TIM Participações: As The Chess Pieces Move In Europe, Double-Digit Upside In Brazil

| About: TIM Participações (TSU)
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As the largest economy in South America, and one of the ten largest in the world, Brazil offers compelling long-term growth opportunities for a variety of companies in a variety of sectors, both those based in Brazil and beyond. Chief among them is the Brazilian wireless market; to date, perspective buyers of Brazilian wireless companies have been stymied by the convoluted ownership structure of Brazil's leading carriers. However, recent events in Europe have served to create an opening for strategic buyers to take control of one of Brazil's leading carriers, TIM Participações (NYSE:TSU) (hereafter referred to as TIM). Telecom Italia (NYSE:TI) has long controlled TIM, but as a series of events serve to loosen its grip on TIM, we believe that its true value will be unlocked. And with shares undervalued on a standalone basis when taking into account sector-leading growth in revenue, EBITDA, and EPS, we see upside of at least 20% for shares of TIM, with further gains likely to occur as various events unfold in Europe and Brazil, to the likely benefit of TIM' investors. In this article, we will discuss TIM's core performance in 2013, the upside offered by its shares on a standalone basis, and finally, the possibility of a strategic transaction involving TIM. Unless otherwise noted, financial statistics and managerial commentary used in this article will be sourced from the following: TIM's Q3 2013 earnings presentation, TIM's Q3 2013 earnings call transcript, and TIM's Q3 2013 earnings release.

Overview & Q3 2013: Broad-Based Opportunities in Brazilian Wireless

With almost 73 million customers, TIM is the 2nd largest carrier in Brazil, with over 27% of the market, behind only Vivo (NYSE:VIV), which is controlled by Spain's Telefonica (NYSE:TEF). TIM has seen solid success in 2013 across a variety of metrics, and we delve into its Q3 results below. TIM's total subscriber base grew by 5.04% to 72.9 million customers, and while the bulk of TIM's customer base consists of prepaid subscribers, crucial postpaid customers are continuing to comprise more and more of TIM's overall subscriber base.

TIM Subscriber Growth, Q3 2013

Q3 2013

Q2 2013

Q3 2012

Sequential Change (%)

Y/Y Change (%)

Prepaid Subscribers

61,000,000

60,800,000

59,100,000

+200,000

(+0.33%)

+1,900,000

(+3.21%)

Postpaid Subscribers

11,900,000

11,400,000

10,300,000

+500,000

(+4.39%)

+1,600,000

(+15.54%)

Total Subscribers

72,900,000

72,200,000

69,400,000

+700,000

(+0.97%)

+3,500,000

(+5.04%)

Prepaid Share

83.68%

84.21%

85.16%

-53 bps

-148 bps

Postpaid Share

16.32%

15.79%

14.84%

+53 bps

-148 bps

Although Brazil has a long way to go until postpaid subscribers constitute a majority of the country's wireless subscriber base, TIM is making progress in growing its postpaid base, and has grown its postpaid subscriber base by double digits in Q3 2013, and postpaid subscribers now account for over 16% of its total subscriber base. Although TIM's churn rate increased to 13.1% in Q3 2013 from 11.9% in Q3 2012, this was due to volatility within its prepaid customer base caused by more "austere" disconnection policies, and CMO Roger Sole Rafols stated on TIM's Q3 earnings call that its postpaid churn rate is far lower. In any case, we do not believe that TIM is having difficulty attracting subscribers within Brazil. Gross additions grew to 9.7 million in the third quarter, up 17% from the 8.7 million additions in 2012, even as the company drove subscriber acquisition costs down by 9.23% to R$30.5. Furthermore, subscriber acquisition costs fell to 1.6 months of ARPU, down from 1.8 months in Q3 2012, even as ARPU dipped slightly to R$18.60, down 1.6% year-over-year (but up 2.6% sequentially). On its earnings call, TIM outlined its drive to grow ARPU through 2014, and based on management's commentary, we believe that the company is well positioned to grow ARPU in 2014. Although TIM's consolidated ARPU stands at R$18.60, its postpaid ARPU ranges from R$30 to R$35, and with its new Liberty Controle plan, TIM is well positioned to grow its ARPU throughout 2014. For R$29.90, Liberty Controle offers subscribers unlimited calling to other TIM numbers, and R$10 in credit for internet usage and texting, which are charged at a daily rate of R$0.50 for unlimited usage, and only on the day that subscribers wish to use them. Management noted that the bulk of TIM's new users are signing up for its Controle plan, and as these subscribers begin to flow through the company's customer base, we expect to see upward pressure on ARPU, as well as lowered churn rates. The company noted that Controle is already helping to drive down churn rates within its postpaid subscriber base, and we expect more color on Controle's success throughout 2014. However, Controle is not TIM's only avenue to higher ARPU; continued smartphone penetration offers yet another route, and here, TIM is well positioned. While TIM has less than 28% of Brazil's overall wireless market, it sold 39% of all smartphone within Brazil during Q3, and with smartphones accounting for 67% of all phones sold by TIM (up 25 percentage points year-over-year and 10 percentage points sequentially), we expect that this will help grow both TIM's market share as smartphone growth continues.

