team Richard Dineen Analyst HSBC Securities (USA) Inc. +1 212 525 6707 richard.dineen@us.hsbc.com Sean Glickenhaus Analyst HSBC Securities (USA) Inc. + 1 212 525 4131 sean.x.glickenhaus@us.hsbc.com Enrique Gomez-Tagle,* CFA Analyst HSBC Mexico, S.A. + 52 55 5721 2167 enrique.gomeztagle@hsbc.com.mx Ivan Enriquez* Analyst HSBC Mexico, S.A. + 52 55 5721 2397 ivan.enriquez@hsbc.com.mx *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 1
2 Sector structure Telecoms, Media & Technology Telecoms Media Technology Diversified telcos Pay-TV operators Telecoms equipment vendors Latin America Equity Research America Movil Telefonica Brasil Oi Entel Telecom Argentina TIM NII (Nextel) Mobile operators Televisa, Megacable Televisa TV Azteca Free-to-air-TV operators Ericsson, Alcatel- Lucent, Nokia Satellite operators Televisa Megacable, Televisa Cable operators Source: HSBC Sector price history (Brazil)
1200 1000 800 Latin America Equity Research 600 400 200 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 FTSE Brazil Div telecom Viv o Oi TIM Source: Thomson Reuters Datastream, HSBC 3
4 Sector price history (Mexico) 1200 1000 Latin America Equity Research 800 600 400 200 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Thomson Reuters Datastream, HSBC FTSE MEXICO TELECOM AMX Telev isa AZTECA
EBITDA margin asset turnover chart (2011) Asset turnover (x) 1.75 1.50 TEO 1.25 1.00 Nextel Entel AMX 0.75 TIM TEF 0.50 Megacable Oi Televisa 0.25 Az teca 0.00 20% 22% 24% 26% 28% 30% 32% 34% 36% 38% 40% 42% 44% Latin America Equity Research EBITDA margin (%) Source: Company data, HSBC 2011-14e EBITDA CAGR EV/EBITDA (2012) 2011-14e EBITDA CAGR 16% 14% 12% 10% 8% 6% 4% 2% 0% TEO TIM Entel Televisa TEF Nextel Oi Az tec a AMX Megacable 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 Source: Company data, HSBC, consensus estimates EV/EBITDA 5
Sector description Telecoms sector: Telecoms operators offer mobile and fixed-line services. In mobile, operators offer voice, messaging and data services. In fixed-line they offer telephony, broadband, and in some cases, pay TV (via IPTV or satellite broadcast platforms). Richard Dineen Analyst HSBC Securities (USA) Inc +1 212 525 6707 richard.dineen@us.hsbc.com Media sector: Globally, the media sector brings together a large range of services. Traditional subsegments are pay-tv and free-to-air broadcast TV, communications agencies, publishers and internetrelated players. Satellite and cable operators are effectively linked to both media and telecoms sectors. In Latin America, as in the rest of the world, technological change is driving convergence of telecoms and media sectors enabling media players to offer broadband/telephony and telcos to offer pay-tv. Barriers to entry in telecoms are intrinsically very high, given high levels of capital investment required to build network infrastructure (and in mobile to also acquire radio spectrum). Telecoms markets in Latin America are generally dominated by a small number of players, with the subsidiaries of regional giants America Movil and Telefonica typically figuring among the market leaders as scale and investment are key determinants of success. However, Latin American telecoms regulators are seeking to reduce barriers to entry with initiatives such as unbundled local loop (ULL), which gives new entrants access to existing fixed broadband infrastructure, easing the path for the entry of MVNOs (mobile virtual network operators), and enforcing spectrum caps or offering low-priced set-aside spectrum to new mobile entrants. In the media space, the need for dedicated distribution platforms (terrestrial, satellite or cable broadcast systems) has been a powerful barrier to entry, but in future we believe that viewers will increasingly turn to the internet to receive their video content over the top via broadband. This will open up the media market to a broader range of players, in particular to internet, telecoms and other consumer brands. Telecoms and media are coming together converging in some instances and colliding in others. Telecoms service providers in many Latin American countries (most recently in Brazil) are now allowed to offer pay TV. Mexico is an obvious exception for now though as America Movil s fixed-line subsidiary Telmex is still awaiting regulatory approval. On the media side, cable/satellite TV operators are vying for telecoms customers through converged triple-play packages, offering voice and broadband alongside pay TV. Overall, long term, we believe converged players will have significant advantages over single-play competitors, not only from a customer perspective (bundling, cross-selling and churn reduction), but also from a network cost perspective, as backbone and backhaul network capacity can be shared across fixed and mobile. We therefore expect mobile-only players to increasingly seek to add fixed-line capabilities. This process has already begun with America Movil merging its fixed and mobile subsidiaries throughout the region, as Telefonica Brasil is doing by merging Telesp (fixed-line) with Vivo (mobile) as well as driving TIM s acquisition of AES Atimus s regional fiber networks in Brazil. We also expect integrated telcos to seek to expand their content capabilities through acquisition of smaller content/application companies (as America Movil has started to do) and for media companies to expand into wireless as with Televisa s 50% stake in Mexico s third-placed mobile operator Iusacell. 6
