Brasil Telecom Participacoes S.A. (BRP)

TOP CONTRIBUTORS

Claudio Freitas

www.zacks.com

Brasil Telecom Participa es S.A. (BRP) is one of the three major fixed-line telecom service providers in Brazil with more than 8 million lines in service in the wireline segment, 4.2 million mobiles in service, and more than 1.5 million broadband ADSL accesses in service. The company was formed after the breakup and privatization of Telebras in 1998. Brasil Telecom provides local, intra-regional long distance, interstate long distance and data transmission service in nine of the western, central and southern states of Brazil, plus the federal district under government concessions. The service territory represents approximately 30% of the total area of Brazil, and includes 23% of the country's population. In the second half of 2004, BRP decided to start its own wireless business in order to capitalize on the rapid growth of the Brazilian wireless industry. Below we can see the revenue breakdown for the first half of 2007:

Previously, Brasil Telecom was the target of a bitter dispute for its control among Telecom Italia, Banco Opportunity, and some local Brazilian pension funds. Banco Opportunity is a local investment bank controlled by a well-known investor, Daniel Dantas, who manages two investment funds that control 19% of the ordinary shares and 62% of Brasil Telecom's preferred shares. The main investors behind those international investment funds are Citigroup and some Brazilian pension funds.

At the beginning of 2005, this bitter dispute caused a large-scale scandal, when police raided the Brazilian offices of international security consultant Kroll, Inc. and arrested five employees on conspiracy charges. The homes of Brasil Telecom former Chief Executive Carla Cico and Opportunity Founder Daniel Dantas were also searched. Kroll was hired by Opportunity in order to gather information about Telecom Italia. Later, on March 10, 2005 Citigroup ousted the Opportunity group as manager of the CVC equity funds, which controls Brasil Telecom, and has a stake in Telemig Celular (TMB), and Telemar (TNE). Brazilian pension funds removed Dantas from the management of the national CVC fund back in 2003.

On April 12, 2005, the National Telecommunications Agency (Anatel) ruled that Citigroup could dismiss Opportunity and its founder Daniel Dantas as administrators of the CVC/Opportunity fund. On April 13, 2005, Daniel Dantas was charged with criminal conspiracy, breach of confidentiality and corruption. On April 28, 2005, Opportunity decided to sell its shares to Telecom Italia, but Citibank decided to appeal to a New York court against this deal. In the first half of 2006, Telecom Italia announced it did not want to buy the shares of Brasil Telecom anymore, and that it will sell its own stake in the company. In the fourth quarter 2006 Telecom Italia announced it wants to sell its Brazilian subsidiary Telecom Italia Participa es (TSU), a statement that was later denied. During the first quarter 2007, some Brazilian newspapers announced the possibility of a merge between Brasil Telecom and Telemar (TNE). It was also said that the Brazilian government was trying to put together a major Brazilian telecom player in order to avoid the complete internationalization of the Brazilian telecom industry. Some months ago, some Brazilian newspapers announced that the merger between Brasil Telecom and Telemar was already closed and that the controlling shares of Brasil Telecom were acquired by the amount of R$4.8 billion (USD2.7 billion). Even though on January 2008 Brasil Telecom issued a statement denying the deal, we still believe that the merger was indeed closed. Nevertheless, the price is too low. There are some rumors in Brazil that Spanish Telefonica (TEF), which already controls Telesp (TSP) would be interested in acquiring Brasil Telecom too. This is highly likely. However, the Brazilian Government is very involved in the deal. Thus, it is difficult for any other company to interfere.

Unfortunately, the price for the shares of Brazil Telecom was not as high as we expected due to the Brazilian Government interference. However, the deal will represent the end of the bitter fight for the control of the company and the creation of a major industry player, a market leader with 62% of the Brazilian wireline market. This new company will surely deserve a much better valuation than the ones of Telemar and Brasil Telecom in separate.