As the chart above (from Anatel, Brazil's telecommunications regulator) shows, TIM was the only carrier to gain market share year-over-year in Q3 2013, boosting its share of Brazil's wireless market by 120 basis points year-over-year, as all three of its major competitors lost share [we note that the chart above amounts to 99.5%; the remaining 0.5% is held by NII Holdings (NASDAQ:NIHD) via its Nextel Brazil division, which ended Q3 2013 with just under 3.9 million subscribers]. Continued growth in smartphones will do more than simply drive TIM's market share. More importantly, the transition will help drive its revenue growth. Although total revenues grew by 7.6% in Q3 2013 to R$5.083 billion, TIM grew data revenues by 21.5% during the quarter to R$1.362 billion, and we break down TIM's overall revenue growth below.

TIM Revenue Growth, Q3 2013 (in Thousands of R$)

Q3 2012

Q3 2012

Y/Y Change

Fixed Line Revenue

R$257,437

R$339,426

-24.16%

Mobile Usage & Fee Revenue

R$2,884,968

R$2,800,713

+3%

Value Added Services Revenue*

R$1,362,498

R$1,121,694

+21.48%

Long Distance Revenue

R$832,558

R$808,359

+2.99%

Interconnection Revenue

R$919,536

R$996,439

-7.72%

Other Mobile Revenue

R$55,153

R$55,879

-1.3%

Product Revenue

R$1,227,478

R$900,808

+36.26%

Gross Revenue

R$7,539,627

R$7,023,138

+7.35%

Less Discounts & Deductions

(R$2,456,469)

(R$2,300,713)

-6.77%

Net Revenue

R$5,083,158

R$4,722,425

+7.64%

*Data

Although TIM's fixed line revenues continued to decline in Q3 2013, this division makes up just over 5% of TIM's net revenues, and its decline has not adversely affected TIM's results, and continued growth within its mobile division (consolidated mobile revenue grew 4.7% year-over-year) has more than offset this decline. TIM's handset division posted the strongest revenue growth across all of the company's segments as TIM's efforts to grow smartphone penetration flowed through to its income statement. However, TIM's revenue growth has not fully flowed through to the company's EBITDA, and while some may see cause for concern in this, we believe that the reason for this lack of full revenue growth translation to EBITDA is sound. For Q3 2013, TIM posted R$1.252 billion in EBITDA, up 4.25% from Q3 2013. TIM's EBITDA growth was held in check by declining margins, in both its service segment (down 50 basis points to 30.5%) and on a consolidated basis (down 80 basis points to 24.6%) as expense growth outpaced revenue growth. During Q3, there were two main drivers of TIM's expense growth. The first was cost of goods sold (TIM reports its cost of goods sold within its operating expenses), which grew by over 31% to R$906.944 million as TIM continued to grow its smartphone sales; although TIM does not subsidize handset sales, the company has seen an opportunity in being flexible with handset pricing in order to both capture market share and migrate its subscribers more rapidly to higher-margin data plans. While this approach may trim EBITDA margins in the short run, we believe that it is a worthwhile long-term decision, and as data revenues continue to grow, EBITDA margins will recover. The 2nd source of cost pressure for TIM was personnel expenses, which soared by almost 25% (personnel expenses are TIM's 2nd largest cost center, behind only network costs) as the company expanded its store count and hired new workers within its call centers and network operations. The benefits of this expense surge can be seen in TIM's performance across several customer care metrics, as shown in the charts below.

