Description
SUMMARY
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My recommendation is to short NETC , based on its lofty valuation and the increased number of shares due a debt restructuring. I believe that could provide a 50% return to investors in the next year.
NETC shares appreciated by 198% YTD, in the same period NASDAQ appreciated 43%, and the local index IBOVESPA (ticker: ^BVSP) rose 88%, and the company (Local Ticker : PLIM4) is one of the components of the IBOVESPA with a weight of 1,57% . I would like to emphasize that this outperformance ocurred without any remarkable improvement in the fundamentals.
NETC is the leading provider of Pay-TV services in Brazil, its operations are clustered in the richest regions of the country, that are Southeast and South, but the market for Pay-TV is almost satured. The total number of subscribers is flat in the last three years. The cable TV operators are trying to increase the top line by offering broadband access to Internet, however they suffer a fierce competition from the telecom incumbents (tickers: BRP, TNE and TSP) which are the dominant players in each market.
The company hired the Blackstone Group to restructure its debt of $ 346 million, in the proposed restructuring plan the company is expecting that debtholders convert 43,6% of the total debt in equity, this would imply in the issuance of 125,740,000 new ADRs (1 ADR = 10 shares) , this represent an increase of 62% in the number of shares. Commercial banks have almost 50% of the total debt, so if they accept NETC ´s proposed terms , they will received almost 60 million of ADRs, and they have few incentives to keep this amount of ADRs.
The lofty valuation is not sustainable, because the company has few growth opportunities, even after the restructuring almost everything has to run smoothly in order to achieve the goals stated in the business plan submited to debtholders.
NETC is trading at a little higher multiple than companies that operate in USA and Canada (EV/EBITDA multiples of 12,5x for 2003 and 10,7x for 2004), however cost of capital in Brazil is higher due to currency instability, dependence from external financing, high interest rates, and political risks.
I performed a valuation of NETC based on a transaction with a comparable company, Canbras Communications Corp. (ticker – TSX: CBC), which sold all of its Pay-TV operations in Brazil to Horizon Cablevision. The Canbras operations are locate in the greater metropolitan area of São Paulo city, which are the richest and the biggest city in the country.
BRAZILIAN MARKET for PAY-TV
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The Brazilian market for Pay-TV is stagned due to low economic growth, shrinking disposable income fueled by high unemployment rate and inflation.
In the last four years the evolution of total subscribers was flat, as shown below:
In thousands 2000 2001 2002 1H2003
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Total Subscribers 3,442 3,554 3,520 3,461
% growth - 3,3% (1%) (1,7%)
DBS subscribers 1,055 1,165 1,164 1,162
% growth - 10,4% (0,1%) (0,2%)
NETC subscribers 1,505 1,447 1,330 1,319
% growth - (3,9%) (8,1%) (0,8%)
GDP Growth 4,4% 1,3% 1,9% 0,7%
Sources: NETC reports, ABTA (sector association), IBGE
The number of total subscribers is almost equivalent to 10% of the households which have TV sets. The low penetration in comparison to other countries is due to low income of the average household. In order to growth this number is necessary to increase the income level of the average household.
NETC´s customer base decreased from 1,5 million subscribers in 2000 to 1,32 milion at end of 3Q03, but in the meantime the number of total subscribers in the industry remained flat around 3,5 million. DBS providers (DirecTV and Sky ) are the biggest NETC´s competitors.
INVESTMENTS CONCERNS and POSITIVES
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The reasons for NETC´s subscribers decrease are separated in Internal and External Factors, which are below:
a) Internal Factors:
- reduced marketing efforts to attract new subscribers;
- bad churn management;
- canceled subscriptions rightway due non-payment of accounts;
- poor customer service/relationship; and
b) External Factors:
- fierce competition from DBS providers (DirecTV and Sky TV), which skimmed the high end of the market;
- Brazilian Pay-TV market is reaching saturation, because the households that can afford the service already have it;
- Economic conditions – the service is perceived as a “luxury” good in Brazil, so it is subject to economic fluctuations and therefore it is dependent on the level of disposable income;
- Open TV in Brazil is very good, and soap operas are very popular, so there are few incentives to switch to Pay-TV.
