Punching Above Its Weight

At the height of European maritime expansion five centuries ago, Spain and Portugal ended their rivalry for colonial conquests in Latin America by signing the Treaty of Tordesillas, which divided the New World into two spheres of influence. In a fitting parallel for the era of globalization, the two dominant Iberian telecommunications operators have forged a Latin American business alliance that aims to share the spoils of the Brazilian mobile phone market  – and perhaps lead to a wider partnership.

Spain’s Telefónica and Portugal Telecom (PT) agreed in January to merge their mobile telephone assets in Brazil in a $10 billion joint venture that will become Latin America’s biggest cell phone operator. The deal gives the two companies 9.3 million subscribers – 42% of the fast-growing Brazilian market, where the number of cell phone users is forecast to soar to almost 60 million by 2005 from about 22 million today.

“Telefónica and PT will be working together to create one of the world’s top 10 cellular companies within the next five years,” says Francisco Murteira Nabo, PT chairman. “We have agreed to join forces to fund the aggressive expansion of the new company to ensure that it can capitalize on its leading market position.”

As a national corporate icon and Portugal’s biggest listed company, PT is anxious to avoid playing a subservient role in any alliance that could lead to its absorption by a bigger foreign group. But PT’s strategic investments in Brazil have created an asset that has enabled it to punch above its weight in the partnership stakes.

Since 1998, PT has invested more than $5.5 billion in Brazil to become the largest mobile operator in South America. It began by buying control of Brazil’s biggest mobile company, Telesp Celular in São Paulo state. This January, through Telesp, it went on to acquire Global Telecom, Brazil’s second-largest mobile operator, for $1.2 billion.

Part of the aim was to use its strength in Brazil as a bargaining counter in the negotiation of international alliances. “Brazil is effectively the only chip PT has to put on the table,” says Diego Hernando, head of research with BBVA Midas Investimentos, a Lisbon-based investment house.

The strategy appears to have paid off handsomely with the agreement on the PT-Telefónica joint venture in Brazil. PT and Telefónica will each own 50% of the new company, which brings together holdings in five Brazilian mobile operators: Telesp, Global Telecom, CRT, TeleSudeste and TeleLeste. This gives PT-Telefónica more than twice as many subscribers as its nearest competitor.

“The joint venture in Brazil strengthens the relations and the alliance between the two companies and is a decisive step in the process which is taking place in the international communications sector,” says César Alierta, Telefónica’s chairman. To further bolster the partnership, Telefónica is to increase its stake in PT to 10% from 4.75%. PT will raise its holding in the Spanish group to 1.5% from 1%.

PT and Telefónica have indicated that they could be in the market for more acquisitions of existing Brazilian mobile operators. Analysts are focusing their attention on TeleCentroOeste in the Brasília region and Telemig in Minas Gerais, which PT has acknowledged as attractive companies. The Iberian partners have made clear that their aim is to remain the dominant mobile player in Brazil with a footprint covering the whole country. However, Murteira Nabo says the joint venture is not expected to begin operating effectively until January 2002, as Brazilian law does not allow consolidation in the telecommunications sector before then.

“This integration should imply strong savings for both companies as regards investments in operating licenses and the capital expenditure necessary to be present in all the attractive Brazilian mobile markets,” says Maria Rotondo, an analyst with Spain’s Banco Santander Central Hispano. “The two groups’ assets in Brazil are highly complementary. There is no overlap.”

The close fit between the two companies appears to extend beyond Brazil. PT seems to have been mirroring Telefónica’s structure by spinning off and floating sub-holding companies, such as PT Multimedia for Internet services and cable television, PT Prime for corporate services and PT Móveis for mobile telecommunications. Analysts interpret this as a deliberate strategy designed to facilitate downstream mergers of individual operating divisions.

It was partly to gain critical mass to enter Brazil that PT sealed an alliance with Telefónica in 1998. The two groups crossed shareholdings to cement their cooperation focusing their separate Brazilian operations on mobile and fixed services respectively, and agreeing on a non-competition pact in their home markets.

This collaborative partnership still left PT vulnerable and the group has been working for almost a year on a new alliance strategy with a group of international investment banks, whose names it declines to disclose. The aim is to decide on a definitive and large-scale partnership that will determine PT’s position in the global network of telecom alliances. But the promised announcement of these partnership plans has been postponed several times.

The next step with Telefónica could be a wider alliance in the mobile sector. The combined mobile phone assets of PT and Telefónica cover large areas of Latin America and North Africa, as well as the Iberian peninsula, and would produce an international competitor of considerable stature. A broader alliance with Telefónica would also help PT play a role in the competition for third-generation mobile licences in Europe, a race it could not afford to enter alone.

But the question remains whether PT is overextending itself in building a Brazilian empire. After its $1.2 billion Global Telecom acquisition, Moody’s placed PT’s A2 debt rating on review for possible downgrade. Moody’s said PT had taken advantage of “a unique investment opportunity in a high-growth wireless business,” but added that the size of the investment “could constrain the group’s financial ratios and expose it to a higher-risk operating environment.”

Still a Strong Credit
In February, Standard & Poor’s lowered PT’s long-term corporate credit rating from single-A plus to single-A. The short-term rating was left unchanged at A-1. S&P said that although the Brazilian joint venture “significantly improves PT’s financial exposure, it also cements the company’s increasing exposure to this market.” PT also announced a f1 billion issue of five-year bonds in February, aimed at cutting short-term debt. Merrill Lynch and UBS Warburg are the lead managers.

“There is always risk associated with Brazil,” says Pedro Dias, PT’s head of investor relations. “But we think we have compensated for this through the quality of the operations we have acquired and their potential for growth. The risk at all levels has always been factored into our financial analysis and projections.” He says PT aims to keep within the “A” area of credit ratings and remain in the single-A area this year.

Analysts share PT’s confidence that growth potential in Brazil outweighs the risks. PT made a ?1.5 billion capital increase last year through a rights issue, specifically to fund investments in Brazil.

The issue equivalent to 15% of PT’s capital and was made simultaneously with a global offering of the government’s remaining 8.2% share in the company. The rights issue raised ?1.5 billion and the offering raised ?708 million. The price for both operations was fixed at ?9.4 share. Telesp has also raised funds though equity issues and may go back to the market to finance further expansion.

Rotondo, of BSCH, says PT has one of the more manageable debt levels among European telecom operators. “PT’s net financial debt represents 25% of its market cap, compared with an average of above 40% for most European telecom groups.”

Luis Prota, a Madrid-based telecom analyst with Morgan Stanley, says the joint venture will considerably enhance the finances of the two groups’ Brazilian operations. By establishing a large footprint of existing operators they do not need to compete for new mobile operating licenses. This will save them a considerable amount of capital expenditure on license fees and related costs, to which can be added the synergy savings from combining their mobile assets.

“PT has one of the soundest balance sheets in the sector,” says Prota. He puts its debt-to-equity ratio at about 110%, compared with a ratio of 150% to 160% from most European telecom groups. PT’s debt-to-capital ratio is about 60%, he says.

PT’s shareholders have also welcomed the Brazilian venture. Ricardo Salgado Espírito Santo, head of Portugal’s Espírito Santo financial group – which is PT’s largest shareholder, controlling just under 10% directly and indirectly – says the deal will substantially increase PT’s value in Brazil. Manuel Serzedelo, president of the Espírito Santo group’s investment bank, would welcome an expansion of the joint venture into the Brazilian fixed-line and Internet markets. “We are in favor of every partnership that increases PT’s value,” he says. LF