Key themes Data explosion, capacity crunch and pricing power The widespread adoption of smartphones, tablets and laptop dongles has translated quickly from developed to emerging regions like Latin America, helped by sharply falling device prices the result of ferocious competition among Asian electronics manufacturers. This is driving strong growth in mobile data revenues too. However, these new bandwidth-hungry smart devices are putting unprecedented pressure on mobile networks (Ericsson forecasts global mobile network traffic will rise ten-fold by 2015). Some expect the arrival of 4G LTE (with spectrum auctions held in several Latin American countries in 2012) to provide long-term capacity relief. However, our research indicates that 4G LTE provides only a minimal (c30%) capacity boost versus today s HSPA 3G technology on a true like-for-like basis, as network efficiency gains are plateauing, increasingly constrained by the hard laws of radio physics (known as the Shannon Limit ). As a result we believe that adding mobile capacity in Latin America going forward will be relatively expensive either via overlaying new spectrum or by increasing the density of existing cellular networks (in order to reduce contention for increasingly limited network capacity resources). We therefore expect capex levels in mobile to remain relatively elevated longer-term and typically trend them to a 12-14% capex/sales range. Even so, it is still unlikely that operators can fully meet what is effectively multi-year exponential growth in mobile capacity demand, given the various constraints on supply (limited spectrum, plateauing network efficiency, capital intensity and other barriers to increasing network density). We therefore believe the only option will be for operators to ration mobile data usage, most likely via price. In other words we expect a mobile network capacity crunch to introduce a degree of pricing power for mobile data something the sector has conspicuously lacked in the voice era hitherto. We see signs of this important transition underway with the bulk of developed region mobile operators (e.g. AT&T, Vodafone Europe) having already migrated customers from unlimited data offers to tiered volume-based plans. In Latin America, operators like America Movil s Telcel in Mexico have recently switched from unlimited to tiered plans for postpaid customers, while remaining unlimited offers like TIM Brasil s Infinity plans constrain usage by throttling data speeds after a certain volume threshold has been reached. The importance of scale and fixed-mobile diversification The transition from a narrowband mobile voice world to a broadband mobile data world also hands a distinct competitive advantage to operators that are (1) large relative to rivals, and (2) have both fixed-line and mobile assets. First, for technological reasons, mobile data is scale-friendly in a way that mobile voice is not. Voice services operate at a uniform bit rate, meaning that voice quality does not vary according to the caller s proximity to the cell tower. By contrast, data services operate at a variable bitrate with the user s speed increasing or decreasing sharply based on the distance to the tower. Consequently whereas it never benefited larger players to build voice networks more densely than those of smaller rivals (as this would not have delivered superior voice quality), it will very much benefit scale leaders to build much more dense mobile data networks which will be able to offer materially faster data speeds to their customers. Second, the rising tide of mobile bandwidth demand will, over time, force operators to change the underlying architecture of their networks, with the traditional system of large outdoor cell towers replaced or overlaid over 7
time with multiple lower-power small cells (<100m radius each perhaps). Small cell products like Alcatel- Lucent s LightRadio cube are, we believe, a clear indication of this future direction for mobile networks. However, each of these small cells will require a high-capacity backhaul link (to carry traffic from the cell tower to the mobile core network for onward routing and transport), which should benefit diversified fixedmobile operators who already have (or who can easily deploy) fiber-based fixed broadband down every street. Regulation Another key determinant of media and telecom sector company performance and returns is regulation. Latin American telecoms and media markets have until recently been barely touched by regulation. However, industry watchdogs in key markets like Mexico and Brazil are becoming more active with the objective of facilitating more competition. Regulatory developments in Latin America include interconnection rate cuts, managed spectrum auctions (giving favorable bidding status to small, challenger operators), number portability, as well as supporting the introduction of mobile virtual network operators (MVNOs). Arguably most significant is the threat of unbundled local loop (ULL) in the fixedline sector. ULL is a regulatory framework designed to stimulate broadband competition by providing new entrants with access, at regulated cost-based prices, to the incumbent s local access infrastructure (which is otherwise not replicable due to the massive expense involved). In regions like Europe, ULL has been the dominant mode of competition in broadband for the past decade, and in our view, has been a major factor in the underperformance of the European incumbent peer group over this period. Over-the-top (OTT) video Similar to what is already happening in the developed world, we believe that pricing power will be a key differentiator between the different subsets of the media sector in Latin America. Demand for content is growing and the media sector has historically commanded a good deal of market power due to the limited number of conduits to the consumer. However, the ability of existing media owners to monetise this demand for content is being threatened, as users can access an increasing level of content via the internet. In the past, broadcasters faced little competition: they used to control the what, when and how of video content delivery. An initial shift occurred with the transition to digital TV increasing the number of channels available. But another shift began, driven by the internet, applications and networks. Through internetenabled devices and connected TVs, consumers can now increasingly control the what, when and how thanks to the capabilities of broadband networks. The OTT trend is starting in Latin America too: at the end of 2011, Netflix started offering its popular online video streaming service in the region. This fragmentation is expected to gradually impact both market power (diluted by the increase in market participants) and pricing power (related advertising and subscription fragmentation) for free-to-air broadcasters and eventually pay-tv operators. Partially offsetting this, free-to-air broadcasters like Televisa (which has other business segments) and TV Azteca produce most of the content they transmit. While OTT may over time undermine traditional broadcast and even pay-tv revenues, it should benefit content owners by enabling them to distribute globally without requiring traditional TV channel aggregators. The beneficiaries of this audience fragmentation will be the network-based businesses, we believe. Consumers need the infrastructure to access content whether on a TV, tablet or smartphone. Ideally, these networks have to be fast and reliable. The supply of so-called fat pipes to the home is scarce, controlled by the telco incumbent and the cable operators (and the mobile operators with respect to usage on the move). 8
We think that the scarcity of super-fast broadband access networks should translate into market power for fixed telcos and cable operators, which in turn can be translated into pricing power. Cable operators are upgrading their physical networks to deliver super-fast broadband connections (up to 100Mbps) while telecom operators are in the process of upgrading their access networks from copper to fibre. While we expect cable s traditional pay-tv business to come under pressure, the cable business model has been evolving, adding new services like broadband to create multi-play bundles. We believe that the higher gross margin from broadband access should more than offset the cannibalisation of lower gross margin traditional linear cable TV by OTT services. Strategically, satellite operators sit in between. In some sense, they are another fat pipe to the home, but satellite platforms lack uplink capabilities and therefore cannot fully compete with cable operators. Still, due to the still low pay-tv penetration rates in Latin America, we believe that satellite providers can sustain their current pricing power over the medium term. Sector drivers Telecoms The telecoms industry is subject to many drivers, including the affordability and availability of services, the rate of technological innovation (Moore s Law exerts a particularly powerful influence) and the extent of regulatory intervention. And note that, although the sector is not highly geared to the economy, it is clearly influenced by economic and business cycles. The level of penetration (fixed, mobile and broadband) is a basic driver for telecom services and is, in turn, driven by the availability and affordability of services. Strong economic growth, more even distribution of wealth resulting in expanding middle classes combined with steadily falling prices for user equipment and services have led mobile penetration in Latin America to cross the 100% threshold. Still, we believe that these figures are overstated by growing incidence of users with multiple accounts implying that the underlying level of individual ownership is lower. More penetration growth upside versus developed markets (which are today practically saturated) has historically led developed-market operators to take stakes in emerging market names (eg, Telefonica and Telecom Italia in Latin America). Data services have recently been the key growth driver for mobile revenues, and we expect this trend to continue. The three main enablers that we think are underpinning the