Argentina's Telecommunications Sector: The Latest Target For Nationalization?

| About: Telecom Argentina (TEO)

There have been a litany of worrying events for investors in Argentina. First investors saw the government of President Kirchner order oil and mining companies to repatriate all future export revenue to Argentina. This was followed with the introduction of tighter oversight of the foreign exchange market, the implementation of further protectionist policies to restrict imports and the revocation of oil concessions from foreign controlled oil companies. All of these actions culminated in the nationalization of Argentina's largest and previously state-owned oil company YPF (YPF) by the expropriation of almost all of the Spanish company Repsol's (REPYY.PK) shares in the company. All of which has created speculation that the government of President Kirchner will target other former state-owned business for nationalization. Two companies that have in recent months come under the government's gaze are the two largest Argentine telecommunications companies Telecom Argentina (NYSE:TEO) and Telefonica de Argentina. Both of these companies once formed the state-owned telecommunications company Entel.

The period from 1990 to 1996, saw Argentina undergo broad structural reform, including the privatization of most state owned enterprises including airlines, telecommunications, utilities, railroads, ports, petrochemical plants, the state oil company and some provincial banks. As a result of this privatization Entel was divided into two companies, with Telecom Argentina being awarded the north of the country and Telefonica de Argentina the south. Telecom Argentina is now majority owned by Nortel Invesora (NYSE:NTL), a company that is controlled by Telecom Italia (NYSE:TI). Telefonica de Argentina is owned by Spain's second largest company Telefonica (NYSE:TEF).

The Argentine telecommunications market is seen as one of the most advanced telecom infrastructures in Latin America and telecom revenues are expected to reach more than $14 billion in 2012. All of this indicates that it is a highly profitable market for its two main players Telecom Argentina and Telefonica de Argentina.

Both of these companies reported strong financial results for the first quarter 2012, with Telecom Argentina reporting in comparison to fourth quarter 2011 that revenue remained steady at %$1.2 billion but that OIBDA rose by 17% to $370 million and net income rose by 16% to $157 million. For the same period Telefonica de Argentina's revenue rose by 12.9% to $1.1 billion, but OIBDA fell 11% to $345 million.

Both companies are seeing substantial growth in their Argentine mobile and internet operations because as in other Latin American countries fixed-line revenues are gradually decreasing. Furthermore, Argentina has one of the highest rates of internet use in Latin America, having the third highest number of users after Brazil and Mexico.

Since the end of fourth quarter 2011 Telecom Argentina has seen a 2% increase in the number of mobile subscribers and an 8% increase in average revenue per mobile user to $12.60. Whereas, Telefonica de Argentina saw its mobile subscribers increase by 3.3% by the end of first quarter 2012 from fourth quarter 2011. For the same period average revenue per mobile user grew by 2% to $12.36.

As at the end of first quarter 2012, Telecom Argentina has a 34% share of the mobile market, a 35% share of the broadband internet market and a 47% share of the fixed line market. Whereas Telefonica de Argentina has a 40% share of the mobile market, a 31% share of the broadband internet market and a 48% share of the fixed line market.

As the market share figures illustrate both companies have a dominant position in the Argentine telecommunications market and are capable of delivering solid financial results. Both Telecom Argentina and Telefonica de Argentina's parent Telefonica, have seen their stock prices plunge since the start of 2012, but for very different reasons. Telecom Argentina has dropped by 33% for its ADRs to now be trading at around $12 and Telefonica by 30% to now be trading at around $12. The key reason for Telecom Argentina's plunge is the increase in Argentina political risk and the ongoing pressure being applied to the company, firstly with regard to payment of its dividend and now with regard to capex in Argentina.

Telefonica has a geographically diverse business with a strong presence in Latin America but it only receives 6% of its revenue and 5% of its OIBDA from Argentina. The majority of its revenue and OIBDA from its Latin American operations is obtained from its independently listed Brazilian subsidiary Telefonica Brazil (VIV), which accounts for 23% of Telefonica's revenue and 25% of its OIBDA. Therefore, for Telefonica, any substantial drop in its Argentine market share or revenues will not have a significant impact on its bottom-line.

However, since President Kirchner's re-election in October 2011, there have been a series of developments concerning Argentina's telecommunications industry that have affected both incumbents. It started with President Kirchner's government applying significant pressure to Argentina company's including Telecom Argentina not to pay out dividends and instead reinvest that capital in Argentina. This occurred on the back of increasing capital flight that was putting pressure on the value of the Argentine peso, leading to further price increases in an economy with problematic inflation.

However, to its credit and in stark contrast to the views of many analysts and market commentators, myself included, Telecom Argentina defied the government pressure announcing on 27th April 2012 it would pay dividends totaling $183 million dollars to shareholders. This has given Telecom Argentina a very attractive dividend yield of 7.5% based on this 2012 dividend payment. If it is followed up with the usual second dividend payment which is typically the same amount the company will have a very appealing dividend yield of 16%. However, given the previous pressure brought to bear on the company by the Argentine government, there is no guarantee of a further dividend payment at this time.

Furthermore, as a conciliatory gesture aimed at deflecting further government criticism and further intervention in the company's actions as a result of electing to pay the dividend, Telecom Argentina has committed to boosting investment in Argentina by more than 40% to $1 billion. The Argentine planning minister Julio de Vido earlier this year stated that the government would keep a close eye on whether the company's investments in Argentina were in line with its profits. Obviously, this is to remind Telecom Argentina that the government expects it to follow through with its capex investment promise.

