Tele Norte Leste Participa es S.A. (TNE), also known as "Telemar," is a leading provider of fixed and wireless telecommunications services in Brazil. The company operates two business segments: wireline/ broadband communications, and wireless services. The company has a diverse mix of revenues. As we can see from the following graph:
Through its subsidiary, Telemar S.A., the company is the largest provider of wireline services in South America, with around 14.3 million access lines in service. Telemar also provides local, intra/inter-regional, international long distance services, and custom data transmission services in a territory encompassing approximately 64% of the population of Brazil. The company has established quite some time ago a strong presence in the fast-growing Brazilian wireless sector. In mid-2002, the company launched its wireless service operating under the brand name Oi. We are encouraged by the company's strategy to increase its focus on the wireless business, which provides TNE with a healthy mix of businesses. Recently, the company decided to focus on the Oi brand, which is now the company's brand for all its products.
Telemar's success in wireless services has been impressive. The mobile subscriber base increased 76.3% during 2004, 50.7% in 2005, 26.4% in 2006, 2.1% quarter-over-quarter in the first quarter of 2007, 2.1% quarter-over-quarter again in the second quarter 2007 and 9.3% in the third quarter 2007. At the end of September 2007, Oi had 14.9 million total subscribers and an estimated market share of 27% in its business area. Oi is still one of the fastest growing wireless operators in Brazil. Even better, we believe Oi now has a new avenue for growth in the very short term. In October 2007, TNE acquired wireless licenses to expand to Sao Paulo and to increase its frequency range in many other states in order to enhance the company's capacity to handle traffic. In fact, the company acquired 5 out of 36 blocks of frequencies for 3G (third Generation) services auctioned by Anatel (Brazilian National Agency for telecommunications). Even though the acquisitions were highly necessary, Telemar paid R$867 million (US$480 million), a very expensive price, representing a premium of 79.67% in average from the minimum prices established by Anatel. We understand the Sao Paulo license will be very positive for TNE's strategic position, including the automatic provision of roaming services to existing clients traveling to the Sao Paulo. This license will enable TNE to gain access to the richest and most populated state in Brazil.
We believe Oi will continue to benefit from favorable industry trends in upcoming quarters. According to Anatel, at the end of 2006 wireless subscribers were over 99 million, a growth of 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. Even though those are for sure not encouraging news, we believe it will not affect the wireless market in the short-term.
The performance of the broadband ADSL segment (Velox brand) has also been very positive. During 2004, this segment grew 128.6% year-over-year. In 2005, the growth reached 62.3%. In 2006, it went up 33.5%, reaching a total of 1.128 million subscribers. During the first nine months of 2007 broadband subscriber's base reached 1,393 million, representing 23.5% growth from the end of 2006. If we consider only the third quarter 2007, subscriber growth reached 10% quarter-over-quarter and 33.2% year-over-year. The outlook for the broadband business in Brazil remains positive in the short term, in fact Brazil is one of the countries in the world where internet connection has been growing more fast and we still believe that this process is far from over.
On December 2008 TNE announced that one of its subsidiaries acquired all shares of Paggo Empreendimentos S.A. for the amount of R$75 million (US$42 million). Paggo is a pioneer company that has developed the "Paggo credit and payment system", a kind of credit card that operates from the mobile phone. Currently Paggo has 106,000 clients and a huge potential for growth in the very short-term, since Brazil has been migrating from paper toward electronic payment. Paggo has obvious synergies with TNE and its strategy is in line with the current TNE's strategy of diversification of revenue sources. We believe Paggo could reach as much as 750,000 clients in the end of 2008.
It is undeniable that the wireline business has stagnated. We think that this is an international trend that will prevail in the short-to-medium term. However, TNE has been able to almost stabilize the wireline customer base and to offer attractive convergent plans that link all the products offered by the company. We are very encouraged by this strategy, since we believe TNE is in a better competitive position than most of its peers because of its integrated nature and healthy mix of businesses. Telemar has been offering convergent and alternative plans to different segments, which had already attracted 4.7 million customers at the end of the third quarter 2007 or 32.8% of total fixed lines and 42.1% of residential lines, increasing customer loyalty. This strategy has enabled the company to deliver solid operating results, including solid operating margins and healthy cash flow in a very competitive business environment. Moreover, Telemar is making a continued effort to reduce net debt. We believe this strategy is positive considering the still high interest rates in Brazil and is already helping to increase earnings, mainly during the third quarter 2007. Having completed its major capital expenditures, TNE's cash flow has improved, which has enabled the company to increase its dividends payouts to around 60% of its net income and reduce its debt. Currently, its dividend yield is 3.0%, and we expect it to reach something around 4.0% during 2008.
Telemar is getting ready to become an important player in the Brazilian fast growing pay TV market. On October 23, 2007, the Brazilian Telecommunication Agency (ANATEL) approved the acquisition of Way TV by Telemar. Way TV provides TV subscription and broadband access in some cities in the State of Minas Gerais. Additionally, the company is preparing to launch a new product called IPTV in early 2008. This product will enable clients to access video on demand. To begin, the product will be available only in some areas of Rio de Janeiro. We believe the convergence strategy of the company, including audio/visual content, will be very successful in the medium-term.
Third quarter results were better-than-expected. The wireless segment was able to increase its EBITDA margin considerably, mainly due to subscriber growth and the ending of subsidies on handset sales for pre-paid customers. Additionally, thanks to the lower debt and falling interest rates, consolidated financial expenses were down 46.8% year-over-year. We believe earnings will keep increasing in the following quarters for the same reasons: lower debt coupled with improved results in the wireless and broadband segments. There was also a small tariff hike. The Brazilian telecom authority (Anatel) authorized on June 20, 2007, a tariff increase for TNE of 1.83% for the wireline segment and a tariff increase of 2.88% for fixed-to-mobile calls.
A few months ago, some Brazilian newspapers announced the possibility of a merger between Brazil Telecom (BRP) and Telemar. 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. This fact would represent the huge step for the long waited consolidation process for this industry, the end of the bitter fight for the control of Brasil Telecom and the creation of a major industry player with 62% of the Brazilian wireline market, a market leader that will for sure deserve a much better valuation than the ones of Telemar and Brasil Telecom nowadays. Just some weeks ago, some Brazilian newspapers announced that the merge between Brasil Telecom and Telemar was already closed and that the controlling shares of Brasil Telecom were acquired by Telemar by the amount of R$ 4.8 billion (USD2.7 billion). Even though on January 2008 Brasil Telecom issued an statement denying the deal, we still believe that the merge was indeed closed. The reaction of the market was very positive for TNE since the price is considered 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.
We believe the current price of TNE remains attractive. Additionally, the company has been posting good results, the merge with Brasil Telecom will create a company that is comparable to Telmex (TMX) in size and third quarter results were particularly encouraging. All considered, we are keeping our current Buy recommendation on TNE.