demand for data services are: (1) better network speed and coverage; (2) increased penetration of data-optimised devices, like smartphones; and (3) improved packaging and marketing of data offerings. The penetration of smartphones is still quite low we believe (mid-teens in LatAm is our estimate with Argentina leading the way at around 25% and Brazil at about 15%, which compares to around 45% in the US for example), so we see considerable upside potential for the region going forward. Regulation also plays a very important role. It is one of the main drivers in determining competitive intensity, as the regulators decide the number of licences to be issued and set the level of many tariffs (in particular, those relating to interconnection and unbundling). On the mobile side, the regulators set mobile termination rates (MTR) and roaming tariffs, which have a material impact on mobile revenues and EBITDA. Technology cycles (and upgrades) influence the capex intensity of the industry, and operators that upgrade to the new technology early can enjoy competitive advantages over the laggards (but are also often exposed to the practical problems that inevitably accompany new technologies). 9
The economic environment also has an impact on the telecom sector. Consumer spending is usually less cyclical, while enterprise revenues (eg, roaming and IT contracts) exhibit greater cyclicality. However, we stress that the relatively high margins seen in the telecom sector mean that, while revenues are tightly linked to the economy, profits and cash flows are relatively defensive in nature. Media Given the different type of services provided by the media sector, we believe it lends itself more to stock picking than to top-down sector-based analysis. While pay-tv operator growth is mainly driven by consumer and service take-up, with these players generating the majority of their revenues from subscriptions, free-to-air TV relies predominantly upon corporate advertising expenditure. Pay-TV operators are more defensive in terms of their revenue-generating abilities during a downturn than are free-to-air-tv broadcasters given the long-term nature of pay-tv contracts. Revenue growth is driven by market share gains from competitors, as well as from other types of media (for example, if advertisers shift money from radio to TV), and GDP growth. Seasonal factors like major sporting events (eg the soccer World Cup, Olympics) and political elections also tend to have an important effect on revenues. Top-line momentum, EBITDA margins and the ability to generate free cash flow each play a critical role in driving the stocks in our view. The sector is generally exposed to fluctuations in the local currency, as many of its inputs and capital expenditures are done in USD. Media groups are mostly asset-light, and capital intensity varies according to the platform (eg cable TV is much more capital-intensive than satellite TV). Valuation We value Latin American telecoms and media companies using a DCF-based methodology in order to attain our twelve-month target prices. We also compare the companies primarily on an EV/EBITDA basis to normalize variations in capital intensity. We tend to de-emphasize free cash flow yield as this can be seen to reward companies that under-invest. Since most of the LatAm telecom and media companies are still in a period of growth, capital expenditure is a critical component for long-term success, in our view. Latin American telecoms and media 2009 2010 2011 2012e 2013e Growth Sales 23.8% 14.2% 10.9% -2.3% 3.8% EBITDA -6.0% 16.1% 4.3% -5.0% 4.3% EBIT -25.5% 17.8% 7.4% -4.9% 6.5% Net profits -32.9% 25.0% 9.5% -4.5% 7.2% Margins EBITDA 36.3% 36.9% 34.7% 33.8% 33.9% EBIT 19.8% 20.4% 19.8% 19.3% 19.8% Net profit 10.6% 11.6% 11.4% 11.2% 11.5% Productivity Capex/sales 14.4% 14.5% 18.0% 18.2% 16.6% Asset turnover (x) 0.66 0.59 0.62 0.63 0.66 Net debt/eq 0.60 0.39 0.48 0.53 0.50 ROE 18.8% 15.5% 15.8% 15.6% 16.3% Note: based on all HSBC coverage of LatAm TMT sector aggregate Source: HSBC estimates 10
Sector snapshot Key sector stats Mobile data traffic growth forecasts Telecom services 9.33% of MSCI EM Latam Trading data ADTV (USD mn) 221.42 Free float market cap (USD bn) 71.47 Performance since 1 Jul 2002* Absolute 481.16% Relative to MSCI EM Latam -16.66% 3 largest stocks AMX.N, VIVT4.SA, TIMP3.SA Correlations (5-year) with MSCI EM Latam 0.92 Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 *Performance includes dividends 120% 100% 80% 60% 40% 20% 0% 2012e 2013e 2014e 2015e 2016e LatAm Global Top 5 stocks Stock rank Stocks Index weight 1 AMX 'L' 6.81% 2 TELEF BRASIL PN 1.00% 3 TIM PART ON NM 0.61% 4 OI PN 0.50% 5 ENTEL 0.29% 6 OI ON 0.17% Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Country breakdown Country Weights (%) MEXICO 31.65 BRAZIL 3.63 CHILE 3.33 COLOMBIA 0.00 PERU 0.00 Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Source: Cisco Visual Networking Index, June 2012, HSBC PE band chart 800 700 600 500 400 300 200 100 0 2001 2003 2005 2007 2009 2011 Price 10x 15x 20x Source: Thomson Reuters Datastream, HSBC, MSCI PB vs. ROE 6 5 4 3 2 1 0 30 25 20 15 10 5 0 2001 2003 2005 2007 2009 2011 P/B (LHS) ROE (RHS) Source: Thomson Reuters Datastream, HSBC, MSCI 11