VIV - Telefonica Brasil

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Hi, 

 

I think there is some interest in South American Telcoms, so I thought I would post this new research from BTIG.  Price Target at $24 on this research piece is 25% above today's price.  Hopefully someone finds this interesting or informative. 

 

Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In Brazil

Posted on Sun, Dec 15th, 2013 at 6:00 pm

by Walter Piecyk — POSTS | DISCLAIMER RSSEmail Phone: 646-450-9258 Categories: Wireless, Equity Research

Tags: VIV, TEF

We upgraded Vivo (Telefonica Brasil) to Buy from Neutral because we expect it to be the primary beneficiary of strong wireless data growth trends in Brazil.  We believe Vivo can return to EBITDA growth in 2014, driven by accelerating revenue growth and some margin stabilization.  While Vivo is not an acquisition target, it could also benefit from likely consolidation in Brazil.

 

We recognize that investors are concerned about recent margin contraction, but we believe that Vivo’s investments in Pay TV and the shift to post-paid wireless growth increases their ability to accelerate revenue growth.  We also find the valuation to be compelling as it trades at only 4.5x our 2014 EBITDA estimate with a dividend yield of 10.9%.  Our target of $24 is based on 5.5x our 2015 EBITDA estimate, a year we expect 7.5% growth and one that could also benefit from market consolidation.

 

Data usage has just begun in Brazil

 

We estimate that smartphone penetration in Brazil is ~25% and we estimate that Vivo’s smartphone penetration is below the overall average since it’s 3G user base trails that of both America Movil’s Claro and TIM Part according to Anatel’s October subscriber data.  This level of penetration is quickly approaching a key inflection point of higher growth in past consumer adoption curve cycles.  If we include web phones, which are basic phones that have some/limited data access, Vivo’s web and smartphone penetration is ~52%.  That is in-line with the web and smartphone penetration at TIM Part and these subscribers should be the easiest to upsell to smartphones on their next device purchase.

 

ARPU has turned positive but could grow even faster in 2014 and 2015

 

An acceleration in growth of smartphones should result in higher data usage that has a positive impact on ARPU and helps to offset the negative impact of MTR cuts, price competition and SMS cannibalization.  These positive impacts have Brazil Wireless ARPU Comp 300x179 Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In Brazilalready begun to show up in Vivo’s reported numbers as the 6% decline in 2012 ARPU has turned into 2%, 4% and 6% ARPU growth in the first three quarters of 2013. We expect Vivo’s wireless ARPU to rise 5% in 2014 and 7% in 2015 as smartphone penetration expands and LTE usage begins.

 

LTE should provide an incremental lift to ARPU

 

Smartphone adoption in Brazil, like many markets, has started on 3G.  While 3G smartphones increase average usage and ARPU compared to feature phones, we believe the shift to LTE will have an even greater impact because LTE’s superior speeds and lower latency enable data applications that consume far more data.  Telefonica Deutschland has indicated that its LTE smartphone usage is 3x that of other smartphones.

 

LTE can be an alternative to fixed Broadband and Vivo is leading the way

 

Brazil LTE Market Share 300x180 Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In BrazilFixed broadband penetration in Brazil is just 33% (according to Anatel), so the wireless data opportunity is much larger there than Europe or the United States, where fixed broadband penetration is over 70%. LTE also offers a reasonable alternative to benefit from rising broadband penetration in Brazil.  In fact, last week DirecTV indicated that wireless broadband customers were opting for lower speeds to save money despite having higher speeds available on a wireless connection.  Vivo’s LTE network currently reaches >50 million people in >70 cities, most of which are in the State of Sao Paulo.  While there were only 731,000 subscribers in Brazil using LTE at the end of October, Vivo had 40% share of that market based on the most recent Anatel data.

 

Revenue accelerating to double digit growth

 

We expect the smartphone adoption and Vivo’s deployment of LTE to result in an acceleration of Vivo’s revenue growth in 2013 and 2014 to nearly 10%.  It’s not easy to find this type of revenue growth in global telecom services, particularly in a market as large as Brazil.  In recent years, the growth in Vivo’s wireless business has been largely offset by the decline in wireline revenue, resulting in total consolidated revenue growth of just 2% for the past two years.  However, we expect the declines in wireline to moderate as a result of the investments in Pay TV and reduced marginal impact from MTR cuts.  The impact of wireline is also diminished as it now represents less than one third of total revenue, down from 43% three years ago.  The net result of accelerating revenue growth trends in wireless and moderating declines in wireline is that we expect consolidated revenue growth to accelerate to mid-single digits from the 2% growth of the past two years.

