Description
My recomendation is to short EMT. I think that could provide a return of 30% in a period of 12 months. The main reason is overvaluation, because this class of shares represented by ADRs does not have voting rights and therefore no tag-along rights. Last November 13th , MCI announced that EMBRATEL will be sold.
The reason for that, in my opinion, is that EMT has too much debt ( US$ 1,27 billion) for trailing sales of US$ 2,45 billion and an EBITDA of US$ 590 million , and a weak competitive position in the long-distance telecommunication business in Brazil. Besides that, MCI is not consolidating EMT into their books. MCI will emerge from Chapter 11 with a debt of US$ 5 billion or lower than that, so EMT contributes to much in the negative side than in the positive.
Overview
EMT is the long-distance MCI´s subsidiary in Brazil, which has an economic interest of 19,26% of total shares and 51,79% of the voting shares. Actually, EMT has 124, 37 million voting shares, and 208,25 NON-Voting shares. An ADR is equivalent to 5,000 (five thousand) shares. MCI owns 64,4 million voting shares. The voting shares are only traded at São Paulo Stock Exchange in Brazil.
MCI acquired EMT in the privatization auction carried out in 1998, and paid US$ 2,3 billion (R$ 2,65 billion), but due to the Real devaluation in the meantime of 60%, this stake has now a book value of US$ 910 million for 51,79% of voting shares.
The competitive landscape in Brazil for the long-distance business is not different from USA. There is a fierce competition from the local incumbents telephone companies (ADR´s tickers: TNE and TSP) which are taking market share from EMT, and next year will enter another incumbent competitor, Brasil Telecom (ADR´s Ticker: BRP).
Besides EMT, Intelig is also up for sale in Brazil, which is another long-distance telephone company privately owned by Sprint, France Telecon and National Grid, but is controlled by its main debtholder, Alcatel. Intelig is up for sale for more than 2 years, and so far Alcatel does not give yet enough discount on the debt in order to attract a buyer.
In the beginning of the year, EMT restructured its debts but didn´t get any reduction in the principal, just got more time to pay the debt with a higher interest rate, around 12,4% per year in real terms or 18% nominal rate per year from 2004 on. This assumes that all debt will be converted to the local currency , the Real, so the company will not have any more Dollar denominated debt.
Valuation
A DCF valuation of EMT is not appropriate because the lousy business perspectives due to: fierce competition, shrinking market share, lack of access to last mile; and most of company´s value depends on the assumptions used for calculating the terminal value. Finally, and the most important factor : we are valuing a minority non-voting stock. In this case, the DCF valuation will be speculative and will not assure an adequate margin of safety.
The problem is how to allocate the equity value among different classes of share which don´t have the same rights, and this happens when we will have a transfer of controlling ownership and the buyer is not obliged to acquire all classes of shares, but this will treated later on.
a) Comparable Transactions Method
A more reliable and conservative valuation approach is the private market value calculated from comparable transactions. Two weeks ago, Telmex (ticker: TMX) bought AT&T Latin America (ticker: ATTLA.PK), which was in the Chapter 11. ATTLA operates in Brazil, Argentina, Chile, Peru and Colombia, offering long-distance and data transmission services to the corporate market. The differences between ATTLA and EMT is that the former operates in more countries and does not provides LD to households.
According to the news, Telmex paid US$ 200 million (enterprise value) for ATTLA , and this is equivalent to an EV/Sales of 1,25 x , based on trailing sales. The price paid was expensive, maybe TMX is paying up in order to entry in the LATAM market and block other competitors such as: EMT and TEF (Telefonica).
EMT also made an offer for ATTLA, but the amount was much lower than Telmex, it was $ 110 million and this is equivalent to 70% of ATTLA´s trailing sales. TMX and EMT made the two highest offers for ATTLA assets.
EMT has annual net sales of R$ 7,1 billion, or US$ 2,45 billion, below is calculated its enterprise value.
