Oi S.A. (OIBR) OIBR RESEARCH REPORT: Rating: SELL. Too Many Risks at This Time, Please Try Again Later COMPANY BACKGROUND AND GENERAL MARKET OVERVIEW:

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1 OIBR RESEARCH REPORT: PUBLISHED APRIL 17, 2014 COMPANY BACKGROUND AND GENERAL MARKET OVERVIEW: Despite recent weakness in emerging markets, investors should not completely abandon their holdings in these economies as most of these markets still offer a significant amount of growth opportunities. Chief among the BRIC countries in particular is Brazil, which is in a unique position with regard to the telecommunications industry and the tremendous growth in mobile that has spread throughout the world as of late. Although Brazil is currently fourth in the number of mobile phones in the world, the country sports a relatively high 136 mobile phones per 100 citizens, which is higher than the three countries in front of Brazil (China, India, and the US). Further, mobile growth is only expected to increase as Brazil s middle class sees increasing wealth and therefore higher smartphone penetration. Presently, Brazil is the world s 7th largest economy with GDP of approximately $2.2 trillion annually. One of the companies that has and should continue to capitalize on the growth potential in Brazil is Oi S.A. Oi S.A. (OIBR), through its subsidiaries, provides integrated telecommunication services for residential customers, companies, and government agencies in Brazil. The company operates in three segments: fixed-line and data transmission services (i.e. local and long distance services); mobile services (i.e. voice, text, and data applications); and other services (i.e. internet access services, online advertising, television services, etc.). The company is one of the principal telecom service providers in Brazil with approximately 75 million revenue generating units (RGUs). According to ANATEL, the Brazilian agency that regulates and supervises telecommunications in the country, OIBR most recently controlled approximately 41.4% of the Brazilian fixed-line market and 18.6% of the Brazilian mobile telecom market. 1 It is important to mention that OIBR s mobile network covers areas in which roughly 88.5% of the Brazilian population lives and works. Currently, the telecom industry offers a unique balance of stable cash generation coupled with growth opportunities. While cash generation can be seen largely in paid subscriptions through fixed line segments and others, the higher growth opportunities can be seen largely in mobile. As a result, companies across the telecom and diversified communications sectors, such as OIBR, can offer investors a nice blend of value and growth. It is for these reasons, in addition to increasing competition, that consolidation across the telecom industry worldwide has become more commonplace over the years. It should come as no surprise then that OIBR is no exception to this global theme. 1

2 MERGER WITH PORTUGAL TELECOM: In October 2013, OIBR entered into an agreement to merge with Portugal Telecom (PT) which should be completed sometime later this month pending remaining shareholder and regulatory approvals. As a result of this merger, OIBR will be able to expand its reach to more than 100 million customers in seven countries with a total population of approximately 260 million people. As you might expect, reaction to this merger has been mixed to say the least with a majority of investors/analysts taking a more negative view despite the synergies that are expected as a result of the merger. Although both firms are minority owners in each other s companies, I fail to see the true benefits in combining the two. Both companies claim that they will be in a better position to compete in the global telecom market as one combined company while also realizing over BRL 5 billion in synergies/cost savings. Moreover, OIBR expects to simplify its overly complex shareholder structure as a result of the merger. For example, following the merger, OIBR will be only one listed entity with one share class having the same voting rights and dividend. Currently, OIBR is owned by a series of holding companies with different owners including the government, pension funds, PT, and TmarPart. While these benefits may be realized in the end, there are a significant amount of issues and risks arising from the proposed merger as well. Chief among these risks is the inevitable capital raise that has been proposed to increase OIBR s share count by nearly 6 billion consisting of approximately 1/3 common shares and 2/3 preferred shares. This increase coming on top of an already large existing share count of roughly 1.8 billion shares will push total shares outstanding (common plus preferred) to almost 8 billion. Significant dilution such as this is likely to pressure shares over the short-term and quite possibly the medium-term as well as the effects of this capital raise set in. Remaining on this side of the balance sheet, OIBR will further increase its already large outstanding debt burden as a combined company. As of December 31, 2013, OIBR had approximately BRL 35.8 billion in outstanding debt, while PT and TmarPart had roughly BRL 24 billion and BRL 3.3 billion, respectively. Combined, the total debt burden will be over BRL 63 billion. For a company that is already highly leveraged with a Debt/Equity ratio of over 5 and a long term debt ratio of 45%, taking on an additional 75% debt load is probably not the best thing. Granted the telecom industry is one of the highest leveraged industries, taking on this much additional debt will likely hinder the company s ability to secure additional financing at favorable rates while eating away at their cash flow. Ultimately, the main goal of the merger is to realize the full benefit of the present value of the nearly BRL 5.5 billion in synergies. If OIBR is not able to achieve this, the main advantage of the merger will not be realized and may end up hurting shareholders in the end. One analyst in particular has pointed out that some of the savings will likely not be realized as additional costs related to customer retention and growth efforts will cut into these synergies. 2 Expanding upon these concerns, it is also likely that 2