 

We believe Vivo can hold margins at 30%

 

Brazil EBITDA 2013E Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In BrazilVivo’s EBITDA service margins of more than 35% in Q4 2012 contracted to less than 30% in the last two quarters and resulted in a 10% decline in EBITDA in 2013. MTR cuts, higher handset subsidies and Pay TV investments all contributed to the lower margins.  Our ability to be precise with the relative impact of these factors is hampered by Vivo not breaking out the EBITDA between its wireless and wireline segments. With no large MTR cuts expected in 2014 and the higher ARPU benefits of smartphones, we expect Vivo’s margins to return to 30% in 2014/2015. Maintaining 30%+ margins might be easier if consolidation is permitted to occur in the market, which we expect.  In the meantime, Oi’s financial strain could limit the incremental competition from this operator, thereby helping margins.

 

Accelerating revenue and margin stabilization could result in a return to EBITDA growth in 2014

 

If Vivo’s margin’s find a bottom at 30%, as we expect, it will be able to generate high single digit EBITDA growth in 2014/2015 that matches its revenue growth.  This would clearly be a compelling metric for investors and could drive multiple expansion. We expect Vivo to return to EBITDA growth in the first quarter of 2014, after three quarters of EBITDA declines. The biggest risk to our estimate is a higher than anticipated conversion of its wireless subscriber base to post-paid and/or smartphones. Typically, Q1 is seasonally weaker with a pickup in the Q2 for Mother’s Day and Valentine’s day.  Nevertheless, our expectation of a return to EBITDA growth in Q1 could be impacted if the conversion to smartphones/post-paid surged in Q1.

 

A return to profit growth should result in a higher valuation multiple

 

A number of factors have contributed to Vivo’s valuation of an Enterprise Value to EBITDA multiple of 4.5x. Many of these items are out of the control of management such as rising inflation, weak currency and cuts to mobile termination rates.  Our view assumes that the relative change in these factors will moderate but this is not an area of expertise and risk that investors should consider.  With that said, when a company’s EBITDA declines 10% there is likely to be a contraction in the multiple and vice versa when it returns to growth.  Wireless stocks in Brazil have historically had a difficult time commanding higher multiples but we think the return to growth along with positive industry growth/consolidation trends will result in an increase in the valuation multiple by 1.0x turn to 5.5x.  This type of growth could justify even higher multiples considering what investors are willing to pay for other telecom stocks throughout the world. Vivo also offers a dividend yield at 8-9%.

 

Consolidation speculation will persist in 2014

 

Possible consolidation in Brazil will continue to be a primary topic of discussion in 2014 no matter how many companies deny plans to sell, buy or merge.  The catalyst for change is Telefonica’s rising stake in Telecom Italia Group in Italy.  In fact, Cade, the anti-trust agency in Brazil, has voiced its concern with Telefonica’s planned increased stake in Telco, the controlling stakeholder of Telecom Italia. We believe this could be the early pretext for regulators to begin their examination of a possible a sale of TIM Brazil to a new entrant or to an existing operator in the market.  On Friday, Telefonica announced that its two executives would step off the Telecom Italia board in order to relieve some pressure from the regulators on their rising ownership in Telecom Italia.

 

TSU Nov 2013 Pres Competition Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In Brazil

 

The contraction of wireless operators is a global trend

 

The global wireless industry still offers wireless data growth but the maturation of subscriber growth, decline in fixed line services and cuts to mobile termination rates combined with a low interest rate environment will likely lead to further consolidation around the world.  We believe regulators are increasingly open to consolidation particularly if they can point to increased investment in fiber and LTE if these deals are approved.  We also think it will be increasingly important to aggregate spectrum for LTE networks with incumbent operators that can leverage their existing wireless networks.  It makes little sense for a new entrant to construct a new network and it’s foolish for regulators to expect to draw this type of interest.

 

E-Plus is a milestone deal

 

The move to global consolidation will not be a smooth one.  There are likely to be notable approvals and rejections of market consolidating transactions that will occur along the way but investors will look for sign posts.  In the United States, the DOJ reached a settlement that would enable the airline industry to consolidate to 3 from 4 which many wireless investors have viewed as a good sign for a future Sprint/T-Mobile deal.  Investors have turned their focus to Germany, where Telefonica Deutschland is trying to purchase E-Plus, the third wireless operator.  Consolidation has occurred in other markets, but E-Plus is not exactly in a desperate situation with 22% subscriber market share.  Germany is also relatively healthy market and smartphone penetration is still low at ~39%.

 

Vivo is a buyer

 

There are multiple consolidation scenarios that could emerge in Brazil in 2014, but Vivo is likely to be a buyer of assets in each scenario.  While it is typically better to invest in the acquisition target rather than the buyer, market consolidation would be good for Vivo, as the industry leader.  We also believe that, in most cases, Vivo could realize considerable synergies in the acquisition of assets, be they wireline or wireless.  We will further examine these scenarios as they arise or where and when we think they make sense.