Brasil Telecom has been showing positive developments in the last quarters. The company has a large and stable customer base in its wireline business, which enables it to generate solid profit margins and healthy free cash flow. The wireline segment has decent operating margins. However, the wireline is already mature. As a result, the company has been facing a continued reduction in its wireline business, and we expect this trend to continue in the short term. However, the growth in non-traditional areas like the wireless segment and in the broadband Asymmetric Digital Subscriber Line (ADSL) segment called BrTurbo has been impressive. There are reasons to believe they continue to grow in the following quarters. Fourth quarter of 2007 results were better-than-expected, particularly impressive was continued the huge net debt decrease, which will help reduce financial expenses in the short-term as a result, we are increasing our 2008 and 2009 earnings estimates.

In August 2004, Brasil Telecom launched its own mobile service, which was an attempt to participate in the fast-growing Brazilian wireless industry. After three years of operations, Brasil Telecom's wireless segment already has over 4 million subscribers. In the third quarter of 2007, its subscriber base increased 6.8% quarter-over-quarter and 31.9% year-over-year and in the fourth quarter 2007 subscriber base increased 5.9% quarter-over-quarter and 26.2% year-over-year. BRP is still one of the fastest growing wireless operators in Brazil. Even better, we believe the company will continue to benefit from favorable industry trends. According to Anatel, at the end of 2006 wireless subscribers were over 99 million, up 15.9% from December 2005. During the first quarter of 2007, total subscribers reached 102.15 million. In the second quarter of 2007, it reached 106.66 million and in the third quarter 2007 it reached 112.75 million. The growth continued in October and November reaching 116.31 million. Considering those numbers it is quite clear that the wireless business in Brazil remains heated. Currently, the penetration ratio in Brazil is now over 61% and has been growing quarter-after-quarter, but it still remains below international levels. We believe this impressive growth will continue in the short-to-medium term, albeit at a slightly lower pace in the following quarters. Below, we can see the growth of the Brazilian wireless subscriber base during 2006 until November 2007:

The continued expansion in the Brazilian wireless market has been fueled by the positive environment for the Brazilian economy. The economic outlook for Brazil for the medium-term remains promising, since we believe that the continued improvement in the Brazilian economic environment will make Brazil reach investment grade within the following 12 months, thus leading to a multiple expansion for Brazilian stocks. However, Brazilian Central Bank decided to stop to cut basic interest rates in the very short-term. Indeed, after the August Bank meeting an official report was released with strong comments on domestic inflation pressures and in October it was decided to leave rates unchanged for the first time in 2 years. On December 2007 and January 2008 rates were left unchanged too. Those are not positive news. However, we are keeping our positive view on Brasil Telecom.

The wireline business remains stagnated. However, there has been some good news in this segment too. During the third quarter 2007 Brasil Telecom was able to increase to 43.3% (from 41% in the previous quarter and 32% one year ago) the amount of clients in the full bill plan. During the fourth quarter 2007 the total amount of customers in the full bill plan reached 44.1% from 33.9% in the same period 2006. This plan is designed to suit clients' profile, increasing retention and loyalty among clients. The performance of the broadband ADSL segment (BrTurbo) has been also very positive. During the fourth quarter, this segment grew 19% year-over-year and 2.9% quarter-over-quarter, reaching 1.57 million customers. We believe that the outlook for the broadband business in Brazil remains very positive for the short-to-medium term. In fact, ADSL penetration in the company's area is growing but remains very low at 19.5%. We believe there is room for growth in the very short-term.

Brasil Telecom has been posting solid results, with sound operating margins in the mature wireline segment and huge growth in both wireless and data segments. We believe there is room for continued positive results in the very short term. The company remains highly undervalued and the merger between Telemar and Brasil Telecom will create a major Telecom Group comparable to Telmex (TMX). Considering the positive recent results, the encouraging short-term outlook and the likelihood of a merge in the near future, we are keeping our current Buy recommendation on BRP.

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