My Take on the OIBr and PT Planned Merger

It has been a while since I posted. In part because of work, and in part due to a dearth of news from companies in my portfolio. BTW, the debt ceiling and government shutdown are not what I consider material news.

The only big news is the recent planned merge of OiBr and Portugal Telecom (PT). I have owned OiBr for about 7 years. And in that time, I found it very hard to follow. For one thing it is in a country I have never been to, and it has an extremely complicated ownership structure that has gone through many restructurings. I was drawn to the stock because of the 10%+ dividend yield and the the BRIC story. Stocks from developing countries haven't been very kind to me. I have lost on Cemex (CX) and OiBr. I do have a nice gain in PK Telecom of  Indonesia, but the gain couldn't match the S&P 500. In the future, I will only invest in developed countries.

The PT and OiBr merger is interesting. Both companies command a huge customer base, and both are saddled with high debt. The merger is complex involving both companies as well as many companies that own parts of both companies. I won't try to explain the transaction, but I summarize the bottom line as I understand it. 

• New company is call Corpco
• PT share becomes 0.63 Corpco share
• OiBr common shares becomes 1 Corpco share, preferred shares becomes 0.92 Corpco share, I'll simplify this by saying each old OiBr share is worth a weighted average of 0.95 Corpco share
• OiBr will issue new shares which in turn will become 0.95 share Corpco in order to generate around 8 billion reais new cash
• The number of shares issued is yet to be determined
• PT shareholders will get R$5.5 bil worth of the new shares because they will give OiBr more than R$5.5 worth of equipment as part of the merger
• PT owns 13% of OiBR
• OiBr own 10% of PT (confusing enough yet?)

So the bottom line is a new company with containing OiBR, PT and R$8 billion. First, I estimated my dilution by estimating the eventual number of Corpco shares. I assume a weighted average common and preferred Oi share price of R$4.2, which is at the recent trading range.

		Corpco Shr
PT share conversion	855 PT shr x 0.63	539
-10% owned by OiBr		(54)
PT equipment contribution	R$5500 ÷ R$4.2/shr	1310
-10% owned by OiBr		(131)
Total attributed to PT shareholders		1663
OiBr share conversion	1640 OiBr shr x 0.95	1561
-13% owned by PT		(193)
OiBr Capital Raise	R$8000 ÷ R$4.2 /shr	1905
Total attributed to OiBr shareholders		3198
Total		4861

Note, that the above factors in the cross-ownership of the two companies: I assume the cross-ownership shares will be retired. This is very likely wrong but it is my best guess at what will happen. The merger announcement said the goal is 38% PT shareholder ownership of Corpco. My above calculation winds up with 34%. This means there is probably something wrong with the above assumptions and calculations. But for the purposes of this article, my estimates are close enough.

The above results in a market cap of R$20.4 bil. And I did some valuation calculations on Corpco. The company would have a trailing Ebitda of R$12.8 bil. A net debt of R$41.2 bil, post capital raise. Which means an EV/Ebitda of 4.8. This is a reasonable number. And as a OiBr shareholder, for each of my weighted average shares I have R$8.47 of debt and R$2.60 of Ebitda. Currently each OiBr shares has about R$16 of debt and R$4.50 Ebitda. So the merger is a good idea because it reduces OiBr debt profile. But the debt profile was bad before the merger, and it is still not so great after.

On the operational side, this merger will hopefully give the combined company a better debt profile so that they will get better interest rates. Right now it is running at the 9% range for new debt. And hopefully the two companies can take advantage of synergies so that their fortunes will turn around by 2015. Nonetheless, OiBr is in a complex situation, and both PT and OiBr are in countries that are suffering a downturn or worse,. In the end, I think my time is better spent with easier to understand small and microcaps. Currently, I am reducing my position and hopefully I'll be rid of OiBr completely before the merger.