TIM has maintained its position as the least complained about carrier at Procon, Brazil's consumer protection agency, and TIM is the 2nd-highest ranked carrier in Anatel's index rankings of performance and customer complaints. However, the company has strived to do better. In April, TIM began a series of changes to its core operations in several Brazilian cities that together represent almost 50% of total subscriber traffic. The goals of this program are to improve TIM's ability to detect and diagnose network quality issues, and to implement new customer service protocols. In its Q3 earnings release, TIM noted that the program is progressing, and in September led to a 19% reduction in network-related complaints to Anatel, and we expect further reductions to occur in Q4 2013. In addition to this targeted program, TIM is investing over R$50 million in an overhauled CRM platform in order to streamline its customer service throughout Brazil. As of today, TIM operates nine different customer care systems, resulting in incompatibilities and subpar service. TIM is forecasting that the platform will be rolled out for its prepaid customers by the end of the year and throughout 2014 for its postpaid customers.

Peer Comparison: Giving Credit Where Credit is Due

In our view, TIM's performance in Q3 2013 was solid, and the company is making continued progress across a variety of metrics. Subscribers are growing in both its prepaid and postpaid segments, and the company is continuing to grow its smartphone penetration, which is helping drive growth in both data revenue and market share. However, although TIM's growth in revenue, EBITDA, and EPS is above the average growth rate for its peers across all three metrics, shares of TIM do not reflect its growth potential, and when compared to its peers in the Brazilian wireless market, we believe that TIM is undervalued. We present a peer comparison of TIM's financial position in relation to its peers below, which include the following companies: Vivo (controlled by Telefonica), Oi (NYSE:OIBR), America Movil (NYSE:AMX), which operates in Brazil via its Claro brand, and NII Holdings, which operates in Brazil via Nextel Brazil (notes: figures for TIM, Vivo, and Oi are presented in reals, and figures for America Movil are presented in pesos; share prices, multiples, and consensus estimates are accurate as of the close of trading on December 20, 2013 and are subject to change).

TIM Peer Comparison

Company

TIM

Vivo

Oi

NII Holdings

America Movil

Peer Average

Share Price

R$ 12.15

R$ 43.50

R$ 3.82

$2.58

$14.45

Shares Outstanding

2,417,632,647

1,125,601,930

1,797,086,404

172,438,555

71,720,000,000

Market Capitalization

R$ 29,374,236,661

R$ 48,963,683,955

R$ 6,864,870,063

$444,891,472

$1,036,354,000,000

Stockholder's Equity

R$ 14,444,342,000

R$ 43,631,100,000

R$ 10,322,000,000

$1,217,764,000

$217,876,000,000

Non-Controlling Interest

R$ 0

R$ 0

R$ 0

$0

$0

Book Value per Share

$5.97

$38.76

$5.74

$7.06

$3.04

Cash & Equivalents

R$ 3,335,000,000

R$ 9,472,300,000

R$ 4,758,000,000

$1,897,355,000

$72,226,000,000

Debt

(R$ 4,781,000,000)

(R$ 9,213,300,000)

(R$ 34,053,000,000)

($5,791,057,000)

($512,405,000,000)

Net Cash (Debt)

(R$ 1,446,000,000)

R$ 259,000,000

(R$ 29,295,000,000)

($3,893,702,000)

($440,179,000,000)

Net Cash (Debt) per Share

(R$ 0.60)

R$ 0.23

(R$ 16.30)

($22.58)

(R$ 6.14)

