAT in Europe. On top of the charges over the gross revenues, and aside from the Csb{jm regular taxes charged indeferentially to all sectors, the sector also supports important 1% 61% 211% charges to finance FISTEL (Fund for Telecommunication supervision). Contrarily to the above mentioned tributes the FISTEL charges are booked in the company's Smartphone penetration 2012 Opex and weight close to 5% of the industry Opex (3.6% of the net revenues). (% population)
VL
Telecommunication sector tributes (BRL bn) VTB
91 61% Qpsuvhbm 51% 71 Dijob 41% 51 Csb{jm 31%
31 1% 31% 51% 71% 21% Source: Oi. 1 1% 2I2 3111 3112 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124
Usjcvuft %$ofu$sfwfovft
Source: TeleBrasil and BPI Equity Research.
Mobile segment is the main source of revenues by far. In less than a decade mobile revenues surpassed fixed telephony revenues and now represent more than the double of the revenues of fixed telephony, once the lion's share of telecommunication services. The extension of territory (almost the size of Europe but 3.7x less population) has favoured a strong fixed-to-mobile substitution, as deploying mobile technology is significantly more efficient, on top of the worldwide commoditization of fixed voice. Pay-TV and wireline broadband have in smaller scale also been growing significantly and increasing the levels of penetration. Still Brazil continues to compare poorly in most penetration metrics of telecommunication services with Western countries and there is significant room for growth on this front.
4 Equity Research 4 Telcos Brazil 4 October 2014
Gross revenues evolution (BRL bn) Gross revenues 1H14
361
311
261
211
61
1 3111 3112 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124
Gjyfe$ufmfqipoz Cspbecboe Npcjmf Qbz-UW Usvoljoh
Source: TeleBrasil.
The main telecom operators in Brazil per segment are the following:
Main Telecom Operators in Brazil
Fixed telephony Mobile Broadband Pay-TV Telefonica Telesp Vivo Telesp TVA Oi Oi Oi Oi Oi America Movil Embratel Claro Net & Embratel Net & Embratel Tim (1) Tim (2) - GVT (4) GVT - GVT GVT Nextel (5) - (3) -- DirectTV (6) -- SKY SKY (1) Less than 2% market share. (2) Less than 1% market share. (3) Nextel worked intiatially with Trunking and then acquired 3G spectrum in 2010. (4) In the process of being acquired by TEF only pending regulatory approval from Brazilian authorities. (5) Nextel only shareholder, NII Holdings, as filled for creditors protection in the US. (6) DirectTV is the process of being acquired by AT&T only pending regulatory approval from US authorities. Source: BPI equity Research.
Telecommunication sector Only 3 players in Brazil are able to work in all segments with relevant coverage. revenue market share With no surprise America Movil, TEF and Oi are the biggest players by revenue market share. Moreover, given the size of the mobile market no player without a relevant presence in the mobile segment is able to have a relevant position in the telecommunication arena. Therefore the pie of revenues is mostly divided among the big 4 groups that dominate the mobile segment (America Movil, TEF, Oi and TIM represent 85% of the total market or 89% if we include GVT which is in the process of being acquired by TEF).
It's worth to mention, as it might have some implications in the evolution of the market structure, that AT&T is entering the market indirectly through the acquisition of DirectTV and that Nextel sole shareholder has filled for creditors protection in the US. Source: Companies data & Teleco.
5 Equity Research 4 Telcos Brazil 4 October 2014
Despite the size of the market, the scale benefits are not reflected in the margins the operators report. We believe is a combination of high tax burden, a vast territory with low population density that brings along significant costs in network and commercial capillarity, and a high inflation context that pressures costs and capex up but is not fully reflected in top line.
2013 EBITDA (BRL mn)
23$111 61%
21$111 51% 9$111 41% 7$111 31% 5$111 21% 3$111
$1 1% UFG Bnfsjdb Pj UJN Tlz HWU Ofyufm Npwjm FCJUEB FCJUEB$nh
Source: Companies data & BPI Equity Research.
The picture gets worse when looking from an OpCF point of view as TEF Brazil as the only player that is generating sizeable operation cash flow before corporate taxes. Nonetheless, we cannot ignore that Brazil is deploying a massive capex plan in the sector in an effort to catch up to western countries and to support the big sports events in the country (2014 Football World Cup and 2016 Olympic Games). The sector investments have grown from BRL 19bn in 2009 to BRL 29bn in 2013! Vivo superior performance partially reflects its bigger exposure to mobile (66% of the revenues) within the 3 integrated players and a significantly higher scale when compared with TIM.
2013 OpCF [EBITDA-Capex] (BRL mn)
7$111 27/1%
23/1% 5$111
9/1% 3$111 5/1%
$1 O0B 1/1%
-3$111 -5/1% UFG UJN Pj Tlz HWU Bnfsjdb Npwjm
PqDG PqDG$nh
Source: Companies data & BPI Equity Research.