For more in-depth analysis, I recommend this article

The other news, I found a thorough article on IEHC. Considering the company's tiny market cap ($9 mil) any analysis is wonderful. I didn't get any new information on OiBr — after all, how much news can you get on a $9 mil company — but it did mention some useful facts about the connector business and its competitors. I didn't know the connector business is actually big business! The press is probably helping the stock too. At $4.20, the stock is 40% up from my initial purchase earlier this year.

Oi Reports Disappointing Q2 2013

Oi (OIBR) just announced their Q2 results. And the news didn't improve. Revenues increased slightly QoQ but EBITDA decreased significantly to 1797 M reais from 2151 M reais a quarter ago — 1 USD is approximately 2.2 reais. This meant earnings came in at -124 M reais (-0.08 reais per share) versus 262 M reais a quarter ago. This is the first losing quarter since 2011.

Management said the 354 M reais drop in EBITDA was because of three main expenses. The followings shows all their operational expenses.

The first problematic expense is personnel. Management said the increase was due to an one-off wage benefit (100M) and a 6% inflation increase to wages. The second is marketing expenses. Oi is the official sponsor of the just completed Confederation Cup and spent 66M. The third one is bad debts (115M) which was due in part because of the downturn in Brazil's economy. So the management emphasized that the drop in net income can be explained by one-off special expenses and bad credit requirements. Bad debt is running at about 300M a quarter and should be half that. But if the sales department get picky with customers, how will that affect revenue?

To me, the crux of the problem is the margins, EBITDA margin is now 25.4% versus 30.5% a quarter ago. This is clearly unacceptable. But can the company change that, or is it that the company needs low margins to sustain the revenue? The jury is out. But from a revenue perspective the company seems to be doing ok. The newly appointed CEO Bava did emphasize costs as his first priority. The media is very positive about him, if he is that good, I think he should be able to fix the cost problem.

Debt and Dividends

The company's net debt level is now at 29.5 B reais. That is a 2 B increase over a quarter ago despite 1 B in asset disposals! The company paid 900 M reais in various fees that are not quarterly recurring. Capex was 1506 M reais. Bava said that capex will be lower next year, below 6 B reais. The company has 12 B reais of liquidity so I don't think it is an issue over the next year or two.

To help manage the debt problem, the company will now pay the legal minimum of about 500M reais a year in dividends. That works out to about $0.14 USD per share. The preferred stock last traded at $1.61 USD per share.

In addition, in the coming two quarters the company will realize more than 1 B reais cash for previously mentioned asset sales.

Final Thoughts

My original reason for buying Oi many years ago was to participate in the rise of the BRICs. Many developing countries are now hitting a speed bump. But emerging ecomonies will be the growth of the future. Brazil has a fast rising middle class that will very much need telecom services. Oi I feel is a company that just needs to get its act together. It has been under medicore mangement for too long.

Portugal Telecom, Bava's previous company and Oi's parent company, also reported poor earnings recently. In the coming weeks, I will, look into PT to see if Bava is really that good and what he did at PT. I may post my findings.
 
As another note, Fitch just downgraded Oi from BBB to BBB-. This is the last rating before junk.

My OI S.A. Fiasco

May a year ago I found a Brazilian telecom company that paid more than 10% dividends. I was amazed, and bought it without understanding too much about it. The company ticker was TNE. I watched the stock as it climbed while still giving me 10%. And even when it dropped I thought oh ok I still made good money on this stock considering the huge dividends I got over the year. Then about a year ago, the stock started a incredible slide. And being comfortable being an owner for many years, I bought some more earlier this year. But it continued the slide. The stock has dropped some 80% to date.

Background

Before I continue the story, let me recap the company's history. Brazil is a country with quite a lot of regulations. And company's have complex structures as a result. The company was Tele Norte Leste Participacoes. In 2008 it merged with Brazil Telecom, and after several reorganizations, the company became Oi S.A. (OIBR ticker). Oi is the brand name of the mobile phone service they provide. Oi is one of the four biggest cell phone providers in Brazil, and it has biggest landline network in the country. It is also the second largest telecom company in South America.

