Latin America telecoms Ringing the changes www.latinfinance.com

Brazilian fixed-line is consolidating while ferocious competition in mobiles pressures margins. Both sectors are calling for fundraising solutions.

The slow decline of Brazilian fixed-line services is tempered only by the painful birth of a new national telecoms champion through the fusion of two of the three original fixed providers. Rio de Janeiro-based Telemar Norte Leste (Telemar), branded as Oi, is swallowing Brasil Telecom, giving it extensive national coverage except in São Paulo, the traditional home of Telefônica.

The deal now looks like a certainty: back in April Telemar announced that it would buy Brasil Telecom for 5.9 billion reais and offered to buy out minority shareholders. If they accept en masse the deal will reach a value of 12.4 billion reais. The takeover yields a lending bonanza for banks. The expected total debt fund raising by Telemar will amount to some 11 billion reais or 85% of the total. Telemar has completed two of the three stages. The first saw the firm borrow 4.3 billion reais from Banco do Brasil in July via an eight-year loan.

Then, in August, the firm sold 3.6 billion reais worth of two year floating rate promissory notes at 1.6% over the money market CDI rate. Banco Itaú led the deal.

The last stage will see a further 3 billion reais in fund raising, slated to take place by year-end. That is slated to come through a jumbo $1.5 billion bond issue with maturities in 2014, 2019 and 2038 and could include multilateral funding. Citi, Santander, Bradesco, Banco do Brasil, and Itaú are joint bookrunners on the bond deal.

The merger has been actively supported by the government, which is keen to create a national champion. That has helped the firm achieve funding in spite of a messy shareholder structure and ensured the support of the BNDES, which offered 2.6 billion reais to help with shareholder reorganisation.

Death of a Fixed Line
Banks may be rubbing their hands at all the debt underwriting business, but the merger has been greeted with dismay by those concerned with competition. “In the 11 years since privatization, Brazil has been deficient in implementing pro-competition regulations to ensure greater penetration of fixed-line and broadband,” says Luis Cuza, executive president at TelComp, a group funded by telecom company members that lobbies to open up the sector. The proposed merged entity would have an effective monopoly of fixed lines and the government could favor it with contracts, Cuza warns.

Competitors may be forgiving as the fixed segment is in long-term, secular decline, thanks to growing mobile penetration. Mobile calls still cost at least five times fixed, but as tariffs come down, cell phones will increasingly dominate, according to Andrew Campbell, analyst at Credit Suisse in São Paulo. At the same time, dial-up internet traffic is declining because of broadband, he says.

Oi’s heavy reliance on fixed line is not ideal, says Carlos Eduardo Sequeira, telecoms analyst at UBS Pactual in Rio de Janeiro. “[It] is like giving a square ball to Pelé. He won’t be able to play soccer too well,” he quips.

Fixed-line penetration in Brazil is relatively low at 20% and has been slowly declining, but there are still attractive niches, says Paulo Pessoa, corporate marketing director at Embratel, a subsidiary of Mexico’s Telmex. Small and medium enterprises (SMEs) have fallen between the cracks: larger telecom firms are more interested in high-end residential and big corporates, he says. Embratel intends to be able to serve 50% of the SME market in three or four years and anticipates growth of 50% per annum over the next few year years, albeit from a small base.

Mobile Battleground
Things could hardly be more different in the mobile market. Cracking it is a tall order because Brazil has the most ferocious competition in LatAm, and margins are relatively skimpy, analysts say.

In Brazil, Ebitda margins are some 24%-25%. In the rest of LatAm, they are typically 35%-40%, says Campbell. For Carlos Slim’s América Móvil, which has more than 75% market share, Ebitda can be as high as 50%, he notes. América Móvil controls the Claro brand in Brazil and has focused on other Latin markets where the fruit is more low-hanging.

Moreover, the Brazilian market produces low revenues. A whopping 82% of cell phones are pre-paid, generate very little revenue and are almost exclusively used to receive incoming calls, Cuza notes. The US average client spend is $60 per month, versus just 13 reais in Brazil, adds Sequeira.

Margins are recovering slowly as competitive behavior between mobile providers becomes more rational, however, he believes. After scrapping over low revenue, pre-paid clients, the battle has sensibly moved to bigger spending, longer-term, plan-based users.

There is much to play for as Brazil's mobile market is big and in expansion mode. There are some 133 million mobiles and penetration is rising by some 10% per year, says Campbell. Mid-2008, penetration passed the 70% mark, having finished 2007 at 65% and 2006 at 55%, he says. He and others see no reason that this growth should not be sustained for at least three years, noting that Argentina has penetration of 100%, with some clients having multiple handsets.

Vivo, owned by Spain’s Telefónica and Portugal Telecom, is ensconced as Brazil’s market leader with 40 million subscribers and more than 30% market share. Telefónica of Spain earned yet more to crow about last year when it consolidated its advantage over America Móvil by snatching Telecom Italia, owner of TIM in Brazil.

That deal may finally allow for consolidation among Brazil’s mobile players, if Telefónica can put together TIM and Vivo, both of which have been loss making this year. The best thing that could happen is a reduction in competition, analysts agree. But this is difficult as operators cannot hold multiple licenses in the same region, says Campbell.

Telefónica’s 50/50 share in Vivo with Portugal Telecom may also complicate any deal. Even so, shares in TIM have occasionally spiked on the possibility, say analysts, and if it were to occur, it would create a truly dominant national player as TIM is number two in the country in mobile.