We have also seen the Argentine government recently fine Telefonica $43 million for a service outage in April this year in its Movistar unit, which offers wireless voice and data services in Argentina and across South America. During this outage 18 million Argentine clients of Movistar were without phone and data services for several hours due to technical problems. After the outage, the company moved to compensate customers but the Argentine government decreed that the compensation wasn't sufficient. The fine was composed of $41.6 million as compensation for affected customers, or $2.25 per customer, and the remaining $1.4 million to be paid as a regulatory fine to the Argentine government. Interestingly, at the time of announcing the fine the planning minister has also asked telecommunications companies to increase their investment in fixed infrastructure in Argentina stating;

"Cellphone service quality has declined in recent months. We need to have full service, not service that gets worse when you walk a few meters one way or another."

All of which I believe indicates that the government is increasingly using the regulatory stick to pressure telecommunications companies to increase investment in infrastructure in Argentina. Especially as any investment will improve government popularity, as it seen to create jobs in a country with high unemployment. It also alleviates the government's inability to raise the necessary funds to invest in critical and much needed internal communications infrastructure, because they can't tap international credit markets for those funds.

This becomes even clearer when we consider that last week, the Argentine government met with Vale (NYSE:VALE), Xstrata (OTC:XSRAF) and Barrick Gold (NYSE:ABX) to apply pressure on these mining companies to develop and implement plans to replace imported equipment with locally manufactured equipment. This accords with what is becoming a recurrent theme, the government is forcing companies to adopt measures that decrease the flow of capital outside of the country and increase consumption of domestically produced goods. These actions do accord with the view expressed by the CEO of Telecom Argentina Franco Bertone that he doesn't expect the government to nationalize telecommunication companies.

Even more cynically, I would think that the fine is nothing more than a much needed capital injection, rather than a move down the path towards nationalizing Telefonica de Argentina. I have taken this more cynical view as the government faces renewed balance of payments pressure and attempts to raise funds for investment in newly nationalized YPF. Given Telefonica's share of the Argentine telecommunications market and the strong financial performance of its subsidiary it is unlikely that it would depart the Argentine market.

However, if Telefonica were to sell its Argentine operations it would not see significant impact on its revenue or net income. Nonetheless it would see the loss of valuable income producing assets. Any decision for investors on whether to invest in Telefonica should obviously not be based solely on the performance of their Argentine subsidiary especially as the company has debt management and cost issues that need to be addressed.

Despite no indications that the government has considered expropriating Telefonica de Argentina from Telefonica, I have lingering suspicions that it has at least been considered in some form or another by members of the current government. Given the current Latin American predilection for expropriating domestic companies from their Spanish owners it is certainly something that can't be discounted. Particularly when it is considered that Argentina does not contribute a substantial amount of and the company is focused on building its Brazilian operations as well as being distracted by managing debt and expense issues and the ongoing contraction of the Spanish economy.

There have been some signs that share strong similarities to the events that led up to the nationalization of YPF. These include the planning minister making demands of both Telecom Argentina and Telefonica de Argentina to increase investment in Argentine telecommunications infrastructure. In the case of YPF the government made claims that the company wasn't meeting agreed levels of production. This then saw the government commence stripping away oil concessions from the company, which impacted on its production, revenue and eventually profits. Finally, on the basis that YPF was unable to increase production the government nationalized the company.

It leaves me pondering what action the government will take if one or both companies fail to invest in telecommunication infrastructure at the level demanded. It is possible that the government will place restrictions on either company should they fail to comply or, even worse, revoke the non-compliant companies telecommunications license, which would prevent them from operating in the industry. This in effect would shut down their business and be only a short step from providing the government with the excuse to nationalize the license less company, so as to ensure Argentina's telecommunications structure remains intact.

Based on its current price Telecom Argentina appears to be a compelling investment. This is particularly so when as the company is trading at only 23% of its book value per share of $9.99, has an earnings yield of 23%, a profit margin of 12% which is being converted into a very tidy return on equity of 34% and a historical dividend yield of 16%. However, given the increasing political risk in Argentina combined with the governments somewhat erratic and unpredictable decision making it would certainly be only a very hardy speculative investor who would consider the company. Even more so when it is impossible to predict whether the company will continue paying a dividend.

Telecom Argentina also makes up 4.4% of the holding of the only Argentine ETF currently available the Global X FTSE Argentina 20 (NYSEARCA:ARGT), which has fallen by 26% since the start of 2012. Until the government's direction with the telecommunications industry and the economy as a whole becomes clearer, it would be prudent for investors to reconsider investing in this ETF.

At this time there is no clear evidence that the Argentine government is seeking to nationalize part or all of the country's telecommunications industry. However, there are indicators that the government is willing to intervene directly in the industry in order to achieve its economic and political agenda. This includes pressuring telecommunications companies to retain profits in Argentina and increase capital investment in telecommunications infrastructure. The increased capital expenditure required to please the government will obviously have an effect on the profitability of both Telecom Argentina and Telefonica de Argentina. Investors should also be actively monitoring the situation, because the government's actions to date closely mirror those that were taken at the start of the process to gain support for the nationalization of YPF. The government is also in a position where it can play the politically popular position that intervention in, and partial or full nationalization of the telecommunications industry, is a means of ensuring national security.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.