The EMT´s equity value based on TMX offer for ATTLA is the following:
Enterprise Value $ 3,10 billion (= Sales $ 2,45 x 1.25)
(-) Debt $ (1,50) billion
(+) Mkt. Securities $ 0,24 billion
(-) Minority Shareholders $ (0,09) billion
(=) EQUITY VALUE $ 1,75 billion (comparable method)
Equity Book Value $ 1,68 billion (3rd Quarter, 2003)
The EMT´s equity value based on the average EMT and TMX offers for ATTLA is the following:
Enterprise Value $ 2,39 billion (= Sales $ 2,45 x 0.975)
(-) Debt $ (1,50) billion
(+) Mkt. Securities $ 0,24 billion
(-) Minority Shareholders $ (0,09) billion
(=) EQUITY VALUE $ 1,04 billion (comparable method)
Equity Book Value $ 1,68 billion (3rd Quarter, 2003)
For comparison purpose, AT& T (ticker: T - $ 19,14), is trading at 0.85x EV/Sales, suppose that they get an offer with a premium of 30%, so this implies an EV/Sales of 0.98x, which is very close to the average of the offers made by EMT and TMX for ATTLA. It is important to emphasize that the competitive pressures in Brazil are not different than USA, but cost of capital in Brazil is much more expensive due to currency instability, high interest rates, and political risks.
b) Adjusted Book Value Method
We made some subjective adjustments to book value, mainly in fixed assets, account receivables and cash pledged to lawsuits. EMT have had serious problems with its billing system and client deliquency, but we don´t know for sure that this account is clean . Besides that, we adjusted the fixed assets account because the replacement prices of telecom equipment are falling since 2000. The telecom equipment represents 80% of the net fixed assets account. The adjustments made are below:
Equity Book Value $ 1,680 million (3rd Quarter, 2003)
(-) Acc. Receivables Adjust. $ (133) million
(-) Cash Pledged to Lawsuits $ (120) million
(-) Fixed Assets Adjustment $ (498) million
(=)ADJUST.BOOK VALUE $ 929 million
We adjusted the account receivables in 25% and net fixed assets by 20%, and 100% of the cash pledged to lawsuits, because the company is envolved in a lot of lawsuits and some don´t have a provision.
Three Classes of Shares
According to the Brazilian Corporate Law, there are three classes of shares when there is a change of controlling ownership due an acquisition offer, as follows:
1) controlling voting shares: gets full price;
2) minority voting shares: gets 80% of the price received by the controlling shareholder;
3) non-voting shares: does not have any tag-along rights, wich is the case of EMT´s ADRs.
However, the non-voting shares have the right to receive a dividend 10% higher than those received by voting shares, when the company has profits, which is not the case of EMT.
Allocating the Equity Value Among Classes of Shares
This is the tricky part of the investment idea, because the value of the non-voting shares depends on the value attached to voting shares which are two classes, so we have a kind of circularity.
I have envisage three ways to attribute value to each kind of shares, that are discussed below. We will use for these calculations the Equity Value of US$ 1,04 billion, it was based on the average EV/Sales multiples of TMX and EMT offers for ATTLA.
1) Allocation Based on the Market Value of the Minority Voting Shares
In this approach, the basic assumption is that the market is valuing correctly the minority voting shares, so that its market price is equivalent to 80% of the price to be received by the controlling shareholder. Therefore this implies that the premium for controlling voting shares is 25% over market prices, as it was established by the Brazilian corporate law. Under this approach, the ADR´s value is the leftovers of the voting shares.
