With companies increasingly expanding their footprint beyond their base territories in order to drive growth and shield their businesses from geopolitical swings, it has become evident that concentrating operations in one country entails a significant disadvantage, as well as high risks.
Portugal Telecom SA (PT, Financial) is now aware of this. The sovereign debt crisis in Portugal pushed the government to implement several austerity measures, which have plunged the country back into recession. Hence, despite being the incumbent telecom operator, PT has been suffering a downswing in its small and midsize enterprise business and its low-end wireless operations, a trend that is likely to continue.
Consequently, its revenue has declined, and so have its margins and its return on capital, which is now well below its WACC.
The Business
Portugal Telecom is the leading player in the country, with 2.55 million fixed-lines, 7.9 million wireless users and 1.32 broadband customers, thus boasting the largest share in each category. Moreover, its 1.29 million subscriber base has positioned it as the second largest pay TV operator.
However, increasing competition from cable operator ZON Optimus SGPS SA (ZONMY, Financial) and giant Vodafone Group Plc (VOD, Financial), which have added bundled services to its offering, has pressured pricing. As a result, although PT controls almost half of the wireless market in Portugal, the double-digit decline in its ARPU has largely offset the growth, netting a revenue dropoff that is further empowered by the economic recession.
International Footprint
PT’s international operations, particularly those in Africa, have an interesting growth potential. Yet, they are generally quite small and the firm has a minority position in most of them. Therefore, even though they are growing at a healthy pace, its benefits are not significant to the company’s financial results.
A different story is the firm’s involvement with Brazilian Oi SA (OIBR, Financial). PT owns 25.6% of the company, which is the incumbent fixed-line operator and the fourth largest wireless company in Brazil. This ownership allows PT to reach the country’s large market, thus gaining scale in the purchase of equipment. Oi, in turn, has a 10% stake of Portugal Telecom.
A Better Outlook
Most importantly, both companies are in the process of a full merger which is expected to be completed by midyear. Upon its announcement, PT’s spokesperson said, “The merger will consolidate the position of both companies as the leading operator for Portuguese-speaking countries with leadership positions in all markets where it operates.”
The deal comes at the right time for both firms. Presently, Oi is pressured by enormous debts, in spite of which it must continue investing to remain competitive, while PT is struggling to support revenue in a recessive environment. Therefore, the merger will unify forces boosting both companies’ potential.
Together, the companies have more than 100 million subscribers, a combined net debt of 41.2 billion Brazilian reais ($18.7 billion), and combined annual revenue of 37.45 billion reais. PT’s shareholders will own about 38% of the new firm and it expects the merger to generate cost savings of around €1.8 billion.
Valuation
PT’s stock trades at 9.4 its trailing earnings, a discount compared to its peers’ average of 16.80. Its return on equity showcases a healthy 20.2% against its rivals’ average of 12.8%. And despite its revenue declines, the firm showcases a growth of 21%, much higher than the industry median of just 3.3%.
Even with economic and political headwinds, the company remains well positioned, and the merger will further bolster its leadership. Thus, although investment guru Charles Brandes (Trades, Portfolio) reduced his holdings in the firm, I feel bullish about PT’s growth potential.
Disclosure: Vanina Egea holds no position in any stocks mentioned.