6 Equity Research 4 Telcos Brazil 4 October 2014
WIRELINE ACCESS LACKING QUALITY AND ALTERNATIVES
The access to telecommunications services in Brazil through wireline is available nationwide. Oi, America Movil and GVT present a wide broadband coverage in the country. TEF has been focused in São Paulo but with the acquisition of GVT will boost its wireline coverage and Brazil will have three integrated players able to offer quadruple play offers in the country.
TEF fixed broadband footprint GVT fixed broadband footprint
OI fixed broadband footprint America Movil fixed broadband footprint
Source: Companies data, Telebrasil & BPI Equity Research.
7 Equity Research 4 Telcos Brazil 4 October 2014
Nonetheless, the coverage illustrated represents the regions where the operators Market share of broadband are present but not the full capillarity within those regions. The level of competition accesses (2Q14) in both fixed telephony and broadband is low in a large number of regions. As the map with number of operators per municipality with authorization to provide fixed telephony services reveals in a vast extension of the territory the incumbent is the only provider. In broadband, out of 5561 municipalities, 60 municipalities have only one provider, 1085 have only two providers and only 229 have cable networks able to compete with the copper network. According to Oi CEO, Oi is present in 4800 municipalities and covers seven times more municipalities with fixed networks than the second largest operator.
Source: Teleco. Distribution of number permissions for fixed telephony services per municipality
Source: Atlas Brasileiro de Telecomunicações.
8 Equity Research 4 Telcos Brazil 4 October 2014
Probably as reflection of the lack of alternatives, Brazil still presents low levels of Broadband access speed penetration of broadband services and a strong concentration in a few number of (1Q14) cities. Still the trend has been significantly positive in the recent years and in the opposite direction to fixed telephony penetration. For now, and despite the deficient coverage of wireline, the fixed-to-mobile substitution is a phenomena mostly limited to telephony services.
Penetration of wireline services per home (%)
71%
61%
51%
41% Source: Anatel.
31%
21%
1% 311: 3121 3122 3123 3124 Gjyfe$ufmfqipoz$qfofusbujpo Cspbecboe$qfofusbujpo Qbz-UW$qfofusbujpo Breakdown of broadband technology (Dec13) Source: Teleco.
The quality of accesses is also revealing of the underdevelopment of wireline communications as 87% of the users have broadband speeds below 12 Mbps. According to "State of Internet" study the average broadband speed in Brazil is 2.9Mbps below the world average of 4.6Mps.
The question is if wireline broadband will keep the pace of mobile broadband enhancement and if it will still be economic viable in a large number of regions to do significant more investments in the wireline network. Having said this, there is no 4G without connecting with fibre 4G sites. It's true that extending the capillarity of fibre to cover 4G sites Source: Teleco. is not the same as to connect homes with fibre (there are 69k mobile cell sites in Brazil of all operators which compares with 65mn homes in Brazil) but that should continue to ensure investments in wireline networks. Moreover, in more dense areas that will likely have more concentration of 4G mobile towers the marginal cost of rolling over FTTH will likely pay-off. Therefore we expect the recent trend of higher weight of investments in the wireline to persist. Market share of fixed telephony accesses (2Q14) Still, the wide extension of the territory of Brazil will continues to favour wireless solutions in most of the territory and we believe that wireline investments are likely to be concentrated in more dense areas. In this sense we believe mobile broadband usage is likely to accelerate massive and fixed-to-mobile-substitution is likely to spread to broadband particularly outside the more dense areas.
Source: Teleco.
9 Equity Research 4 Telcos Brazil 4 October 2014
Capex in the Brazilian industry (BRL bn) 31
27
23
9
5
1 3111 3112 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124 Xjsfmjof Xjsfmftt
Source: Teleco & Companies data.
In 2015, Anatel will perform the quinquennial review of the concession contracts of fixed telephony (STFC). The companies have been arguing that the decline of fixed telephony is starting to put at risk the financial and economic equilibrium of the concessions and Anatel may consider changes in the terms of the contract before the end of the concession in 2025. This could represent a dramatic change in the wireline segment with important implications for Oi. If any change is implemented we would expected to be done with the intention of promoting more investments in the wireline network and at same time ensuring Oi has a key role on it.
10 Equity Research 4 Telcos Brazil 4 October 2014
PAY-TV - SEVERAL TRYING BUT ONLY A FEW SUCCEEDING
The development of the Pay-TV segment in Brazil was conditioned by legislation that until 2011 did not allow Telecom operators to operate in the PaV-Tv segment. Moreover, the poor development of wireline networks favoured the satellite TV solution. Consequently, today the Pay-TV market services are strongly independent from the remaining wireline services leading to a lower penetration of 3-Play. America Movil is probably the only player that is being able of successfully playing the 3P and is also the leading Pay-TV provider. Another important aspect of the market structure is the heavy concentration as the two biggest groups operating in Pay-TV represent 83% of the total market.
Overall, the segment has decelerated significantly the growth in 2013 and 2014 despite the almost unanimous view of the segment growth potential. The economic environment and operators concerns with the quality of sales in order to reduce customer default are the main forces behind this deceleration.