Besides the issues above, NETC has the folowing shortcomings:
- revenues are in local currency but expenses with programming and capex are in certain way dollar denominated;
- high leverage;
- management does not have control on two key aspects of their business, which are programming content and costs. The control of this aspects belongs to Net Brasil, which is controlled by the main shareholder, Globopar.
On the positive side, NETC has the following:
- It is the leading provider of cable TV in the country, with almost 34% of the market;
- It has access to premium programming and the best open TV (Globo TV), for instance DirecTV does not provide Globo TV signal to its subscribers because Globo TV does not allow it.
VALUATION
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a) Comparable Transaction
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I used for valuing NETC a comparable transaction in order to ascertain “How much NETC is worth today ? “ instead of the traditional DCF that is used by almost all “sell-side analysts”.
The Canbras Group (ticker (TSX): CBC ) is the 5h largest provider of Pay-TV in Brazil and the 2nd largest based on wireline cable. Canbras competes with NETC only in the city of Santos, which is located in the coastal region of São Paulo state. The main competitor of Canbras is Tevecap (4th largest Pay-TV provider) which uses MMDS technology (wireless cable) and DirecTV (2nd largest) and Sky TV (3rd largest) , and both use DBS (Direct Broadcast Satellite) system.
As NETC , Canbras also provides high-speed Internet access services, but it is not significative for both companies. They also suffer a fierce competition from telephone incumbents in this segment, they don´t have any competitive advantage over ADSL.
In October 8th, 2004 Canbras Communications Corp. announced it has entered into an agreement with Horizon Cablevision do Brasil S.A. to sell to Horizon all of its Pay-TV and broadband operations in Brazil for CN$ 32.6 million plus assumption of debt . This transaction is expected to be closed until the first quarter of 2004. Horizon acquired the operation located in the São Paulo state, except Guarulhos city.
The remaining operations were sold to a local company named ALUSA, which get Guarulhos by swaping a stake in the São Jose dos Campos city operation and by assuming all debt of the Paraná state operation, which is around CN$ 4 million. The Paraná state operation is not significative because it represents only 7% of total revenues and 3,5% of total EBITDA, besides that the Parana network is a little bit outdated. In brief, Alusa got 25,000 subscribers , annualized sales of CN$ 6.6 million and Ebitda of CN$ 1,3 million. Based on this , I made some adjustments in the ratios used for valuing NETC.
Enterprise Value: Canbras´Operations Sold to Horizon CN Dollars– Millions)
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Horizon
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Payment for Equity $ 32.6
(+) Debt/Liabilities 38.9
(+) Minority Interests 4.8
______
(=) Enterprise Value 76.30
Sales 2003 (annualized) 53.8
Ebitda 2003 (annualized) 18.4
Ebitda Margin 34.2%
Total Subscribers (end 3Q03) 166,000
Source: Management Proxy Circular – November 14, 2003 ; Info from Canbras and analyst estimates.
Implied Multiples (*)
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Annual Revenue per Subscriber CN$ 324
US$ 247 (Forex US$/CN$ = 1.31)
EV/Sales 1,42x
EV/Ebitda 4,14x
EV/ Subscribers CN$ 460
US$ 351 (Forex US$/CN$ = 1.31)
Obs. (*): This is based on the São Paulo state operation, which was acquired by Horizon, but does not include Guarulhos city.
b) NETC Implied Multiples
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Based on the data below we can realize that NETC is very overvaluated, and if its shares starts trading at multiples close to Canbras, NETC´s shares have room for a huge drop in price.