Debt-to-Equity

-33.10%

-21.12%

-329.91%

-475.55%

-235.18%

-346.88%

Net Debt-to-Equity

-10.01%

0.00%

-283.81%

-319.74%

-202.03%

-268.53%

Adjusted Share Price

R$ 12.75

R$ 43.27

R$ 20.12

$25.16

R$ 20.59

Enterprise Value

R$ 30,820,236,661

R$ 48,704,683,955

R$ 36,159,870,063

$4,338,593,472

$1,476,533,000,000

2012 Revenue

R$ 18,763,947,000

R$ 33,931,400,000

R$ 25,169,200,000

$6,086,500,000

$775,070,000,000

2013 Revenue

R$ 20,080,000,000

R$ 34,798,000,000

R$ 28,588,000,000

$4,840,000,000

$779,583,000,000

2014 Revenue

R$ 21,034,000,000

R$ 35,750,000,000

R$ 28,706,000,000

$4,500,000,000

$790,827,000,000

2015 Revenue

R$ 21,923,000,000

R$ 36,944,000,000

R$ 27,109,000,000

$4,719,000,000

$804,815,000,000

2012 EBITDA

R$ 5,052,163,000

R$ 11,562,900,000

R$ 8,801,000,000

$935,900,000

$260,895,000,000

2013 EBITDA

R$ 4,960,000,000

R$ 10,674,000,000

R$ 8,275,000,000

$324,000,000

$254,613,000,000

2014 EBITDA

R$ 5,506,000,000

R$ 11,232,000,000

R$ 8,184,000,000

$313,000,000

$254,419,000,000

2015 EBITDA

R$ 5,834,000,000

R$ 11,814,000,000

R$ 8,473,000,000

$484,000,000

$254,544,000,000

2012 EPS

R$ 0.5995

R$ 3.72

R$ 1.088

($4.46)

$1.20

2013 EPS

R$ 0.64

R$ 3.54

R$ 0.53

($6.32)

$1.16

2014 EPS

R$ 0.68

R$ 3.81

R$ 0.41

($5.37)

$1.19

2015 EPS

R$ 0.71

R$ 4.13

R$ 0.70

($3.94)