All calculations will be done based on a scale which is based on the number of shares per ADR, so will be easier to make them. The company has the following quantity of shares per class in million:
Controlling Voting Shares = 12,882
Minority Voting Shares = 11,992
Non-Voting Shares (ADRs) = 41,652
Total Number of Shares = 66,526
Note: One ADR = 5,000 shares, and prices in the local market are per 1,000 shares.
a) Allocation to Controlling Voting Shares:
Based on the Brazilian corporate law, which states that a minority voting share is equivalent to 80% of the value of the controlling voting share, so based on it , we have the following:
Mkt Price = $ 19.94
Implied Value per Share = $ 24.93 (= $ 19.94 / 0.80)
Allocated Value = $ 321,2 million (= $ 24.93 x 12,882 shares)
Premium on Mkt. Price = 25%
b) Allocation to Minority Voting Shares:
Mkt Price = $ 19.94
Implied Value per Share = Mkt Price
Allocated Value = $ 239,2 million (= $19.94 x 11,992 shares)
Premium or discount to Mkt. Price = None
c) Allocation to NON-Voting Shares:
The allocated value for this kind of share will be the remaining of the total equity value, as follows:
Total Equity Value $ 1,040 million
(-) Controlling Voting Shares $ (321,2) million
(-) Minority Voting Shares $ (239,2) million
(=) Implied Value of Non-Voting $ 479, 6 million
Implied Value per Share $ 11,52 (a)
ADR´s Market Price $ 16.45 (b)
Overvaluation ((a/b)-1) 30%
Obs.: In order to facilitate the understanding, I have put all classes of shares in the same scale, which is the ADR´s scale: 5000 (five thousands) shares for one ADR, and adjusted also the market prices (November 18, 2003) by the same scale. The forex used was the implied forex rate of R$ 2.933 per US$ 1.00, which were calculated using stock prices from the local market and from the USA market. The Implied Value per Share is obtained by dividing the Allocated Value by the number of shares based on the ADR scale.
Based on the calculations above , EMT (the non-voting share) is OVERVALUED by 30%.
Under this hypothesis, the driving factor that shapes the distribution of the equity value among the classes of shares is the Market Price of the minority voting shares. The sensitivity of Embratel´s ADR for a price increase of the Minority Voting Share is 0,8% , that means if the market price of the minority voting share rises by 1%, the overvaluation of the ADR (non-voting share) increases by 0,8%; other reading is for each 1% price increase of the minority voting share the ADR has to fall 0,8%.
2) Allocation Based on Comparable Situation: Relationship Between Market Value of the Minority Voting Share to the Non-Voting Share
In this hypothesis, we use an actual example of the price relationship among the classes of shares, for allocating the equity value of Embratel .
In January 2003, Telesp Celular (ADR´s Ticker: TCP) bought Tele Centro-Oeste Celular (ADR´s Ticker: TCO). In this transaction, the controlling shareholder received full price, the minority voting shareholders got 80% of the price paid to the controlling shareholder and the non-voting shareholders will receive a compulsory share exchange of 1.27 shares of TCP (non-voting) for each share of TCO (also non-voting). However, the non-voting shareholders are complaining to CVM (the local SEC), that the offer is unfair due to the huge difference regarding the price received by the minority voting shareholders, but this is allowed by the Brazilian Corporate Law. We can use this relationship because both companies (EMT and TCO) have the same proportion of voting shares to non-voting shares, which is 1/3 voting and 2/3 non-voting.
Today (Nov 18, 2003) the TCO shares are trading in the local market (São Paulo Stock Exchange) as follows:
Tickers: TCOC 3 (voting) : R$ 16, 73
TCOC4 (non-voting) : R$ 9,15
Relationship = 0,55 , so a NON-voting share is equivalent to 55% of the value of a MINORITY voting share, and a minority voting share is equivalent to 80% of the CONTROLLING voting share.
Based on this, we have the following relationships among the classes of shares:
N= non-voting share
M= minority voting share
C= controlling voting share
N= 0.55 M
M= 0.80 C, therefore
N= 0.55 x (0.80) C
N= 0.44 C , so a Non-voting share is equivalent to 44% of the value of the controlling voting share.
Based on the relationships above, we have to determine the weighted number of shares for each class in order to distribute the equity value among them.