3 successful integration of the companies will be tougher than expected given the complex, costly, and time-consuming process involved in completing the merger. Further, the fact that PT operates in a completely different (and less growth-oriented) market than OIBR should be considered. For example, as one of Portugal s largest companies (and therefore one of its largest employers), its operations are closely tied to the economy in Portugal, which has suffered greatly as a result of the global recession. Also, while PT operates in other countries that exhibit higher rates of growth in the telecom market (especially mobile), such as Africa and Asia, those markets are also subject to additional risks that OIBR is not currently exposed to. Of significant concern to me is the fact that although PT claims that the performance and value of its company is significantly affected by the performance and value of Unitel (an Angolan mobile telecom services provider) OIBR has been unable to meet with officers of Unitel to discuss its business, financial conditions, prospects and results of operations. In fact, all OIBR has been given thus far are audited financial statements as recent as the period ended December 31, Considering how important this minority interest is to PT, and therefore OIBR, it is noteworthy (and somewhat worrisome) that more clarity on Unitel s operations has not yet been provided. In addition, PT currently has unfunded pension obligations of almost 1 billion euros (approximately BRL 3.1 billion) which may limit their future use and availability of capital. This, coupled with OIBR s pension deficit of BRL 644 million, may further hinder the combined company s ability to realize the full benefits of the merger. Unfavorable market conditions may force the company to make additional contributions and/or record liabilities or expenses that are higher than they currently expect. Moreover, I am wary of the size of PT s unfunded pension obligation, which is nearly five times as large as OIBR s current deficit. However, although it is unlikely, even if the merger does not end up coming to fruition, an investment in OIBR as a stand-alone company is questionable at best. OIBR FINANCIALS AND VALUATION: While OIBR does generate significant revenue, post positive net income and free cash flow (in most years), and produce decent gross margins, there are considerable issues when looking at the company as in investment. Additionally, while OIBR s accruals ratio has indicated that earnings over the years have not been largely made up of accruals, which is encouraging for the company, it is not enough to warrant an investment in shares of OIBR at this time. Over the years, revenue growth has been fairly volatile with several years exhibiting negative growth. Additionally, if you strip out the 172% gain in net operating revenue in 2012 due to the corporate reorganization that consolidated the results of Telemar and its subsidiaries, OIBR only grew revenue approximately 2% per year on average over the past decade. Meanwhile, over that same period (again after stripping out the 2012 outlier), cost of goods sold increased by over 7% each year on average. 3