Main TV operators x-ray
Coverage(1) Group Operator Technology Subs Dec 13 Mkt share Cities Homes (mn) Pop. (mn) America Movil Net Serviços Cable 6 060 176 34% 155 24.5 79.5 Claro TV DTH 3 597 928 20% N.A 37.8 10.9 DirectTV SKY DTH & MMDS 5 371 385 30% 144 1.1 3.3 Oi Oi TV Cable & DTH 828 843 5% 4 1.1 3.3 GVT GVT DTH 677 544 4% N.A N.A N.A TEF Vivo TV Cable, DTH & MMDS 605 622 3% 56 11.5 36.2 (1) Coverage relates only to cable and MMDS. DTH is offered in the entire territory. Source: Atlas Brasileiro de Telecomunicações and BPI Equity Research.
Again, the underdevelopment of wireline technology favours the conditions for DTH (Satellite) solutions in Pay-TV. In just 5 years, DTH has taken over the Pay- Tv market and we believe that the mid-term evolution of this segment will continue to be supported on satellite technology. The development of FTTH networks should bring additional solutions for the segment but as we argued before will likely be restricted to a small number of cities.
In our view, this means that raising 3-Play and 4-Play penetration will not be as crystal clear as in countries where all the wireline services are delivered through the same technology in most of the areas. Moreover, we believe that the increasing penetration of 4G will likely favour integrated solutions in countries with strong wireline offers. Off-loading mobile data to WiFi when people are at home will be more and more frequent and operators will have the incentive to lead customers to integrated offers as a result of that. In Brazil we anticipate that trend to be significantly less important and the benefits of integrated solutions less obvious for the customer, aside from price discounts.
11 Equity Research 4 Telcos Brazil 4 October 2014
Weight of Pay-TV subs per technology
7% 6% 4% 3% 2% 1%
44% 48% 57% 66% 72% 73%
71% 69% 62% 54% 49% 49%
3119 311: 3121 3122 3123 3124 Dbcmf EUI NNET
Source: Telebrasil & Anatel.
Nonetheless, America Movil has been quite successful in pushing 3P and 4P products, though in part capitalizing on its cable reach. Without surprise, America Movil continues to lead Pay-TV net additions despite the massive market share it already has. TEF has been the main surprise in the last couple of years. Despite having a competitive advantage in mobile which reflects positively on its brand perception and having the second largest cable coverage in Brazil continues to struggle to grow in the Pay-TV segment. We believe that conditions are likely to change with GVT acquisition.
The strong bet that Oi is doing on Pay-TV, ensuring more satellite capacity, an agreement with Globo and reshaping its commercial reach, is likely to bring some dynamic to the segment as well. Lastly, the ongoing acquisition of DirectTV (Sky shareholder) by AT&T could also bring changes for the segment.
Pay-TV net additions (k) 711
511
311
1
-311 2U24 3U24 4U24 5U24 2U25 3U25
Ofu+Fncsbufm TLZ HWU Wjwp Pj
Source: Teleco.
Regulation could also play an important role in the Pay-TV segment. Brazil is still working with analogic TV and the Government has revealed intention to promote the shutdown of analogic TV in some cities in 2015. It's still unclear what could be the implications of such a change and how will it impact the equilibrium of forces between the main Pay-Tv operators and the main content providers (mainly Globosat and Fox).
12 Equity Research 4 Telcos Brazil 4 October 2014
MOBILE IS KING
The frequencies available in Brazil to provide mobile service (SMP) are in the Usage of spectrum per following bandwidth: bandwidth a) 850 MHz - bandwidths working in GSM auctioned before 2000 b) 900 MHz - extension sub-bands used for GSM <1000Mhz coverage c) 1700 e 1800 MHz - bandwidth and extension sub-band used for GSM auctioned >1.0<3.0Ghz capacity between 2000 and 2002 >3.0Ghz performance d) 1900 e 2100 MHz - mostly destined to 3G and auctioned in 2007 Source: Anatel. e) 2.5 GHz - bandwidth auctioned in 2010 dedicated to 4G f) 700 MHz - bandwidth auctioned in 2014 aiming to promote 4G wide coverage
Map of areas for distribution of frequencies
Source: Anatel.
