Description

Nortel Inversora (NTL) is a holding company that sells at a significant discount to intrinsic value.  Each share of Nortel represents 1.794 shares of Telecom Argentina (TEO), yet Nortel sells at a lower price than TEO.  At current prices, each share of NTL has an intrinsic value of approximately $27.  I believe the discount will significantly narrow if TEO and NTL declare dividends next month.

Note: NTL is a very illiquid stock.  Average trading volume over the past month is only 5,000 shares per day.

Nortel was last written up on VIC in 2005.  The idea was revisited in the messages section of the old post early last year.  A read of these messages provides a good background for both this thesis and the risks attendant with this company.  I do believe that NTL passed an inflection point last year when it paid off its Series A preferreds, and offers a potential for significant upside at this time.

The Math

Nortel Inversora is a holding company that controls 54.74% of Telecom Argentina.  The Nortel class B preferred shares (NTL) are entitled to 48.96% of the income received by Nortel.   As a group, the class B shares are thus entitled to 26.8% of the income from TEO (54.74% x 48.96%). There are approximately 197 million TEO ADSs outstanding (each ADS represents 5 shares of Telecom Argentina). Each of the 29.4 million Nortel B shares is equivalent to 1.794 shares of TEO.  (197 x 26.8% divided by 29.4)

At TEO’s recent price of around $15.00, the intrinsic value of NTL is approximately $27.00, an 80% premium to NTL’s market price.

Why should the discount narrow?

The answer to this question lies in Nortel’s history and capital structure.  Nortel was originally capitalized with Class A preferred shares and Class B preferred shares (NTL) as well as common shares. (The common shares are mostly held by Sofora, which is a joint venture between Telecom Italia and Argentina’s Wertheim family.) The Class A shares were entitled to be paid before the Class B shares.  From 2002 to 2009, TEO did not pay any dividends. When dividends resumed in April 2010, Nortel began retiring the Class A shares.  In May of 2012 the final Class A shares were retired, and Nortel paid a dividend of $.04 per share to NTL shareholders. 

Now that the Class A shares have been retired, Nortel can pass 100% of the dividends it receives from TEO on to the Class B (NTL) and common shareholders.  Based on an anticipated dividend of $1.00 per TEO share (last year’s dividend was $.929), NTL shareholders could receive over $1.70 this spring.

Telecom Argentina

Telecom Argentina is one of two major telephone companies in Argentina.  It also has operations in Paraguay.  Approximately 96% of revenue came from Argentina. Revenue for the Year ended December 31, 2012 rose 20% to approximately 22 billion pesos. TEO reported income of 2.7 billion pesos (approximately $2.67 per ADS) for the year ended 12/31/12.  This was slightly higher than the $2.5 billion pesos of income that TEO reported last year. (Note that because of deterioration in the Peso/Dollar exchange rate, the earnings per ADS is lower in 2012 than 2011.)

Why does this opportunity exist?

The main risk to both TEO and NTL is the Argentine government.  Argentina is a fiscal disaster, and the socialist government has been actively intervening in corporate affairs.  Last summer, Argentina expropriated Repsol's shares in YPF, the company’s largest oil producer.  Last spring, when TEO reportedly planned to pay out approximately 70% of its prior year’s profits as a dividend, the Argentine government pressured TEO into paying only 33% of profits as a dividend on the theory that additional capital investment was required to improve phone service.

In addition, NTL is an illiquid stock.  It is not surprising that an Argentine company would sell at a discount, but why would it sell at such a steep discount relative to another Argentine company?  Liquidity is part of the reason, but I believe that relatively few investors have taken the time to look behind the headline dividends on the two securities.  TEO’s trailing dividend yield is around 6%, which attracts dividend focused retail investors.  NTL’s trailing dividend yield, which was reduced because of the 2012 payments to the Class A shares is a mere 0.3%.

Timing

TEO reported calendar 2012 results earlier this month.  Revenues increased 19.6%, and operating earnings before depreciation increased 9.6% to 6.6 Billion Pesos. (Inflation in Argentina was officially around 11% last year, although the true rate is estimated to be double the official rate.)   Cash increased significantly from 2.7 billion pesos to 3.6 billion pesos. Translating this to $/per ADS, each TEO ADS would have $3.60 of cash behind it, and each share of NTL would have $6.50 of cash at the TEO level.  Neither TEO nor Nortel has meaningful long-term debt.

The TEO board has recommended that 1 billion pesos be allocated to pay dividends for 2012.  This will be voted on at TEO’s annual meeting on April 23.  Nortel has scheduled its annual meeting for April 26^th. I would expect Nortel to declare a dividend either at the April 26^th meeting or shortly after receipt of the TEO distribution in May.

TEO’s dividend was declared at the end of April last year and paid in May.  Last year NTL declared its dividend June 18^th. There was quite a bit of uncertainty last year due to the repurchase of the series A preferreds and Nortel’s decision to pay a small dividend to the series B and common shareholders. Total payments last year to Nortel’s shareholders were slightly higher than the total dividend received from TEO.

How much will the dividend be?

Last year, TEO planned to dividend 70% of its earnings to stockholders, but was pressured into only paying out 33%.  This year’s proposed 1 billion peso dividend is about 37% of net income, so only slightly higher than 2012 as  a percent of income.  While it’s impossible to say for certain that the Argentine government will not object to this dividend, the 37% payout, with the remaining cash flow reinvested into the business seems reasonable to me.

Assuming that TEO pays 1 billion pesos to its shareholders, Nortel would receive 547.4 million pesos (54.74%) and NTL (the class B shares) would be entitled to 268 million pesos. Translating into US dollars, TEO could pay a dividend of $1.00 per ADS, and NTL could pay a dividend of $1.79. The actual dividend could be slightly less, as Argentina imposes a capital tax of 0.5%.  Nortel has minimal operating expenses at the holding company level.

Risks

The key risk here is the Argentine government.  It is possible that the government will prohibit TEO from paying any dividends in 2013, although I believe it is likely that they will continue to permit a split where roughly two thirds of income is reinvested and a smaller portion is returned to shareholders.

Argentina has a shortage of hard currency, and has been severely restricting the amounts its citizens can take out of the country.  There is a risk that even if dividends are declared, they may not be paid to ADS holders.

In the longer term, the distressed state of the Argentine economy is an obvious risk to both TEO and NTL.  In many ways this is priced in, with TEO trading at less than 6 times earnings and NTL trading at a significant discount to TEO.

For those inclined to hedge, it is possible to borrow TEO at < 1%.

Catalyst