$1.20

2013 Revenue Growth

7.01%

2.55%

13.58%

-20.48%

0.58%

-2.10%

2014 Revenue Growth

4.75%

2.74%

0.41%

-7.02%

1.44%

-1.72%

2015 Revenue Growth

4.23%

3.34%

-5.56%

4.87%

1.77%

0.36%

3-Year Revenue CAGR

5.32%

2.88%

2.51%

-8.13%

1.26%

-1.45%

2013 EBITDA Growth

-1.82%

-7.69%

-5.98%

-65.38%

-2.41%

-24.59%

2014 EBITDA Growth

11.01%

5.23%

-1.10%

-3.40%

-0.08%

-1.52%

2015 EBITDA Growth

5.96%

5.18%

3.53%

54.63%

0.05%

19.40%

3-Year EBITDA CAGR

4.91%

0.72%

-1.26%

-19.73%

-0.82%

-7.27%

2013 EPS Growth

6.76%

-4.84%

-51.29%

0.00%

-3.33%

-19.82%

2014 EPS Growth

6.25%

7.63%

-22.64%

0.00%

2.59%

-4.14%

2015 EPS Growth

4.41%

8.40%

70.73%

0.00%

0.84%

26.66%

3-Year EPS CAGR

5.80%

3.55%

-13.67%

0.00%

0.00%

-3.37%

2013 P/S

1.53

1.40

1.26

0.90

1.89

1.35

2014 P/S

1.47

1.36

1.26

0.96

1.87

1.36

2015 P/S

1.41

1.32

1.33

0.92

1.83

1.36

2013 EV/EBITDA

6.21

4.56

4.37

13.39

5.80

7.85

2014 EV/EBITDA

5.60

4.34

4.42

13.86

5.80

8.03

2015 EV/EBITDA

5.28

4.12

4.27

8.96

5.80

6.34

2013 P/E

19.92

12.22

37.96

0.00

17.75

22.65

2014 P/E

18.75

11.36

49.08

0.00

17.30

25.91

2015 P/E

17.96

10.48

28.74

0.00

17.16

18.79

Despite the fact that it is forecast to post sector-leading growth in revenue, EBITDA, and EPS through 2013-2015, TIM trades at a discount to its peer average on both an EV/EBITDA and P/E basis, with only its price-to-sales multiples currently above the sector average. In our view, such a disparity is unjustified; although TIM's growth is unlikely to be deemed outstanding in a vacuum, it becomes far more impressive when compared to its Brazilian wireless peers, and we believe that its valuation should reflect this relative disparity, in the form of a modest premium to peer multiples. We present our valuation for TIM in the table below, assigning a 10% premium to peer multiples.

TIM Valuation Matrix

Metric

Peer Multiple

TIM Premium

TIM Multiple

TIM Input

Implied Share Price

2013 P/S

1.35

10%

1.49

R$ 20,080,000,000

R$ 12.35

2014 P/S

1.36

10%

1.50

R$ 21,034,000,000

R$ 13.05

2015 P/S

1.36

10%

1.50

R$ 21,923,000,000

R$ 13.59

2013 EV/EBITDA

7.85

10%

8.64

R$ 4,960,000,000

R$ 17.12

2014 EV/EBITDA

8.03

10%

8.83

R$ 5,506,000,000

R$ 19.51

2015 EV/EBITDA

6.34

10%

6.98

R$ 5,834,000,000

R$ 16.24

2013 P/E

22.65

10%

24.91

R$ 0.64

R$ 15.94

2014 P/E

25.91

10%

28.50

R$ 0.68

R$ 19.38

2015 P/E

18.79

10%

20.67

R$ 0.71

R$ 14.68

The average of these 9 multiples leads to an implied value of R$15.76 for TIM's São Paulo-traded shares; when adjusted for TIM's net debt, this creates a price target of R$15.16, representing upside of 24.77% relative to TIM's December 24 closing price of R$12.15. Investors with access to the Brazilian equity markets may wish to simply purchase TIM's São Paulo-traded shares. Alternatively, investors may elect to purchase TIM's ADRs, which trade in New York under the ticker TSU (each ADR represents five ordinary shares). Taking our price target of R$15.16 and applying a slightly conservative real-dollar exchange rate of 2.45:1 (versus a current rate of around 2.3573 to account for a potential depreciation of the Brazilian real) yield a pro forma price target of $30.94 for TIM's ADRs, representing upside of 20.62% relative to their December 24 closing price of $25.65.

While upside of over 20% is notable, such upside only takes into account the developments that are taking place within the Brazilian wireless market, and this does not take into account events that are unfolding in Brasília, Madrid (where Telefonica is headquartered), and Rome (where Telecom Italia is headquartered). As a series of events unfold in these three capitals, we believe that meaningful changes to TIM's ownership structure are at hand, and that in 2014, these events will lay the foundation for even more upside for TIM's investors.

Games Telecoms Play: Unlocking the True Value of TIM

Brazil's wireless market is notable not only for its size and the long-term opportunities it offers, but for its dominance by foreign entities, as each of the country's four main carriers are controlled by either Telecom Italia, Telefonica, Portugal Telecom (NYSE:PT), or America Movil. And in recent months, Brazilian regulators have placed their focus on Telefonica, which is in the unique position of having exposure to both Vivo and TIM by virtue of its stake in Telecom Italia. Telefonica is a key shareholder in Telco SpA, which owns 22.6% of Telecom Italia, and owns Telco alongside several Italian financial institutions. Telco was created in 2007 as a compromise between Telecom Italia and the Italian government to fend off a takeover bid by AT&T (NYSE:T) and America Movil, and since then, Telefonica's presence in Telco has created conflicts, especially with regards to their Brazilian units, given the fact that they compete directly with each other. As competition in Brazil intensified, Telefonica's position became increasingly untenable, and on December 14, Telefonica's CEO and former COO resigned from Telecom Italia's board due to growing scrutiny over this inherent conflict of interest. The two would already recuse themselves from meetings whenever discussions of TIM would arise, but under mounting investigations from Consob (Italy's Securities and Exchange Commission) and Cade (Brazil's anti-trust regulator), the situation became untenable. Telefonica's representatives resigned from Telecom Italia's board ahead of a critical shareholder vote led by activist investor Findim Group to oust the carrier's board due to what it sees as excessive influence by Telefonica. However, on December 21, Telecom Italia and Telefonica emerged victorious, as 50.3% of shareholders voted against Findim's proposal and voted to retain Telecom Italia's current slate of directors. The retention of Telecom Italia's current slate of directors, combined with an order from Cade to Telefonica to reduce its influence in the Brazilian wireless market will likely lead to meaningful upside for TIM.