13 Equity Research 4 Telcos Brazil 4 October 2014 H 20 20 20 20 20 1.9/2.1 Nextel - - - - - M 1.8 GHz GHz 15 20 20 15 20 20 15 20 20 15 15 20 20 15 15 20 20 15 15 15 SME 800/900 ------700 MHz MHz (1) 2.5 V2 Oi F/I 1.9/2.1 40 20 20 40 20 20 40 30 20 30 30 20 45 30 20 30 30 20 40 20 20 50 20 20 30 30 20 40 20 20 1.8 GHz GHz GHz D/E/ M/SE ------5 A/B/SE 800/900
elated with the "Copa das Confederações", to deploy network in 2 700 MHz MHz (1) 2.5 V1 TIM F/G/I 1.9/2.1 30 30 20 20 30 20 20 20 40 20 20 20 30 20 20 20 40 20 20 20 40 30 20 20 1.8 GHz GHz GHz ------
esponsible in the first phase, r A/B/SE D/E/SE 800/900 1 700 MHz MHz (1) 2.5 W F/G/I Claro 1.9/2.1 45 20 40 20 25 20 20 20 20 30 30 40 20 25 20 20 20 20 45 20 40 20 27 20 20 20 20 1.8 GHz GHz GHz D/E/ L/SE - - - A/B/SE 800/900
TE network in the 2.5GHz band. Oi was r 3
e L 700 MHz MHz
X ch. 2.5 J
20 40 20 22 30 20 40eement to shar 20 Vivo 1.9/2.1 - 30 20 40 20 25 20 30 40 20 27 20 20 20 20 1.8 GHz GHz GHz L/M/ E/SE - 22 10 20 40 20 20 22 30 20 40 20 25 20 20 40 20 2227 10 30 20 20 40 40 20 20 25 20 20 40 20 22 30 20 40 20 25 20 20 40 20 20 30 20 40 20 22 10 20 40 20 25 20 30 40 20 30 55 30 60 40 30 55 30 60 40 30 55 30 60 40 30 55 30 60 40 30 55 30
eleco and BPI Equity Resear MHz A/B/SE 800/900 (1)
ce: Anatel, T BA, SE Amazonia Nordeste C. Oeste RJ, ES MG RS PR, SC SP Interior Maximum SP 22 10 20 40 20 25 20 20 40 20 9 8 7 3 4 6 5 2 1 Mobile frequencies per operator and area (MHz) 10 (1) Allowed by regulation (2) The breakdown does not include frequencies from the band P (20 Mhz 2.5 GHz bandwidth). Claro and Oi won 11 lots each in this TIM grabbed 6 lots. (3) Bandwidth dedicated to SME (trunking). Anatel is tudying the possibility of migrating it SMP (regular mobile service). Sour Note: Oi and TIM have closed an agr Rio de Janeiro, Belo Horizonte, Brasília, Fortaleza e Salvador while TIM was liable for Recife. In the second phase, is responsible São Paulo, Natal and Curitiba. Oi will handle 4G deployment in Porto Alegre, Manaus and Cuiabá. Following the agreement between Oi and Claro, Vivo Claro signed an MoU (Mar13) in order to build together a plan for infrastructure sharing blackhaul next 3 years, involving 4G and 3G networks.
14 Equity Research 4 Telcos Brazil 4 October 2014
The most important reading of the breakdown of frequencies, in our view, is that Oi Mobile broadband accesses has significantly less bandwidth than its direct peers (excluding Nextel which is a small market share (Jul14) player with limited coverage). Particularly worrisome for Oi competitive position is that it does not have any frequencies below 1000MHz essential to ensure coverage at an affordable cost. Moreover, in frequencies dedicated to 4G Oi has 1/3 of the frequencies of Vivo and Claro and half of TIM (excluding band P which does not offer nationwide reach). According to a study produced by LCA for the 2014 Telebrasil forum 4G will represent 35% of total traffic of mobile data until 2018 which means Oi competitive disadvantage will be clear in the coming years and not just on the long run.
Obviously this gap was significantly widened due to the recent decision of Oi not to participate in the 700 MHz frequencies auction. This seems a decision based on financial constrains that is conditioning the mid-term competitive position. Moreover, as the Brazilian ministry of industry pointed out the company maintains the compromises assumed at the time of the acquisition of 2.5GHz frequencies but without any Source: Teleco. frequencies in the 700MHz which are significantly more efficient to ensure coverage.
Still this is not the end of the road for Oi. The situation has got tougher and riskier but there is more than one alternative to repair competitive position. Anatel is studying the possibility of allowing the 800MHz bandwidth for LTE (4G). This means migrating Nextel frequencies dedicated to trunking and probably auctioning some sub-bands in 2015. Both the possible auction in 2015 as well as Nextel bandwidth (acquisition, merger or JV) may provide Oi the means to correct (in part?) the current competitive disadvantage. And the fourth lot of 700 MHz frequencies has not been bought by anyone in the recent auction and is not entirely impossible that we saw it being auctioned again down the road. Finally the most widely discussed alternative to repair competitive position is a merger with TIM Brazil which we will analyse in more detail in the next chapters.
Mobile subscribers evolution (mn) 2014 Mobile termination rates E 411 271% ( /min)
231% Csb{jm 1/19 311
91% Dijmf 1/15 211 51% Nfyjdp 1/13
1 1% Qfsv 1/12
2::7 2::8 2::9 2::: 3111 3112 3113 3114 3115 3116 3117 3118 3119 311: 3121 3122 3123 3124 Hfsnboz 1/13 Tvctdsjcfst %$qfofusbujpo$qpq/ Tqbjo 1/13 Source: Telebrasil.
