Oi Market Cap (as of 04/10/13): $2.78bn

Portugal Telecom Market Cap (as of 04/10/13): $4.02bn

On Wednesday, October 2nd, Oi of Brazil and Portugal Telecom (PT henceforth) agreed to merge after three years of alliance, forming a telecommunication heavyweight which will bring together 100mln customers across the Portuguese-speaking world. The deal takes place in an exciting phase of growth and consolidation in the Brazilian market, while Portugal is stuck in recession-induced stagnation. The two companies bring to the table an enticing mix of cost, financial and revenue synergies which have positively impressed investors across the Atlantic (Oi was up 2.84% and PT 7.9% on the announcement).

Oi, the larger player of the two with $12.7bn in 2012 revenues, is a Brazilian integrated telecoms company which is aiming for growth but is mired in high debt.

The Brazilian market is characterized by relatively low penetration rates of broadband, pay-tv and mobile data (9.6%, 26% and 16% respectively) and low proportion (21%) of postpaid (i.e. more profitable) mobile customers vis-à-vis the more developed European and US markets. This condition underscores potential for high current and future growth, also considering the country’s improving demographics (+8.9% average yearly income growth rate since 2006).

Oi offers modern quad-play and 4G bundles to its 75mln customers, but its competitive strength lies in the more mature and low-growth fixed line business (approx. 41% market share), while it still lags behind in the booming mobile data (19% market share, 4th largest in Brazil) and pay-tv (5% market share) sectors. Oi’s positioning in terms of overall market share by revenues is 3rd with 21%, after quad-play competitors Telefonica (25%, owned by Telefonica of Spain) and Embratel/Claro (24%, owned by America Movil). Tim (owned by Telecom Italia), a pure play mobile operator, comes in 4th with 15% market share.

Oi has embarked in an investment effort to update infrastructure, extend 3G and launch 4G coverage in the 2014 World Cup cities in order to stay relevant in its fiercely competitive home market. Accordingly, 2Q13 capex increased 10.7% to 0.84x EBITDA.

Oi’s main problem is however on the financing side, where the firm is saddled with high debt: net debt added up to 2.8x EBITDA in 2012, while in 2Q13 net financial charges added up to 0.48x EBITDA. For the same period, Telefonica and Embratel/Claro (the latter strong of Carlos Slim’ backing) are almost debt-free, while Tim Brasil stands at ca. 1.7 Net Debt/EBITDA and it has been working hardtop reduce its leverage (read also our article on Telefonica and Telecom Italia, at https://bsic.it/2013/09/28/italian-politics-complicate-the-latest-stage-of-a-telecom-ma-revival/).

Even though operating margins are healthy, free cash flows and profit margins are suffering because of these simultaneous dynamics. Oi hopes to achieve deleveraging and higher growth through the merger.

The situation on the other side of the Atlantic is markedly different. PT, with its 25mln customers and a 53% market share, is Portugal’s leading quad-play operator and technology innovator, but demand is stagnating because of high penetration rates already achieved and a recessionary economic landscape. We can therefore see one clear growth rationale for the merger on PT side, as it tries to escape the lack of growth of its home market by expanding into a more dynamic economy as it is the Brazilian one.

The characteristics of the mature Portuguese market allow PT, which had sales of $9.1bn in 2012 (30% lower than Oi) to post an EBITDA margin (34.4%) and operating FCF which are both higher than Oi’s.

PT boast an impressive degree of 4G coverage (>90%) and next-gen FTTH (Fiber To The Home) penetration (41%) across Portuguese households, while leading in the cloud and pay-tv sectors as well. This technology backdrop makes PT well suited to profit from a nearing economic recovery in the Eurozone and could also be of help to Oi’s Brazilian ambitions.

The deal will disentangle cross-ownership issues which started following PT’s sale of its stake in the joint venture with Telefonica in Vivo in 2010 and its purchase of a 24% stake in Oi.

Margins and debt ratios will improve and more cash will be accessible to sustain growth coming from Brazil. The merged company will raise $3.6bn through a rights issue and will benefit from cost savings of approximately $2.5bn from the transaction taking debt levels to initially slightly more than 3x EBITDA.

The improving cash situation would also give Oi-PT more firepower to enter a potential bid for TIM, the fourth mobile carrier in Brazil as Telecom Italia (TIM’s owner) is trying to divest parts of its business to improve debt levels. TIM’s acquisition would greatly improve Oi’s position as a relatively weak mobile operator.

The merged company will be 38% owned by PT shareholders (assuming that the capital increase is fully subscribed) and will be listed both in Sao Paolo and Europe under the name CorpCo.

The deal is subject to regulatory and other customary approval, as well as the capital increase raising at least $3.1bn. Given the latest developments in the telecom sector and the abundance of cash still sitting in many corporate coffins, sit tight and get ready for a very hot winter in the dealmaking industry.


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