By Imari Love
From an investment perspective, Brazil and Mexico continue to dominate the Latin America landscape, and the telecom sector is no exception. Within this sector, we believe America Movil (AMX) offers the most balanced and attractive investment profile because of its massive scale, considerable financial resources, and bundling capabilities. Over the past few years, the sector has been characterized by the acquisitions and integration of fixed-line networks with wireless infrastructure. We believe 2012 will be defined by how efficiently and effectively the carriers will monetize these moves. As we analyze the regulatory, competitive, and economic landscape, it's clear that America Movil is the best-positioned telecommunications company in the region.
Regulatory changes in both countries continue to apply pressure. In Mexico, telecom regulator Cofetel made a major cut in mobile termination rates to try to make these services more affordable, level the playing field, and promote competition. However, the rate cut backfired, as it only widened the profitability gap between America Movil and its peers. While rectifying this could be a painful process, we'd expect Cofetel to either raise mobile termination rates again (by changing the assumptions in its underlying pricing model) or promise no further cuts for the foreseeable future. It could also try to set specific prices for each carrier's network, although we doubt that approach would ever be able to satisfy the entire sector.
Brazilian telecom regulator Anatel is also cutting mobile termination rates, but it's doing so at a much more reasonable pace. It's also worth noting that both the penetration rate (115% versus 85% in Mexico) and interconnection fees ($0.25 per minute versus $0.03 in Mexico) are much higher in Brazil. Anatel recently announced its plans to cut rates over the next few years, and while they are scheduled to fall at nearly 10% per year, this is a slower pace than most were expecting.
In both countries, all the major mobile carriers are net receivers of termination fees, which will have a slight negative impact on near-term margins. The only wireless player who is a net MTR payer is NII Holdings (NIHD), although its 3G launch expenses and rebranding initiatives will likely offset much of the incremental margin benefits. The fixed-line operators in the region will also benefit from the MTR cuts, although they will be forced by the regulator to pass on those savings to their subscribers.
The next major regulatory decision in Brazil will be the framework of this year's 4G spectrum auction. We expect it to be a very expensive process, with at least five players fighting it out for only four blocks of spectrum. Between the capital expenditures necessary to build these networks and the costs of acquiring the spectrum, we believe the deep pockets of America Movil and Telefonica (TEF) confer a clear competitive advantage over cash-flow-constrained peers TIM (TSU) and Oi (TNE).
Economic Outlook Points to Better Days Ahead
Despite Brazil's disappointing stock market performance in 2011 (the Bovespa was down 18%), there is a lot to like about the state of the nation's economy. New president Dilma Rousseff is off to a very encouraging start, exemplified by her 71% approval rating, and looks to be following in her predecessor's footsteps of trying to stem unemployment, improve wage growth, and extend credit to the growing middle class. At the end of November, Brazil cut its interest rate for the third consecutive meeting, to 11%. Consumer inflation has begun to ease and is currently 6.6%, although the central bank's 2012 year-end target of 4.5% might prove overly ambitious. Unemployment in December was a record-low 4.7%, and the country's public net debt is at its lowest level in 14 years. All of this bodes well for a consumer-driven industry such as telecom.
In Mexico, unemployment is also at very manageable levels (5% in December), which has boosted consumer confidence. The Mexican stock market was down only 5% last year, although after adjusting for the severe depreciation of the peso, it was down 14% in dollar terms. Unlike last year, GDP growth in 2012 is unlikely to outpace what we see in Brazil, although we'd expect both countries to grow more than 3%. The improvement in disposable income for the rising middle class is a bullish precursor for the telecom sector, although it will probably lead to the continuation of the current trends of solid subscriber growth being somewhat offset by declines in average revenue per user. The ARPU declines in the region continue to be driven by a customer mix shift toward lower-income subscribers as well as a multiple SIM card effect of customers trying to arbitrage across carriers to find the best deals.
America Movil's Built to Withstand Heightened Competition
The competitive backdrop in Brazil has resembled a roller-coaster ride for years. One or two carriers will ramp up their pricing aggression, the rest of the sector follows suit, and then everyone decides to settle down. Currently, we are in the midst of one of the aggression spikes. TIM launched the first salvo by offering extremely low rates for on-network long distance calls ($0.14 per call). Recently, Claro (America Movil's Brazilian subsidiary), and Vivo (Telefonica Brasil's (VIV) mobile arm), began undercutting those prices in an attempt to boost subscriber growth. Vivo has also started offering unlimited postpaid plans, as well as launching Vivo Directo, a new push-to-talk offering created to fend off NII Holdings. While these maneuvers, along with the injection of new smartphones, have kept subscriber growth strong--up 19% year over year in November for the Brazilian mobile sector--margins on earnings before interest, taxes, depreciation, and amortization have been pressured.
With all of the fixed and mobile integrations that have been made over the past few years, these firms' profitability prospects will hinge on their ability to use their infrastructure to bundle and build scale. Given this and the 4G auction, which should occur in the second half of 2012, we expect capital expenditures to rise for all of the major carriers. To fund this, it's likely the smaller firms will need to raise capital.
Of the four major carriers in Brazil, America Movil is best positioned to handle an uptick in competitive aggression and capital spending. The company is backed by Carlos Slim, the world's richest man, and owns the highest-quality infrastructure in the region. It has already launched quadruple-play bundles of Internet, pay TV, fixed voice, and wireless, and its superior pay TV product (through its takeover of cable giant NET Servicos (NETC)) gives it a strong competitive advantage in bundling. For example, many of NET's cable subscribers use Vivo as their wireless carrier. With its superior infrastructure and a much better pay TV product, America Movil can now offer those Vivo customers a bundled discount that will lower their all-in monthly telecommunications payment. Oi is technically able to offer quadruple-play service as well, but the fact that its management has materially underinvested in its infrastructure over the past few years has severely hindered the quality of its product offerings.
Telefonica Brasil's satellite offering isn't great either, and with parent Telefonica recently cutting its 2012 dividend, the firm's financial flexibility (roughly 2.5 times net leverage) has clearly eroded. TIM and Oi each have much smaller cash flow cushions and will probably have to raise more equity.
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