VL 1/12 The mobile market is considered in a mature stage by some given that the level of SIM cards as a % of the population is already above Western countries standards. Source: BPI Equity Research. However, this reading is a misconception in our view. First the level of penetration differs from State to State and even more if we look on municipality per municipality. Second, the high level of penetration figure is highly influenced by the cost of off- net calls (deriving from still high termination rates) that compels consumers to have more than one SIM card. According to a study performed by IBGE in 2012 each mobile user has on average 2.13 SIM cards and 74mn Brazilians (including children below 10 years old that amount close to 30mn) do not have a mobile phone!
15 Equity Research 4 Telcos Brazil 4 October 2014
Map of the federal districts Mobile penetration per Federal district (UF)
Area UF Mobile penetration 1 SP 154% 2 3 RJ 149% ES 125% 4 MG 126% 5 PR 132% SC 137% 6 RS 146% 7 AC 122% RO 153% MT 141% MS 153% GO 139% DF 246% TO 141% 8 AM 112% RR 109% AP 135% PA 115% MA 95% 9 BA 118% SE 127% 10 PI 119% CE 123% RN 137% PB 125% PE 137% AL 120% Source: Anatel. Source: TeleBrasil.
Aside from the upside that 74mn Brazilians without mobile could bring, the level of penetration of mobile data also contradicts the theory of a mobile segment in a mature stage. The penetration of mobile broadband accesses stands at 67%.
3G and 4G coverages validate our stance and justifies the still low penetration of mobile broadband. Only Vivo has a coverage in 3G close to GSM and 4G coverage is very incipient in all players. Consequently in significant municipalities Brazil still lacks alternatives in mobile broadband which do not seem to reflect the picture of a mature segment. In a nutshell, we believe that mobile segment in Brazil is far from mature stage and mobile data provides a huge upside for the sector augmented by the difficulties wireline faces to provide speed in a vast territory with low population density.
16 Equity Research 4 Telcos Brazil 4 October 2014
Number of municipalities covered (#) Mobile service revenues 5$111 market share (2013)
4$111
3$111
2$111
1 Wjwp Dmbsp UJN$ Pj Ofyufm Puifs
Bmm$Npcjmf 4H 5H Source: Companies data, Telebrasil & BPI Source: Teleco. Equity Research.
Surprising enough, Vivo, despite having a strong competitive advantage in 3G Mobile post paid subs market coverage does not come first in 3G subscribers, though being top1 in total number share (Jul14) of subscribers. Oi without surprise is the operator with fewer number of 3G and 4G subscribers reflecting its poor coverage compared with its direct competitors but also the commercial challenges the company has been facing in the last years.
Number of accesses (K)
211$111
91$111
71$111
51$111 Source: Teleco. 31$111
$1 Wjwp Dmbsp UJN$ Pj Ofyufm Puifs
Upubm 4H 5H
Source: Teleco.
On a value perspective, Vivo is by far the player best positioned with a higher portion of high-end customers probably explained by a superior market share in post-paid segment. Vivo is the player with highest revenue share (33%) by far and the best positioned to ride the strong growth avenue in the segment - mobile data.
17 Equity Research 4 Telcos Brazil 4 October 2014
Breakdown of market shares per region
UF Name % 2014 GDP % territory Popul. (mn) Vivo Claro TIM Oi Nextel SP São Paulo 33.9% 2.9% 44.1 33% 25% 28% 13% 1% RJ Rio de Janeiro 11.2% 0.5% 16.4 29% 35% 17% 17% 2% MG Minas Gerais 9.1% 6.9% 20.7 32% 14% 27% 24% 0% PR Paraná 6.1% 2.3% 11.1 16% 19% 55% 10% 0% RS Rio Grande do Sul 5.6% 3.3% 11.4 41% 29% 13% 16% 0% SC Santa Catarina 4.9% 1.1% 6.7 23% 20% 44% 14% 0% DF Distrito Federal 3.9% 0.1% 2.9 20% 38% 20% 21% 0% BA Bahia 3.7% 6.6% 15.1 25% 29% 23% 23% 0% GO Goiás 2.5% 4.0% 6.5 24% 39% 18% 18% 0% ES Espirito Santo 2.3% 0.5% 3.5 74% 9% 7% 10% 0% PE Pernambuco 2.3% 1.2% 9.3 9% 29% 31% 30% 0% CE Ceará 1.9% 1.7% 8.4 5% 26% 35% 33% 0% PA Pará 1.9% 14.7% 8.1 35% 9% 38% 18% 0% AM Amazonas 1.6% 18.4% 3.9 65% 7% 19% 9% 0% MT Mato Grosso 1.6% 10.6% 3.2 53% 25% 12% 11% 0% MA Maranhão 1.2% 3.9% 6.9 20% 14% 33% 34% 0% MS Mato Grosso do Sul 1.1% 4.2% 2.6 45% 35% 14% 6% 0% PB Paraíba 0.9% 0.7% 3.9 11% 25% 32% 33% 0% RN Rio Grande do Norte 0.8% 0.6% 3.4 8% 29% 36% 28% 0% SE Sergipe 0.7% 0.3% 2.2 59% 13% 12% 16% 0% AL Alagoas 0.6% 0.3% 3.3 14% 31% 33% 22% - RO Rondônia 0.6% 2.8% 1.8 23% 44% 13% 21% 0% PI Piauí 0.5% 3.0% 3.1 14% 40% 31% 15% 0% TO Tocantins 0.4% 3.3% 1.5 20% 36% 14% 31% 0% RR Roraima 0.2% 2.6% 0.5 64% 7% 20% 9% 0% AP Amapá 0.2% 1.7% 0.8 60% 6% 22% 12% 0% AC Acre 0.2% 1.8% 0.8 64% 22% 6% 8% 0% Brazil -- 202.0 29% 25% 27% 19% 0.4% Source: Teleco & Wikipedia.