As of last year, the company was losing customers. So the company hired a Franciso Valim as the CEO and initiate a turnaround effort with heavy capex spending. In turn the company has slowly started to increase its customer base. But today still, the company's mobile business is not great compared to the other three big mobile providers in Brazil. It's landline business is losing customers, although the company is trying hard attract new business with its internet offerings. In January, Valim was suddenly ousted and replace with an interim CEO.

But the company's biggest problem is its debt. This debt is the result of paying for its acquisitions and its huge dividend. The company currently has net debt of 27.5 billion reais — 1 USD equals 2.2 reais. The company calculates net debt to be total debt minus cash and equivalents. In addition, the company plans to pay about two billion reais per year in dividends. This is the primary reason the stock is depressed: the company's net income is only about a billion reais a year! The company can only dole out such high dividends by adding to debt, and the debt is nearing its limit.

The dividend and debt is this screwed up because the company is majority owned by Telemar and Telemar needs the dividend payments to finance its own debt. And I never realized this until recently! This is a very hard lesson on doing my homework.

 

Recent Events

The recent bad news started with the first quarter's results in April. Earnings came in at 0.16 reais. But most disappointing was the 2.5 billion reais increase in debt. About 1 billion reais was for dividends, but that still leaves a 1.5 billion reais cash burn. That was the cause for the stock's slide for the recent months.

Then in June came news that a star CEO Zeinal Bava will run Oi. Apparently, Bava is famous in Europe. He ran Portugal Telecom and apparently did a good job. Portugal Telecom is also part owner of Oi and Bava was on Oi's board.

EBITDA	9.0 billion reais
EV / EBITDA	3.8x
P/E	3.9x
Interest coverage	>1.75x
Price preferred shr	$1.85 USD
Price range Apr'13	$1.44 — $2.50
Total shr outstanding	1.6 billion
1 USD	2.2 reais

Next, in quick succession, the new CEO did the following:

1. ousted the CFO and some other key executives 
2. canceled a planned 2 billion reais debt raise
3. raised 2.4 billion reais by selling company assets 
4. and stopped the coming planned billion reais dividend 

With each piece of news the stock yoyo'ed. It was a sickening ride. The table on the right shows the key stats based on the last 4 quarters.

In times like this with so much negative sentiment regarding a stock, it pays carefully and objectively look at the facts. The company's funding has been a persistent issue, but disregarding that company is profitable enough. EV / EBITDA is a common metric to gauge a company's value for a takeover. For Oi it is 3.8x. As a comparison Sprint, which is in buyout talks, is at 6.4x. So, if someone could pay the enterprise value that person would get a profitable business.

And buyout isn't the only option, an equity raise is another, this is just an illustration to put it all in perspective. If the company can fix it's debt problems, what remains is a good company and the stock will naturally appreciate.

Debt

But seeing that debt is the key issue, it's good to know how Oi got here. The following shows the increase in debt over recent quarters. Clearly the dividend was a big chunk and removing that from now on will help. It isn't clear what the working capital drain is for, but it should be matched by something else on the balance sheet. The escrow item is mostly judicial deposits. I am amazed at how much Oi is being sued. Maybe that's just how things work in Brazil. Escrow is the requirement by law and is not the same as provisions, and could be reversed in the future. But by far, the largest items that affect the debt are EBITDA and capex. EBITDA has to improve, hopefully Bava will make it happen. Capex was targeted at 6 billion reais this year. Oi needs the capex to be competitive. But hopefully it will go down next year.

And so now, after hearing all the negative sentiment online, I know much more about the company. And now I must objectively decide what to do regarding my Oi position. So, I ask myself, if I didn't own any Oi stock, would I buy? And my answer is I am not sure. Oi has screwed up operationally, but the company has turnaround potential. In addition, the Brazilian stock market has fallen close to a five year low. My feeling is that it is oversold. So, part of Oi's fall was in sympathy with the market, and it will rise also when the market reverses.

In any case, investing in Oi takes faith. I believe that Bava knows what's going on in Oi after having been on its board and he took the CEO job because he was confident that he can turn the company around.