Operating Data ( US$ Million)
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Sales 2003 – Annualized 390.3
Ebitda 2003 – Annualized 96.3
Ebitda Margin 24,7%
Subscribers (In 000 at 3Q03) 1,334.7
Annual Revenue per Sub 292.4
Enterprise Value BEFORE Restructuring
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(+) Short + Long Term Debt 345.8
(+) Past Due Accounts: Capex & progr. 58.0
(+) Legal Contingencies (**) 41.0
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(=) Total Debt 444.8
(-) Cash / Mkt. Securities (52.1)
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(=) Net Debt/Liabilities before Restruct. 392.7
(+) Mkt Capitalization (202,885 million shares @ $ 3.31) 671.5 -------
(=) Enterprise Value 1,064.2
(**) Obs.: NETC has many lawsuits envolving labor , civil and tax claims, so I made an educated guess of that amount ($ 41 million), which could be much higher than that.
NETC´s Implied Multiples
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EV/Sales 2,73x
EV/Ebitda 11,10x
EV/Subscribers 797.40
The EV/Ebitda is higher than those presented by companies in USA and other developed markets, but the Brazil risk is well above those countries , so NETC deserves a discount to the actual multiple. Besides that, NETC in comparison to other similar investment alternatives in the local market is very expensive, like the telecoms which are trading at 4 to 5 times EV/Ebitda, and have a very good dividend yield near a two digits level,
c) NETC Implied SHARE PRICE AFTER Restructuring
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The restructuring plan proposed by the company ask for a debt for equity conversion of 43,6% of debt owned by commercial bank and bondholders, and this will require the issuance of 125,740,000 new shares.
Implied Price After Restructuring (In US$ 000)
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(+) Net Debt Before Restructuring $ 392,6
(-) Debt to Equity conversion ($ 150,7)
(=) Net Debt AFTER Restructuring $ 241,9 (A)
(+) Actual Market Capitalization $ 671,5 (B)
(+) New Shares Issues @ $ 1.20 $ 150,7 (C)
Sum (D= B+C) $ 822,2 (D)
(=) Enterprise Value(A+D) $ 1,064,2
Old Shares 202,885,553
New Shares 125,740,000
Sum 328,625,553 (E)
ADR´s Implied Price (D/E) 2.50
Potential Drop in Price =======>>> 24,4%
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This is only due to the increase in the number of shares, almost 50% of the new shares will be received by commercial banks, which don´t have any motivation to carry NETC shares, so they will dump their shares as soon as possible, in order to take advantage of this buoyant market.
d) NETC Value Based on the Comparable Transaction (after restructuring)
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I will demonstrate below that if NETC valuation converges to the level of the comparable transaction, there is room for a huge drop in its price. Someone can argue (the management) that NETC deserves a premium because it is the biggest provider of Pay-TV. However, to justified the present share price the company has perform much better than the overall economy, and in the last years there was no growth.
My objective in this section is ascertain how much NETC shares are overvalued considering the potential increase of number of shares and the multiples from Canbras´ transaction.
I considered also a 15% increase in the Ebitda for 2004, in order to check if the overvaluation persist, and included a premium over Canbras´ EV/Ebitda multiple of 30% because NETC´s market share and brand recognition.
NETC Valuation Based on Canbras ($ million)
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Ebitda 2003 (annualized) $ 96.3
Ebitda 2004 (15% growth) $ 110.8
Canbras´ EV/Ebitda Multiple 4,14 x
EV/Ebitda Premium on Canbras 30%
EV/Ebitda with Premium 5.4x (= 4.14 x 1.30)
Enterprise Value 598.3
(-) Net Debt after Restructuring (241.9)
(=) EQUITY VALUE 356.4
New Total Shares 328.625.553
IMPLIED PRICE per ADR 1.08
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POTENTIAL DROP in PRICE ===>> 67%
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Based on the assumptions and calculations above, NETC is overvaluated, almost 3 times the present price, therefore it has a good potential for shorting.
Catalyst
- NETC is overvalued based on comparison to peers in other countries, other local investment alternatives, and the most recent transaction in the sector;
- Despite the debt reduction proposed in the restructuring plan, every thing has to run smoothly from day one in order to achieve a balanced capital structure, but the Brazilian economy volatility can take its toll;
- A successful restructuring plan will create an overhang on NETC´s share price, because it will increase the number of shares by 62%, and most of it will be in the hands of commercial banks, which have few incentives to keep the shares.