18 Equity Research 4 Telcos Brazil 4 October 2014
IS CONSOLIDATION THE SOLUTION?
Consolidation could bring additional scale benefits, synergies and more market power which in theory are likely to improve the companies CF generation ability. For different reasons we see Nextel, Sky, Oi and TIM as natural candidates to be involved in consolidation processes. Moreover, the combination of factors are so strong that we would be surprised if no further consolidation move happens in the coming months.
Nextet lacks the scale to survive in this market, particularly with a growing trend for convergent packages. Adding to this the fact that its controlling shareholder has filled for creditor's protection in the US we believe the sale to be inevitable.
Sky has been for now out of danger with its focus on the Pay-Tv segment. Still as the other integrated players move more and more to 3P the risks for Sky increase. Moreover, we cannot ignore the ongoing acquisition of DirectTV (Sky parent company) by AT&T. AT&T has already revealed in the past ambition to expand to Brazil and though the primary objective of acquiring DirectTV is not entering Brazil it allows AT&T an entry door. Still we do not exclude a divestment from AT&T.
Oi is now with an important competitive disadvantage in its mobile unit due to the lack of spectrum below 1GHz, low 3G coverage and smaller subscriber base than its competitors. But we believe Oi's risks go well beyond this with the company in financial distress and likely to burn significant cash at least in the coming 2 years. We believe Oi basically reflects a lack of scale to support the opex and capex attached to its current structure. In our view, the company has an urgent need of consolidation in order to improve its competitive position, gain scale and promote some deleverage.
TIM lack of wireline solutions to play the growing trend of convergent packages posts some risks from a strategic point of view. Moreover, the stressed balance sheet of its parent company and lower scale than the others impose some limitations on the cash available to keep the pace of investments in the industry. The cash needs Telecom Italia has in its domestic market with a strong cycle of investments ahead is also a relevant variable for the equation.
When we and the market talk about consolidation in Brazil to enhance the operators CF profile we are basically looking to the mobile segment. It's not that there aren't interesting deals in the wireline as we recently witnessed with GVT acquisition by TEF but the reality is that only consolidation in the mobile segment can constitute a game changer. The two main reasons for this is the weight of mobile in the Brazilian telecommunications but also the lack of alternatives in the wireline which inevitably would force the regulator to impose harsh remedies on any relevant concentration in the segment reducing the value of potential deals. So the benefits have to come from mobile segment. The problems of concentration in the mobile segment will arise from 2 fronts:
19 Equity Research 4 Telcos Brazil 4 October 2014
1) Market concentration per region to be analysed by CADE (Brazilian anti- trust)
As a rule of thumb any concentration that implies a market share above 50% in one state is likely to be blocked or tackled by remedies. Moreover, we believe that a merger between Vivo and Claro to be highly unlikely and therefore exclude it from the analysis. A deal with Nextel while it could be strategic accretive for Oi does not constitute a game changer and consequently we also excluded it from the analysis.
Combined market shares for the several merger scenarios
UF Vivo + TIM Claro + TIM Oi + TIM Claro + Oi Vivo + Oi SP 61% 53% 41% 38% 46% RJ 46% 52% 34% 52% 46% MG 59% 41% 51% 38% 56% PR 71% 73% 65% 29% 27% RS 54% 43% 30% 46% 57% SC 67% 64% 58% 34% 37% DF 40% 58% 41% 60% 42% BA 48% 52% 46% 52% 48% GO 42% 57% 37% 57% 43% ES 81% 17% 17% 19% 83% PE 41% 60% 62% 59% 40% CE 40% 61% 68% 60% 39% PA 73% 48% 56% 27% 52% AM 84% 27% 28% 16% 74% MT 64% 37% 22% 36% 63% MA 53% 47% 67% 47% 54% MS 59% 49% 20% 41% 51% PB 43% 57% 65% 57% 43% RN 43% 64% 64% 57% 36% SE 71% 25% 28% 29% 75% AL 47% 64% 55% 53% 36% RO 36% 57% 34% 64% 43% PI 45% 71% 46% 55% 29% TO 34% 50% 45% 67% 51% RR 85% 27% 29% 16% 73% AP 82% 28% 34% 18% 72% AC 70% 28% 14% 30% 72% Brazil 56% 52% 45% 43% 47% Source: Teleco & BPI Equity Research.