On December 18, Reuters reported that sources within the Brazilian government have said that Cade has given Telefonica 18 months to reduce its influence in the country's wireless market, either by divesting itself of its exposure to TIM (via a selloff of its Telco stake) or by ceding some control of Vivo via the addition of another partner. However, sources close to Telefonica's board have stated that the company sees Vivo as an "absolutely strategic" asset and that ceding control or ownership of the carrier is out of the question. Furthermore, these sources have also said that the Spanish carrier has no intention of ending its quest to gain full control of Telco, in spite of clear opposition to such a move from Brazil, which has already fined Telefonica over $6 million for increasing its stake in Telco from 46% to 66% in September 2013. Given that Telco has the ability to appoint a majority of Telecom Italia's directors, control of Telco effectively grants control of Telecom Italia itself, despite the fact that Telco owns less than a quarter of the carrier's equity. In an interview in November, Telefonica CEO Cesar Alierta ruled out a merger between Telefonica and Telecom Italia (with control of Telco, such a transaction is essentially pointless), and ruled out a merger between Vivo and TIM; for obvious reasons, Brazilian regulators would never approve such a deal. In addition, Alierta stated that he expects the other shareholders in Telco to keep their stakes in the holding company until February 2015, when the current shareholder agreement between Telefonica and its Italian partners expires (there will be a 15-day window in June 2014 in which Telefonica and its partners can scrap the agreement), thereby allowing Telefonica to potentially gain full control of Telco. Telco's Italian investors have lost billions investing in Telco in the name of keeping the carrier in Italian hands; they purchased shares in Telecom Italia at around €2.80 in 2007, only to see its share price fall to around €0.70 as of December 20, 2013. For Telefonica, the willingness of its partners to be rid of their exposure to Telecom Italia has left it with an opportunity that is almost too good to pass up (for it gives the company effective control of Telecom Italia at a cost that is far lower than an outright takeover), despite the fact that such a move runs counter to the demands of Brazilian regulators. Telefonica has received clear orders from Brazilian regulators to reduce its influence in the country's wireless market, and if the company is unwilling to do so by ceding control over Vivo, it will have to reduce its influence over TIM. However, the company's clearly stated moves to tighten its control over Telecom Italia run wholly counter to that mandate. Telefonica is fully aware of this fact, and its preferred solution, according to sources close to the carrier's executives, is to break up TIM and split its business between Vivo, Oi, and Claro. However, this approach carries regulatory risks. Brazilian regulators are unlikely to give blanket approval to a breakup of TIM, for it would reduce the number of major Brazilian carriers from four to three. That being said, industry analysts have noted that Brazilian regulators could consider approving a breakup of TIM, provided that no one carrier emerges as dominant, due to the fact that it would give the three remaining carriers greater ability to invest in their networks and improve coverage across the country. If TIM were to be broken up, we do not expect that it would be done at fire-sale prices, for three reasons: The first is litigation. If Telefonica pressures Telecom Italia into a breakup of TIM at fire-sale prices, it would open itself up to likely litigation across three continents (North America, South America and Europe) as TIM's minority investors sue over what would be seen as an example of preferential treatment for Telefonica. Secondly, and more importantly, Telefonica has made clear that it is committed to doubling down on its investment in Telecom Italia (whether or not such a move is a good idea is beyond the scope of this article), and if TIM's assets were to be sold at fire-sale prices, Telecom Italia's balance sheet would weaken even further, hindering its ability to cut its debt load, which stands at tens of billions of euros. A fire-sale of TIM's assets would help none of the Telecom Italia's investors, chief among them Telefonica. And third, a fire-sale would serve to benefit Oi and America Movil, for both companies would be able to acquire the assets of a chief competitor at low prices, and we see no reason that Telefonica would wish to subsidize the ability of its competitors to compete with Vivo. If a breakup of TIM is to occur, we expect that it will not be detrimental to TIM's outside investors, for such an outcome is not in Telefonica's best interest. In any case, a breakup of TIM may prove to be unrealistic given the Brazilian regulatory climate.

