In the world of Brazilian telecom companies, there are two of the four major players (shown in the graphic below) that I see as worth monitoring: Telefonica Brasil (VIV), also known as Vivo, and Tim Participações (TSU), commonly referred to as Tim. While Tim has normally traded at a discount to Vivo, this pattern has reversed in the past 3 months, with Tim now trading at a premium. In this analysis, I explore why I find this premium to be undeserved, and I outline the reasoning for my recommendation of a pair trade, long in Vivo and short in Tim, or a pure long position in Vivo.
Telefonica Brasil, better known as "Vivo," is the Brazilian arm of the Spanish Telefonica. In Brazil, the company offers a full range of telecom services to both individuals and businesses, including fixed and mobile phone service, fixed and mobile broadband, and pay TV service.
While the tendency of fixed telephone service in Brazil is downward, Vivo has managed to reduce their disconnections through a stronger sales and marketing push, though it has come with a high cost. Fixed broadband is still a growth area, and Vivo targets the upper income classes by offering FTTH service, which is a new option for Brazilian consumers. In mobile services, growth in users is slow, as total market penetration already exceeds 100% of the population. However, with the increasing availability and affordability of smartphones, data use has been growing strongly across the industry.
As Vivo tends to target a higher income clientele, the company has a much larger market share than its competitors in the postpaid segment. This contributes to the average revenue per mobile user that is significantly above its competitors. We will explore comparisons with other companies in the industry after an introduction to what I see as Vivo's primary competitor.
Tim, like Vivo, is a Brazilian arm of a foreign telecom company; in this case, it is Telecom Italia. Until recently, Tim existed as a company purely focused on the mobile services segment, offering mobile telephone and mobile broadband service only. However, the company is currently building a FTTC broadband network in select cities in Brazil.
As Tim does not offer fixed telephone service or pay TV service, it remains isolated from the disconnection headwind that affects the telecom industry in Brazil. However, the mobile phone service segment presents its own challenges, especially in prepaid services, which is the primary market of Tim. The FTTC network that Tim is building is their first foray into fixed services, and is showing significant growth, though it is not yet contributing a material amount of income to the company as of the most recent quarter.
In a comparison of Vivo and Tim, it is wise to start with a general look at their sources of revenue, as they are very different in structure:
While the absolute mobile revenue of Vivo is higher than that of Tim (R$10.5B vs. R$7.8B), it represents just above 60% of Vivo's total revenue, compared to more than 80% of Tim's. This difference could be greater still when device sales are accounted for. Tim shows much higher revenue from device sales, in both absolute and relative terms. A large part of this can be explained by the differences in clientele, as Vivo's large postpaid market share means that many phones are subsidized, while Tim is predominantly engaged in the prepaid market where this is not the case.
Note that, while not obvious from the above graphic, the small relative size of the postpaid market means that Vivo, with 27% of their clients coming in the form of postpaid customers, has a commanding market share in this area, while still maintaining a very significant share of the prepaid market as well, which together total the largest total market share of the four major mobile service providers.
It is also worth noting at this point that the postpaid market has been increasing in overall share over the past year, and that Vivo has been gaining the net additions at a rate consistent with its current share of the postpaid market.
Partially as a result of the differences in postpaid and prepaid market shares, as well as the difference in clientele income classes, Vivo's average revenue per user is approximately 25% higher than that of Tim. This makes the postpaid client more valuable, but more difficult for Tim to gain, because of pricing and packaging structures that we will discuss further below.
The outlook for telecom services is mixed, with a steady decline in fixed telephone use on one end, and strong growth in mobile data usage on the other.
In fixed services, only broadband is considered by consensus to be a strong growth area, while fixed telephone use is in decline, and subscription TV services could hold some potential, though in the longer term the service is likely to be threatened by cost pressures from the greater availability and practicality of internet-based services.
Despite the grey outlook for the segment, the infrastructure for fixed telephone use already exists and, as a sunk cost, any use sustained is beneficial to the companies that operate in this space. There is also a portion of this market that will not be lost to the current rate of attrition, such as businesses. The fixed telephone line has a distinct advantage, because of the "caller pays" system in use in Brazil: fixed lines are less expensive to place calls to, which makes them advantageous for businesses, or households concerned about the cost of calls from family members to the home.
In the fixed broadband space, Vivo and Tim are pursuing two different strategies. Vivo is currently expanding its FTTH network offerings, which offer data speed that is well above what has been offered in Brazil in the past. Tim is also building a fiber network, but in the form of FTTC, which offers sufficient speed for the majority of households, but at a lower price.
The advantage of the fixed service segment is the ability to bundle services together for a single price. In many cases, the total cost of TV, broadband, and fixed telephone service as a bundle is only marginally higher than the cost of broadband alone, giving the perception of value to the bundle including the services that otherwise would be in sharper decline. The lack of available services often means that the choices of consumers are limited to just one service provider, and so the threat of a broadband pricing war is very small. Using a small sampling of postal codes from Rio de Janeiro's affluent South Zone, many have no availability of services from either of the companies in question, and are limited to just one or two companies that offer traditional cable-based broadband service (such as Net, or GVT).