The obvious conclusions from this analysis are that:
a) no centration is possible without all the players involved (in the first phase or in a second phase buying assets to help the operators involved in concentration to comply with the likely remedies from anti-trust authorities) as in any combination there are always several regions where the threshold of 50% is breached; b) The merger between Claro and Oi is the one that triggers less problems of dominant position (but likely to be blocked by authorities due to excessive concentration in the wireline);
20 Equity Research 4 Telcos Brazil 4 October 2014
c) Oi is the operator that posts less issues of being acquired by any of the others and in a scenario of breakup of one of the players is the one that would be more easily digested by the others from a mobile segment perspective (Even merging with Vivo the national combined market share would be below 50%).
2) Spectrum caps to be analysed by Anatel (Brazilian telco regulator) In case of concentration operators would have to return the excessive spectrum to the regulator unless some change is made in the regulation. The problem with this spectrum caps is that in concentration scenarios operators would increase the number of subscribers per mobile site and consequently the need to have more bandwidth. If they have to return the spectrum in excess the quality of service might deteriorate which could also force the regulator to take actions. These actions might be benign, meaning raising spectrum caps, or more harsh like fines and suspension of service until situation is normalized. To normalize the situation without raising the spectrum the solutions are either losing subscribers or increasing the density of mobile sites. The caps of spectrum are defined by bandwidth and the main hurdles would occur in the bands 1.8GHz (mostly GSM) and 1.9-2.1 GHz (mostly 3G).
Mobile frequencies per consolidation scenarios (MHz)
Vivo + TIM Claro + TIM TIM + Oi Oi + Claro Oi + Vivo 800/900 1.8 1.9/2.1 800/900 1.8 1.9/2.1 1.8 1.9/2.1 1.8 1.9/2.1 1.8 1.9/2.1 MHz GHz GHz MHz GHz GHz GHz GHz GHz GHz GHz GHz A/B/SE L/M/E/SE J A/B/SE D/E/L/SE F/G/I D/E/SE F/G/I D/E/M/SE F/I D/E/M/SE F/I 1 22 50 50 25 60 50 80 50 50 40 60 40 2 22 50 40 25 60 50 90 40 60 40 70 50 3 22 50 40 25 60 40 85 50 55 50 65 50 4 52 50 40 25 50 50 60 40 70 40 70 50 5 47 50 40 27 65 40 50 50 60 50 75 50 6 22 60 40 25 50 40 60 50 60 50 50 50 7 22 60 40 25 50 40 60 50 60 50 50 50 8 20 30 50 22 60 50 70 50 40 40 70 40 9 47 30 40 25 65 40 60 50 50 50 85 50 10 27 50 40 52 40 50 60 40 70 40 60 50 Max(1) 30 55 30 30 55 30 55 30 55 30 55 30 Source: BPI Equity Research. (1) Allowed by regulation.
As the table above highlights in red a merger of OI with any other player raises significantly more issues in spectrum caps than a merger with TIM. Even the scenario more rumoured (Oi+TIM) raises significant issues on this front.
21 Equity Research 4 Telcos Brazil 4 October 2014
SYNERGIES: THE HOLY GRAIL OF THE INDUSTRY
Merger deals between mobile operators in the past have pointed out synergies in the range of 7% to 14% of the combined Opex+Capex. Given Brazil low population density we prefer to be closer to the low range and assume synergies could be around 8% of total opex.
2013 financial data for Brazil mobile operators (BRL bn)
America Vivo Movil (1) TIM Oi Total Opex 24.1 25.3 14.7 20.8 85.0 Opex net of Fistel 22.9 24.1 14.0 19.8 80.8 Capex 5.6 6.5 3.9 6.3 22.2 Opex+Capex 28.5 30.5 17.8 26.1 102.9 Weigth of mobile revenues 62% 40% 81% 33% - Mobile Opex+Capex 17.8 12.2 14.4 8.5 53.0 Annual savings (8%) 4.2 Note: Companies do not disclose mobile Opex + Capex. We estimate it based on revenues weight (1) America Movil does report capex. We use EBITDA-EBIT. Source: Companies data & BPI Equity Research.
Under the scenario of a concentration involving the entire industry where all the Number of mobile sites per synergies could be optimized (and the hurdles with regulators overcome without operator (K) any cost) we estimate annual savings for the entire industry to reach BRL 4.2bn, which compares with the current BRL 9.6bn Op.CF being generated by the industry! No surprise Wjwp why so much fuss about consolidation in the Brazilian market. UJN Under this analysis we are not taking into consideration any revenue synergies, though we acknowledge some room for more rational competition in the sector. Pj Still, the risks of synergies in the top line are always high and together with the Dmbsp historical strictness of Brazilian regulators lead us to prefer to be conservative on that front. Ofyufm
More recently, the market has been starting pondering the possibility of a full Puifs merger between Oi and TIM, instead of a breakup of TIM which seemed the
central scenario a while ago. Under this scenario we deduct to the potential synergies 1/1 6/1 21/1 26/1 31/1 the potential impact of remedies, assuming the regulator would force the sale of assets in the States where market shares of the combined company would surpass Source: Teleco. the 50%. We also assume that Oi+Tim sell these assets without grabbing any share of potential synergies it might generate with the other two players (Claro and Vivo) given its condition of forced seller. Moreover, we assume that the spectrum caps will imply integration costs to repair the service quality. Given the difficulties to estimate how much that could be we are deducting from the potential synergies the value of the spectrum to be returned based on the price paid by the operators on the auction of each bandwidth.