Therefore, the solution to the Telefonica's anti-trust issues may be an outright sale of TIM. Telecom Italia has been unable to provide the market with a definitive position regarding TIM; the company has alternated between denying that there is any plan to sell TIM and having CEO Marco Patuano say the following: "[TIM is] a core asset…it is a part of our strategy ... That does not mean a core asset has no price. ... It's not for sale, I'm not facilitating a sale. If we receive an offer it has to be an offer for a core and strategic asset." Within that statement is a key assertion: while TIM may not be put on the auction block by Telecom Italia, the carrier is willing to let other companies create the auction block and place TIM there. And in our view, there will be any number of companies willing to do so, for a sale of TIM creates a unique opportunity to enter the Brazilian market, and to do so without onerous terms.

As of today, carriers that wish to be exposed to the Brazilian wireless market have virtually no path to do so. Telefonica controls Vivo, and it has ruled out ceding control of it. Claro is controlled by America Movil, and given the fact that Carlos Slim controls America Movil, there can be no deal that does not involve Slim and his terms. Oi is in the process of merging with Portugal Telecom, and the resulting combination will create a carrier that carries Portugal Telecom's European baggage, as well as Oi's leveraged balance sheet. And NII Holdings lacks the scale needed to justify investing in it, and carries with it NII's plethora of issues across both Brazil and various other Latin American countries. However, TIM is a different story. If it were to be untangled from Telecom Italia, it would offer other carriers the ability to acquire Brazil's number two wireless provider, and to do so without the baggage associated with legacy European carriers. Telecom Italia is almost certainly aware of this, and if it receives an acceptable offer, we expect it to be acted upon, given Telefonica's influence over Telecom Italia's board of directors. Telefonica may choose to wait on moving to initiate a selloff of TIM until Brazil's next general election (to be held in October 2014) in order to gauge the mood of Brazilian regulators, but with President Dilma Rousseff leading the opposition by well over twenty percentage points in the polls, we do not expect that President Rousseff and her Workers' Party will lose power in October. Assuming the Workers' Party triumphs once again, the Brazilian regulatory climate is unlikely to shift meaningfully, and this could prompt Telefonica to begin applying pressure to sell TIM, assuming it does not act sooner. And if the wireless sector sees that Telecom Italia is open to entertaining offers for TIM, we expect that a number of companies would step up with offers, and we discuss potential suitors below, covering both companies that could make an offer and those that are unlikely to do so.

