EMBRATEL

1
EMBRATEL

• Emerging Markets Finance
• Lorena Navarro
• Jaime Arriagada
• Luis De Zabala
• Fernando Diaz

February 26, 1999
2
Agenda for Today

• Outline and Background of the Case
• Takeaways / Learning Points
• Suggested Solutions
• What happened after?

3
Case Outline

• Introduction
• Brazil and its Privatization Process
• Telebras and Embratel
• Investment Opportunities and Risks
• Valuation

4
Brazil

• History of Instability
• 20 years of military rule
• Unstable political environment
• Capital controls, high tariffs, high interest
  rates
• Cardoso Era
• Plan Real as Minister of Finance
• President of Brazil in 1994
• Privatization Plan
• Where are we ?

5
Telebras and Embratel
The Telebras Transformation
TELEBRAS YESTERDAY
TELEBRAS TODAY

• 12 Privately controlled holding companies
• 3 Regional fixed-line Cos
• 8 Regional Wireless Cos.
• 1 long distance operator

• 1 Government controlled holding company
• 27 local fixed-line subs
• 26 local wireless subs
• 1 long distance sub

6
Telebras and Embratel

• EMBRATEL OVERVIEW
• Embratel Provides
• Domestic Long-Distance (DLD) Inter-region
  Intra-region
• International Long-Distance (ILD)
• Data transmission
• Others (Internet, etc)
• Total Assets of R 7.9 billions
• Total Revenues of R 2.2 billions

7
Investment (I)
Opportunities

• New access charges to the fixed line network
• Based on a flat rate that will have positive
  effects on earnings
• High growth in Long Distance Market
• Domestic long distance represents bulk of the
  revenues.
• Small international LD market if compared Brazil
  with other countries.
• Good opportunities for cost cutting and cost
  control
• Synergies brought by the buyer

8
Investment (II)
Risks

• Competitive environment coming ahead
• Concession of a mirror company in 1999
• Industry completely open in 2002
• Fixed line companies as competitors in
  intraregional market
• Cellular companies are potential competitors
• Big one-time charges against earnings
• Write-off of assets to adjust to the new
  competition.
• Accounting policy changes depreciation, pension
  obligations and tax management .

9
Takeaways (I)
10
Takeaways (II)
11
Suggested Solution - DCF Model

• Build a full valuation model The Puzzle
• Macroeconomics Assumptions
• Market Growth Rates
• CAPEX and Depreciation

12
DCF Model (II)

• Ke Rf ?(Rm-Rf) and ?
• Which Beta?

13
DCF Model (III)

• The WACC under IICCRC is substantially higher
  than under Sovereign Debt Spread model.

IICCRC
SDS - Model
14
DCF Sensitivities

• Company risk should be incorporated through the
  FCF
• Country risk should be included in the Cost of
  Equity (Ke)

Value of 52 in Embratels equity
15
Comparable Company Analysis

• Key issues
• What multiple?
• Which Companies?
• How to incorporate country risk?

16
Latin American Telecoms importanceYTD 1998
Market Cap. as of local index
Argentina
Brazil
Chile
Mexico
Peru
Venezuela
Average
Argentinas correlation is the average of
Telecom Argentina and Telefonica de
Argentina Source Salomon Smith Barney
17
Correlation Local Market vs. ADRs YTD 1998
Argentina
Brazil
Chile
Mexico
Peru
Venezuela
Average
Argentinas correlation is the average of
Telecom Argentina and Telefonica de
Argentina Source Salomon Smith Barney
18
Estimated Telebras Multiple using IICCR1998
Institutional Investor Country Credit Rating
EV/EBITDA 98E
Argentina
Chile
Mexico
USA
Venezuela
Brazil
Source Salomon Smith Barney
19
Estimated EMBRATEL Multiple using IICCR1998
EV/EBITDA 98E
Company
adjusted by country risk 3.3x
Sprint
MCI WorldCom
ATT
Telebras
Source Salomon Smith Barney
20
Valuation Summary
21
What happened ?

• July 1998 MCI Worldcom won auction with a bid of
  2.3 bn.
• This amount represented a premium of 47 of
  minimum price set by the government.
• Sprint offered the best price in sealed envelope,
  R2.499 bn. vs. R2.477 bn offered by MCI.
• The auction went to open outcry MCI acquire
  Embratel in less than a minute for R2.650.

22
What happened ?