4 Surprisingly, gross margins, while not overly impressive, have remained somewhat consistent at around 49% on average. Furthermore, EPS growth has been negative over the years while the company s interest coverage ratio has been flashing warning signs throughout much of the last decade. Most recently, this ratio was around 1.1 at the end of 2013, and has been around 1.3 on average over the past decade. While definitely not surprising given the high debt load of the company, this further shows that OIBR is heavily burdened by its debt expense. Typically when this ratio is under 1.5, the company s ability to meet interest expenses may be questionable and could suggest issues in generating enough cash flow to pay its interest expenses. Further evidence of the company s increasing debt load can be seen in its increasing debt to equity ratio, increasing long-term debt ratio, and decreasing current ratio. For example, over the years, OIBR s D/E ratio has been increasing and currently stands at 5.1. In addition, the same is true regarding its longterm debt ratio which is currently at 45% and has steadily increased over the last five years. Lastly, while still above 1, the company s current ratio has been decreasing over time and currently stands at 1.1 the lowest it has been It is a well-documented fact that the telecom industry is fairly capital-intensive. As such, it should come as no surprise that capital expenditures ( capex ) will likely account for a decent portion of a company s cash flow. In the case of OIBR, capex has been approximately 64% of operating cash flow on average over the last decade. Although this is not uncharacteristically high, it is notable that over the last few years, that percentage has increased significantly and management has made it clear that it will likely remain that way for the foreseeable future (regardless of the costs of integration with PT). In fact, in their most recent Form 20-F, management said it expects to spend approximately BRL 15.1 billion to meet short-term contractual obligations and commitments during 2014 with an additional BRL 30.4 billion to meet long-term contractual obligations and commitments and budgeted capex in 2015 and 2016 all before any additional costs relating to the PT merger. 3 Perhaps the one area working in OIBR s favor is the fact that on a valuation basis (on several metrics), shares of the company appear to be undervalued compared to both a historical basis and an industrywide basis. However, given the significant risks involved in the company s overall business as well as the potential risks involved in the merger with PT, shares could prove to be a value trap when looking at OIBR on these metrics alone. 4

5 Further, in looking across the telecom industry, the current industry averages for the P/E, P/B, and P/S ratios are 17.2, 1.7, and 1.4, respectively far higher than where OIBR currently trades. ADDITIONAL RISKS: Aside from the vast amount of financial issues weighing on shares of OIBR, there are additional risks that should be considered as well. First, OIBR generates the majority of its revenue from fixed-line telecommunications services (i.e. landlines/local and long distance calling) which have been facing increasing competition from mobile services over the years. Although the company has over an 18% market share in this growing mobile market, it is only the fourth largest provider of mobile services in Brazil. Second, the country of Brazil as a whole is susceptible to many economic and geopolitical risks. Specifically, risks associated with inflation, foreign currency exchange rates, interest rates, regulations, monetary policy, and political and socioeconomic developments. With regards to regulatory risk, the telecom industry in Brazil is highly regulated by ANATEL and as such could adversely impact OIBR s business, financial condition, and/or results of operations. Third, TmarPart has a large and controlling interest over OIBR and may or may not act in a favorable way for the company s minority shareholders. By way of example, it is important to note that currently the 5

6 merger between OIBR and PT has not yet been approved by the board of directors or shareholders of TmarPart (or PT). However, it is expected that they both will approve the merger later this month. Lastly, OIBR is subject to numerous legal and administrative proceedings which could adversely affect the company in the future. Although OIBR has set aside some funds for the claims they designate as probable, they have not made the same provisions for claims they see as possible or remote. Each of these groups could see significant claims which would ultimately hurt the company s bottom line and therefore its shareholders. CONCLUSION: While OIBR could potentially mimic the restructuring changes and subsequent price appreciation that France s ALU experienced over the past year and a half, the risk at this point is not worth the reward. The closing of the merger with PT and subsequent capital raise will further dilute the company s shares (and in a massive way). Although the company s CEO (Zeinal Bava) has proven to be a very capable leader over the years (having earned the title of best CEO in the telecom sector by Institutional Investor from 2010 to 2012), it is not enough for me to put my faith (and money) in shares of OIBR at this time. In the end, I would urge investors to take a wait and see approach with this company and re-evaluate an investment in OIBR following the closing of the merger and pricing (and trading) of the 6 billion share capital raise. Sources: 1 OIBR Form 20-F. 31 December Page Nichols, Allan. Portugal Telecom and Oi Agree to Full Merger. Morningstar. 2 October OIBR Form 20-F. 31 December Page