Mobile services look more promising, as smartphones increasingly penetrate the market, driving data usage rates higher. In this case, growth is likely to be slightly on the side of Tim, as prepaid data service becomes more affordable and real incomes increase in Brazil's middle class. However, the negative aspect for Tim is the capital expenditures required to handle the increased data traffic without experiencing significant deterioration of service quality.
Regulation and Network Quality:
This specific topic deserves some expansion because of its importance. Brazilian operators are in a difficult situation in regards to their networks, largely as a consequence of regulatory actions. The regulatory agency that oversees this sector, Anatel, has outlined goals in respect to service quality and coverage that are difficult to meet. One of the primary obstacles that inhibit the attainment of these goals is the variety of municipal restrictions and processes regarding antenna placement. While all companies in the space have expressed willingness to improve network quality, the restrictions and bureaucracy involved with the installation of antennas often prevents the attainment of Anatel's goals within the timeframe given. The other goal outlined by Anatel is one of 4G coverage in the country's largest metropolitan areas. Obviously, this is also highly affected by the aforementioned restrictions, but it is compounded by the high levels of capital expenditures required, and the fact that this coverage is being mandated at a time when even 3G service has very limited coverage throughout the country. I see this as being especially difficult for Tim, as the company has suffered with poor coverage and network quality. In the second half of 2012, Anatel leveled a temporary ban of sales to new customers in selected areas against three of the four major operators, with Vivo being the only exception.
To reduce the capital expenditures required to meet these goals, Anatel allows the companies to form partnerships for network sharing and construction of the 4G infrastructure. Vivo formed a partnership with Claro for this task, and Tim formed a partnership with Oi. I see particular weakness in this partnership for Tim, as Oi has been a somewhat problematic company, plagued with CEO changes and an ownership structure that has been at conflict with the best interests of the company. Currently Oi has a level of leverage that I consider unsustainable (above 3x EBITDA), and is the worst rated telecom company, by Anatel's official ratings, by a wide margin. In comparison, Claro is wholly owned by America Movel, and boasts the highest market share in the mobile broadband segment, meaning that they have more pressure to maintain a high quality of data service, especially in the metropolitan areas described by Anatel.
One final potential catalyst that could work against Tim in the near term is a piece of legislation that is currently pending which, if allowed to become a permanent part of the regulatory structure, would ban the expiration of prepaid phone credits, which currently expire in no more than 90 days after purchase. This would be extremely detrimental to Tim, and also damaging to a lesser extent to Vivo, because of the aforementioned "caller pays" system that Brazil operates under. Without credit expiration, a phone could theoretically be used to receive calls indefinitely without ever needing to purchase more credit, as long as some credit exists on the account. The only form of revenue from received calls, then, would be from interconnection fees (also called termination fees), or fees paid by other operators to complete calls on a competitor's network. These fees are also under pressure to be reduced, further damaging prepaid operations.
The financial results of the companies reflect the higher margins associated with the postpaid segment, and with the use of assets that already exist and require little in the way of maintenance capex.
Despite the more attractive margins, as well as a very high dividend yield (currently above 9% for Vivo ADRs, vs. 3.3% for Tim) that accompanies the better cash flow situation of a company that operates with a solid existing infrastructure, Vivo is currently trading at a 15% discount to Tim based on expected earnings in 2013. The difference in margins means that Vivo does trade at a premium to Tim on a Price/Sales basis, and these numbers will be the basis for my risk evaluation below.
The primary risk to this position, in my opinion, is due to a new piece of legislation that was recently proposed, which would limit the ability of telecom companies to price services differently in bundles than they are priced separately. Though I see very little chance of this legislation being put into practice, it is worth noting that the valuation of Vivo could change dramatically if it were to be enacted. Currently, Vivo is priced at 1.45x 2012 revenue, which is at a significant premium to the price of Tim, at 1.15x revenue of the same period. Part of this premium is attributable to the increased margins of the postpaid mobile segment, but some of it is also due to the value given to the fixed services area, given their ability to be bundled together with fixed broadband service. Without this ability, the value of fixed services would decrease significantly. While I hesitate to try to predict how the market might price the declining fixed services business by itself, I can fairly assume it to be significantly below the level of a growing mobile business. In the table below, we can see potential Price/Sales multiples for the fixed services area, and the resultant multiples for the mobile services area at the current price. Despite the higher quality, more profitable client base, and less required capex of Vivo's mobile business, I believe that even 1.79x sales would be an excessive premium to Tim, with 1.66x being more reasonable, and with 0.9x being the maximum for the fixed line business. That would indicate a minimum of 6% downside to Vivo in this scenario, with potential upside for Tim in the form of improved competitiveness.
In summary, I see Tim's current valuation as too high when compared to Vivo, which is arguably a better company operating in the same space, and also boasts a significantly more attractive dividend yield. The primary risks in the market would affect the two companies equally, or have a greater negative effect on Tim, with the exception of one piece of proposed legislation, to which I attribute a low probability of implementation. My ideal trade based on this analysis would be a pair trade, long in Vivo and short in Tim, with the expectation of a gain in the 15% range. In the event that a short in Tim is unavailable, I believe that the cash generation prospects, quality of clientele, and dividend yield would still warrant a long position in Vivo.