Whether the deal happens or not, Vivo has been pursuing an expansion strategy. It swallowed regional Telemig Celular in early 2008 for 1.2 billion reais. Telefónica agreed to buy all 6.2 million voting shares for 120.93 reais apiece and in May the board approved a 990 million reais capital increase to provide a tag-along offer. Banco Espirito Santo Securities is managing the issue. Since then, Vivo has launched a 500 million reais one-year promissory note issue paying interest of DI of 106.5% to pay down debt.

Claro is the third player while Oi/Brasil Telecom is fourth. For all the nationalistic hype, the impact of the Oi/Brasil Telecom may well be underwhelming. Although Brasil Telecom has been rapidly growing its mobile business, the merged firm faces stiff competition nationwide and is absent in the key market of São Paulo, which it is entering only this year, says Eduardo Tude, president of São José dos Campos-based Teleco, a consultancy. The combined firm has less than 20% of the market, while others have at least 25% each, he adds.

Calling Higher Margins
A fresh squeeze on margins may come from new regulations. Number portability is being introduced gradually. That is likely to exacerbate what is already a high churn rate of 2% per month, says Cuza. Marketing and promotions to keep and win customers is already costing operators, he adds.

The other issue is a review of mobile termination rates, the charge levied to receive a call from different operators, which are high in Brazil at 40 centavos. Vivo generates 38% of its revenues this way and TIM 45%, says Sequeira. Regulator Anatel will probably introduce maximum charges well below current levels in 2010, he says.

Mobile companies are hoping 3G will drive up profit and bind customers to providers. The push really started this year in Brazil with Vivo and Claro and later TIM, says Elia San Miguel, principal analyst, networking and communications services, mobile & wireless, at independent research outfit Gartner in São Paulo. She cautious that the technology is expensive and will require heavy investment. The payback is likely to be the offer of broadband, which is still desperately underused in Brazil, with just 4% population penetration. It will also give firms the ability to profit from niche areas, including video content, she adds.

Heavy investment should not be compounded by expensive auctions. Brazil has come late to the 3G game and will not repeat the mistakes Europeans made, believes Tude. Auction prices will not be anything like as high, partly because Anatel is interested in a commitment to supply to smaller municipalities, he reasons. Furthermore, technology is more advanced and prices of both equipment and handsets have fallen, he points out.

Broadband and Bundling
Broadband and bundling are also slowly becoming more competitive although they remain the purview of the wealthiest, urban Brazilians. One of the problems is that there has been little innovation in broadband by the major operators, says Cuza. Companies are still using technology from 2000 and have not invested in DSL and other technologies, he notes. That has left space for a number of small, nimble alternative players, who are attacking the area through bundling, helped by the fact that incumbents are restrained by regulations that restrict their offerings on pay TV.

Legislation to free up pay TV, contained in the proposed law PL-29, is making slow progress through congress. It could open up the closed cable market, says Tude, explaining that today firms looking to offer services need to go to an auction in each city and bid on multiple licenses while fixed-line operators are restricted in pay TV offerings. The proposed law would provide a national license and undo pay TV restrictions, he notes. That would accelerate bundling and convergence between different players. He expects the law to be passed by mid-2009.

Meanwhile, the new players are building out fast. Net Serviços has been one of the most successful, says Campbell. It offers fixed-line, broadband and pay TV and is focused on the South and South East, including São Paulo. With bundling, it is taking business from fixed line companies and has a 20% market share in broadband, notes Sequeira.

The firm seems to be well and truly recovered from its complicated debt restructuring three years ago. By late in 2006, it was able to raise $270 million through a Banco Bradesco loan due 2013. This June, Net took out a $200 million loan through Mexico’s Banco Inbursa, repayable in three annual installments, with the final installment of principal due in June 2019 at an interest rate at 7.875% per year.

GVT Brasil, based in Curitiba, is growing fast too. It predominantly serves the South but has been growing fast in the Centre West with internet and fixed-line services and has around one million local lines, says Sequeira. It may be a target of Carlos Slim who has enjoyed great success in the areas through Net, according to a report penned by JPMorgan analyst André Baggio.

GVT carried out a successful IPO in 2006, raising 1.1 billion reais with 76% of the deal sold to foreigners through underwriters Credit Suisse and UBS. The IPO helped the firm to recapitalize and expand and it has seen earnings growth rates of some 35%. “The firm is more agile, the cost structure is more lean, it is well managed and focused,” agrees Campbell.

Despite this, investment is urgently needed. Most broadband services are pitifully slow in Brazil. The average speed in Japan is 61 megabytes (MB) against 10-12MB in the UK. In Brazil, it is 0.5MB, points out Cuza. Eventually incumbents will invest to improve networks and offer high speed broadband and compete, says Sequeira.

Still, they are finding it hard to compete because many are using a mix of different, existing networks. Telefônica bought pay TV company TVA and offers broadband through Speedy, but it is unable to offer services on the same network. Its broadband is relatively poor quality and pay TV unreliable.

Brazil’s telecoms market is growing up fast, particularly in the relatively unfettered area of mobile. Broadband and pay TV should get a fillip with new regulations, but in fixed-lines, the government’s applause for an Oi/Brasil Telecom tie-up looks worthy of booing. LF

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