  1. The first perspective bidder is DIRECTV (NYSE:DTV), which operates in Brazil via its Sky Brazil subsidiary. In June 2012, the company spent $45 million to acquire wireless airwaves across Brazil, and it currently sells wireless broadband services in Brasilia. A takeover of TIM, while a meaningful undertaking (DIRECTV's market capitalization is under $35 billion, while TIM's over $12 billion), would dramatically boost DIRECTV's presence in Brazil, and diversify it away from potential weakness in its core U.S. satellite division. If DISH (NASDAQ:DISH) can move to acquire Sprint (NYSE:S), we see no reason why DIRECTV could not do the same with TIM.
  2. AT&T: AT&T is unlikely to be a suitor for TIM, given its longstanding partnership with America Movil, which was expanded in September 2013. Given that AT&T owns around 9% of America Movil and has seats on the company's board of directors, it would have to see a truly compelling financial reason to unwind this partnership.
  3. Vodafone (NASDAQ:VOD): Flush with cash from the sale of its stake in Verizon Wireless, Vodafone is a potential suitor, given the fact that the carrier has long used emerging markets as a way to paper over the sluggish growth of its European holdings. In keeping with Vodafone's newfound stance to fully control as many of its various wireless ventures as possible (the Verizon Wireless deal also gave back Vodafone full control of its Italian operations), we expect that Vodafone would be interested in acquiring TIM, provided that it can secure a "clean deal" in which it receives full control of the Brazilian carrier. Although the company already operates an MVNO in Brazil, Vodafone's reach across Latin America is limited primarily to Chile, and folding TIM into its global portfolio could be an attractive way to bolster its emerging market presence. Although sources close to Vodafone have reported that the carrier is uninterested in bidding for TIM, that report (from Bloomberg) was given in the context of reports that Telecom Italia had in fact begun a process to sell TIM, but only in the context of it 67% controlling stake. It is possible that if Vodafone saw all of TIM as on the table, the carrier's interest could be rekindled.
  4. Verizon Communications (NYSE:VZ): As is the case with AT&T, we believe that Verizon is unlikely to make a bid for TIM. The carrier has not shown interest in meaningful expansion outside the United States, and in any case, even Verizon has limits to the debt that it can accumulate. The takeover of Vodafone's stake in Verizon Wireless has added billions of debt to Verizon's balance sheet, and we expect that the company's management will place the focus of Verizon's cash flows on deleveraging its balance sheet, as well as ensuring that investors do not doubt the company's ability to pay its dividend.
  5. European operators: It is here where we expect the most likely suitor to emerge. Brazil is a large and growing market, and TIM would help any number of European carriers to mask domestic weakness in Europe with continued growth in Brazil, just as it has done for Telecom Italia. While an offer from Telefonica is out of the question, Deutsche Telekom (OTCQX:DTEGY) and Orange (NYSE:ORAN) are potential suitors. In particular, if Sprint or DISH are indeed preparing bids for T-Mobile (NASDAQ:TMUS), and they are successful, Deutsche Telekom would be left with billions in cash, and little remaining exposure in the Americas. A takeover of TIM would help fill this gap, and position Deutsche Telekom as a leading carrier in the largest economies of both Europe and South America.

We believe that once Telecom Italia fully acquiesces to a sale of TIM that a more definitive slate of potential suitors will emerge. As for price, there is already some indication of what TIM may be worth. In October, Bloomberg reported that Telecom Italia is seeking €9 billion for its 67% stake in TIM (in keeping with its track record of doublespeak regarding TIM), or around $12.3 billion at current exchange rates. Such a valuation would imply a pro forma value of around $18 billion for all of TIM. However, TIM's entire market capitalization currently stands at less than R$30 billion, or around $12.46 billion at current exchange rates, implying upside of around 50% for TIM's investors. With €27 billion in net debt, and increasing pressure from Telefonica, we expect that any reticence Telecom Italia has in putting TIM up for sale will slowly but surely erode in 2014.

Conclusions

In our view, shares of TIM Participações offer meaningful upside to investors as events unfold in Brazil and Europe. As TIM's results show, the carrier is posting positive performance across a number of metrics, and it leads its peers in revenue, EBITDA, and EPS growth through 2015. We believe that shares of TIM are undervalued on a standalone basis, regardless of what unfolds in Rome and Madrid, and that if and when a sale of TIM begins, the upside for TIM's investors will be far greater. We believe that at present levels, shares of TIM offer asymmetric risk and reward. On a standalone basis, we see upside of 20% for TIM, and as we have detailed, there is a clear path to further upside via a sale of the company as the pressure on Telecom Italia continues to increase. In our view, this confluence of events will benefit TIM's investors, and as 2014 progresses, we believe that the true value of TIM Participações will be unlocked.

Disclosure: I am long TSU, T, VZ, DTV, S, TMUS, VIV, VOD, DISH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.