7 Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it, and I have no business relationship with any company whose stock is mentioned in the article. The information contained herein is not intended to be investment advice and does not constitute any form of invitation or inducement by Michael Maggi, CFA and Money by Maggi to engage in investment activity. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities, financial instruments, strategies, or commentary mentioned herein may not be suitable for all investors and this material is not intended for any specific investor and does not take into account an investor s particular investment objectives, financial situations or needs. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only current as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fluctuate, and an investor may, upon selling an investment lose a portion of, or the entire principal amount invested. Past performance is no guarantee of future results. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Disclaimer: The information contained herein is not intended to be investment advice and does not constitute any form of invitation or inducement by Michael Maggi, CFA and Money by Maggi to engage in investment activity. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities, financial instruments, strategies, or commentary mentioned herein may not be suitable for all investors and this material is not intended for any specific investor and does not take into account an investor s particular investment objectives, financial situations or needs. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only current as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fluctuate, and an investor may, upon selling an investment lose a portion of, or the entire principal amount invested. Past performance is no guarantee of future results. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. This report may contain certain forward-looking statements and information, as defined within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and is subject to the Safe Harbor created by those sections. This material contains statements about expected future events and/or financial results that are forward-looking in nature and subject to risks and uncertainties. Such forward- looking statements by definition involve risks, uncertainties and other factors, which may cause the actual results, performance or achievements of mentioned company to be materially different from the statements made herein. COMPLIANCE PROCEDURE Content is researched, written and reviewed on a best-effort basis. This document, article or report is written and authored by Michael Maggi, CFA. An outsourced research services provider represented by Michael Maggi, CFA, provided Small Cap Specialists, LLC this article or report. However, we are only human and are prone to make mistakes. If you notice any errors or omissions, please notify us below. Small Cap Specialists, LLC and BrokerBank Securities, Inc. are not entitled to veto, interfere or alter the articles, documents or report once created and reviewed by the outsourced research provider represented by Michael Maggi, CFA. If you wish to have your company covered in more detail by our team, or wish to learn more about our services, please contact us at admin@smallcapir.com. For any urgent concerns or inquiries, please contact us at admin@smallcapstreet.com. 7

8 NO WARRANTY OR LIABILITY ASSUMED OIBR has not compensated Small Cap Specialists, LLC, BrokerBank Securities, Inc., or Michael Maggi, CFA for the creation or dissemination of this report. Small Cap Specialists, LLC and BrokerBank Securities, Inc., is not responsible for any error which may be occasioned at the time of printing of this document or any error, mistake or shortcoming. Small Cap Specialists, LLC and BrokerBank Securities, Inc. do not hold any positions in OIBR. No liability is accepted by Small Cap Specialists, LLC and BrokerBank Securities, Inc. whatsoever for any direct, indirect or consequential loss arising from the use of this document. Small Cap Specialists, LLC and BrokerBank Securities, Inc. expressly disclaims any fiduciary responsibility or liability for any consequences, financial or otherwise arising from any reliance placed on the information in this document. Small Cap Specialists, LLC and BrokerBank Securities, Inc. do not (1) guarantee the accuracy, timeliness, completeness or correct sequencing of the information, or (2) warrant any results from use of the information. The included information is subject to change without notice. Small Cap Specialists, LLC is the party responsible for hosting the full analyst report. BrokerBank Securities in the party responsible for issuing the press release and Michael Maggi, CFA, is the author of research report. Small Cap Specialists, LLC has compensated Michael Maggi, CFA two hundred dollars and fifty dollars for the right to disseminate this report. BrokerBank Securities has been compensated one hundred dollars to issue press release by Small Cap Specialists, LLC. Information in this release is fact checked and produced on a best efforts basis by Michael Maggi, CFA. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. 8