Controlling = 100% of 12,882 shares = 12,882 weighted shares
Minority = 80% of 11,992 shares = 9,594 weighted shares
Non-Voting = 44% of 41,652 shares = 18,327 weighted shares
Total 40,802 weighted shares
Value per Weighted Share = $ 25.49 (= $ 1,040 million / 40,802 w. shares)
a) Allocation to Controlling Voting Shares:
Mkt Price = $ 19.94
Implied Value per Share = $ 25.49 (= $ 25.49 x 100%)
Allocated Value = $ 328,3 million (= $ 25.49 x 12,882 shares)
Premium on Mkt. Price = 28%
b) Allocation to Minority Voting Shares:
Mkt Price = $ 19.94
Implied Value per Share = $ 20.39 (= $ 25.49 x 80%)
Allocated Value = $ 244,5 million (= $20.39 x 11,992 shares)
Premium on Mkt. Price = 2,2%
c) Allocation to Non-Voting Shares (ADR):
ADR´s Market Price = $ 16.45
Implied Value per Share = $ 11.22 (= $ 25.49 x 44%)
Allocated Value = $ 467,1 million (= $ 11.22 x 41,652 shares)
Overvaluation = 32%
Based on the figures above we got almost the same number as in the previous method, the ADR is overvalued by 32%.
3) Allocation Based on Historical Premium Paid
This hypothesis is an educated guess, based on past transactions. In the past, Telefonica (ticker: TEF) made some exchange offers to the minority shareholders of its Latin America subsidiaries. One of them was for the minority shares of Telecomunicações de São Paulo (Telesp Participações S.A. ; ticker: TSP), in order to attract interest Telefonica offered a 40% premium over market price, and those who accepted it received shares of TEF. This happened in June of 2000.
Market conditions today are very different from that moment, on the other hand the premium paid was for minority shares and we are using this premium level to value a controlling stake, so one thing compensate the other.
Based on this, we have below the value´s distribution among the classes of shares.
a) Allocation to Controlling Voting Shares:
Mkt Price = $ 19.94
Implied Value per Share = $ 27.92 (= $ 19.94 x 1.40)
Allocated Value = $ 359.7 million (= $ 27.92 x 12,882 shares)
Premium on Mkt. Price = 40%
b) Allocation to Minority Voting Shares:
Mkt Price = $ 19.94
Implied Value per Share = $ 22.34 (= $ 27.92 x 80%)
Allocated Value = $ 267,9 million (= $22.34 x 11,992 shares)
Premium on Mkt. Price = 12%
c) Allocation to Non-Voting Shares (ADR):
The allocated value for this kind of share will be the remaing of the total equity value, as follows:
Total Equity Value $ 1,040 million
(-) Controlling Voting Shares $ (359,7) million
(-) Minority Voting Shares $ (267,9) million
(=) Implied Value of Non-Voting $ 412,4 million
Implied Value per Share $ 9.90 (a)
ADR´s Market Price $ 16.45 (b)
Overvaluation ((a/b)-1) 40%
In this case the EMT´s ADR is overvalued by 40%.
Potential Buyers
The Brazilian Telecommunications Law and the telecom regulator will allow someone to buy EMT, since the buyer is not operating in Brazil or a local acquirer that will not reduce competition in the segment, or the following companies which have already operations in the country, such as: Telecom Italia and Telmex/America Moviles.
In order to avoid value destruction, the buyer has to have a lot of sinergies with Embratel. Telecom Italia (TIM) controls Entel, which is a Chilean long-distance company that is also the leading cellular company in the country, and TIM is also the 3rd largest cellular operator in Brazil. American Moviles is the 2nd largest cellular operator in Brazil, and a long-distance business could enhance their competitive position as well will be the case for TIM.
Catalyst
1) The ADR (non-voting shares)is overvalued;
2) Embratel sufers a fierce competition from the local incumbents and is losing market share, has a high leverage with high interest rate, so there is no reason for a potential buyer to pay a huge premium for the company;
3) The Brazilian corporate law does not offer enough protection to the owner of non-voting shares (ADRs) when there is a change of the controlling shareholder; besides that the controlling shareholder can impose a compulsory share exchange that could be detrimental to minority shareholders.