22 Equity Research 4 Telcos Brazil 4 October 2014
Synergies in a TIM+Oi merger (BRL bn)
TIM Oi Remedies (1) Total Opex 14.7 20.8 -4.4 31.1 Opex net of Fistel 14.0 19.8 -4.2 29.6 Capex 3.9 6.3 -1.3 8.9 Opex+Capex 17.8 26.1 -5.5 38.4 Weigth of mobile revenues 81% 33% - Mobile Opex+Capex 14.4 8.5 -2.9 20.1 Annual savings (9%) (2) 1.8 NPV gross of integration costs 19.0 Spectrum caps (3) -1.6 Other integration costs (4) -1.1 Net value accretion 16.3 (1) We assume that areas where the combined companies surpass 50% the remedies will impose to sell the entire operation of the smallest operator of the two. In case that is not sufficent to go below 50% we assume additional sales. Under this criteria we estimate a forced sale of 12% of the combined company assets. (2) TIM and Oi have worse coverage than the others. Consequently, TIM and Oi benefit from a higher density on average under its coverage increasing the likelyhood of higher savings in M&A. Moreover, this scenario comprises the reduction from 2 to 1 structure instead of 4 to 3 implying higher savings in percentage. (3) We assume the cost of returning the spectrum to be the average price paid in the respective auctions multiplied by the ammount of band being returned. In the auctions of the 1.8GHz band the average cost per MHz per region was BRL 3.0mn and in the 1.9-2.1GHz was BRL 7.1mn. (4) Integration costs usually range between 40% and 100% of annual savings. We assume 60% on top of the spectrum caps.
We estimate annual savings of BRL 1.8bn and a net value accretion of BRL 16.3bn under this scenario. This compares with the current combined Op.CF and Mkt Cap of both companies of BRL 2.7bn and BRL 44.5bn, respectively!
23 Equity Research 4 Telcos Brazil 4 October 2014
WRAPPING UP
The sector in Brazil seems poised for consolidation for quite some time but the conditions have not been met until now. As we addressed before there are significant obstacles and very diverging interests and reconciling everything has not been possible until now. The big question mark is if we are finally reaching the boiling point.
We agree that conditions seem now more favourable than they have ever been. The growing trend for convergence, Oi's financial difficulties and lack of frequencies in bands below 1GHz, TIM lack of scale and wireline structure and authorities not dismissing entirely the scenario seem to be tailwinds for M&A. Moreover, Oi hired BTG Pactual to pursue a possible acquisition of TIM and TIM is rumoured to have hired Bradesco to pursue a possible acquisition of Oi. So we can say with a certain degree of certainty that something is being cooked.
We believe that TI is now in an historical position to have the upper hand in the negotiations following Oi's decision not to participate in the auction. Oi’s decision, though having cut the industry investment massively deteriorates Oi competitive position and bargaining power in the consolidation process. Having said this, Oi still holds some assets that improve its bargaining power like its unique wireline footprint and its status of "Brazilian champion" and former incumbent.
Acquiring Oi posts several risks and is unlikely to happen without the blessing of Brazilian authorities. Its strategic importance in the wireline communications and its status of national champion make unviable a hostile acquisition. TI also does not seem to have financial shape to finance a cash deal. As such, a cash bid for Oi does not seem the most likely scenario and the opposite scenario whereby Oi does a cash bid for Tim also seems difficult to imagine given Oi financial condition.
Consequently, we are more inclined to believe in a likely merger between the two companies than in cash deals. Still this scenario is not absent of relevant risks for TI that could drag the process for some time. The control of Oi is yet to be clarified as the migration to Novo Mercado and the merger between preference and ordinary shares have not been completed. We do not control all the legal nuances on this matter taking into consideration the restrictions imposed by the combination of business with PT whereas Oi is committed to migrate to Novo Mercado and merge preference and ordinary shares. Still, this raises some risks for a potential acquirer as well as for current shareholders, particularly preference shares owners, if a deal goes through before this matter is solved. Another strong issue that any potential acquirer might want to be clarified is the potential changes in OI's concession contract of fixed telephony which could have a material impact on the value of the deal, which again reinforces the view that authorities will be side by side with the operators in a possible deal. Therefore, being Brazil in the middle of elections and though the pools seem to point that Mrs. Dilma is likely to be re-elected it would be odd to see a move before that.
In a nutshell, the potential for value creation with consolidation in Brazilian Telecommunications is sizeable and the conditions seem now better than ever. The sector is likely to remain under the spotlight and we believe consolidation moves are highly likely in the next months.
24 BPI
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