 

What if Telefonica gets bought?

 

Telefonica would likely have little interest in selling Vivo to interested buyers but someone might want to buy Telefonica to obtain access to Vivo, which represents 20% of Telefonica’s EBITDA, and the rest of its Latam markets, which represent another 32% of Telefonica’s EBITDA.  In the case of a change of control at Telefonica, the Vivo Ordinary shares (ONs) would have tag-along rights although there would clearly be some discussion about what value would be assigned to Vivo, in the purchase of Telefonica. We are not aware if the minority shareholders of the Preferred shares (PNs) have appraisal rights, in the absence of any tag-along rights.

 

Should Vivo buy NII Holdings?

 

NII’s struggles in Brazil are well documented and we believe that a regulator might not be as harsh with required asset divestitures if an existing operator wanted to clean up the NII mess.  In addition, Vivo’s parent Telefonica could also strengthen its efforts with post-paid in Mexico through a purchase of all of NII Holdings.  The major argument against buying NII is that the regulator in Brazil is already carefully watching its rising control over TIM Part, and an additional deal would not look favorable at the moment.  Therefore, we do not view a purchase of NII Brazil by Vivo or Telefonica as likely.

 

Two share classes – Ordinary is Voting.  Preferred is non-Voting

 

Vivo has voting and non-voting share classes.  Telefonica owns 92% of the voting share class, known as the Ordinary shares (ONs), and 65% of the non-voting share class, known as the Preferred shares (PNs).  The ADR is exchangeable with the non-voting Preferred share class.  The Ordinary shareholder has tag along rights during a change of control that are not necessarily shared by the preferred shareholder.  The limited float of the Ordinary shares result in average daily dollar volume of $0.3 million per day, while the Preferred shares offer $22 million/day on the Bovespa and an additional $30 million/day through the ADR on the NYSE.

 

The Preferred shareholder of Vivo does have rights but it’s important to realize that the spread between these two share classes can impact stock performance.  Currently the Preferred shares of Vivo trade at a premium to the Ordinary shares likely because of the better liquidity that those shares offer.  Over the past decade there have been times when the Ordinary shares have traded at a premium to the Preferred shares as investors concerns wax and wane over their ownership rights.  This was heightened in 2006, when Oi (then known as Telemar) tried to combine their Preferred and Ordinary shares into one share class that would have been highly-dilutive to investors.  We were active critics of the proposed combination at the time and ultimately the Preferred shareholder prevailed.

 

Ratio VIV ONs to PNs Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In Brazil

Source: Thomson Reuters 2006-2007

 

Valuation

 

As discussed above we believe Vivo’s EBITDA valuation multiple should expand.  Our price target for the ADR of $24 is based on 5.5x our 2015 EBITDA estimate and assumes an exchange rate assumption of 2.35 BRL/USD.  Our price target for the local shares are R$55 for the Preferred and Ordinary shares. We recognize that the Ordinary shares trade at a discount to the Preferred, as discussed above and note that the lack of liquidity likely make it difficult to purchase.  The equity upside on the stock is enhanced by the dividend yield, which we estimate would still be 8% at our price targets.  Our target also implies a free cash flow/market cap yield of 8.5%.  Our free cash flow in that calculation is EBITDA less capex, interest expense and taxes but excludes changes in working capital.  Our $24 target also implies a P/E multiple of 15.0x our 2015 EPS estimate.

 

Risks

 

The major risks to our rating and target on Vivo include political, economic and currency volatility in Brazil. Please see the chart below to show  some history on the move in the currency over the years.  It’s also important to note that inflation is ~6% when considering the growth rates of the company and the potential impact to future currency moves.  Vivo is controlled by Telefonica, which makes decisions for the company that are in its best interest and could be impacted by Telefonica’s interests elsewhere in the world or its desire to use Vivo’s currency rather than its own.

 

Brazil Forex Hist1 Upgrade Vivo to Buy With $24 PT On Wireless Data Growth In Brazil

 

 

 

 

 

Read more: http://www.btigresearch.com/2013/12/15/upgrade-vivo-to-buy-with-24-pt-on-wireless-data-growth-in-brazil/#ixzz2nahEHkCf

[LowIQinvestor]

Thanks for sharing...it looks interesting.

 

You may also want to take a look at TEO- Telecom Argentina. It is even cheaper at about a 5 PE...and they just announced a 4% dividend and have a great balance sheet. I started a thread on it under "Investment Ideas". Activist Fund bought 23% of the company at a higher level than today.