Tele Norte Leste Participacoes S.A. 20-F 2007
As filed with the Securities and Exchange Commission on June 15, 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
For the fiscal year ended December 31, 2006
Commission file number: 001-14487
Rua Humberto de Campos, 425/8° andar-Leblon
22430-190 Rio de Janeiro, RJ, Brazil
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Securities registered or to be registered pursuant to Section 12(g) of the Act: None
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None
Indicate the number of outstanding shares of each of the Issuers classes of capital or common stock as of the close of the period covered by this Annual Report:
127,373,900 common shares, without par value
254,747,800 preferred shares, without par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark which financial statement item the registrant has elected to follow. o Item 17 þ Item 18
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
We have prepared our financial statements as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 and the notes thereto in conformity with accounting practices adopted in Brazil, or Brazilian GAAP, which are based on Brazilian corporate law (Law No. 6,404, as amended), the rules and regulations of the Brazilian Securities Commission (Comissão de Valores Mobiliários, or CVM), and the accounting standards issued by the Brazilian Federal Accounting Council (Conselho Federal de Contabilidade, or CFC), and the Brazilian Institute of Independent Accountants (Instituto dos Auditores Independentes do Brasil, or Ibracon). Brazilian GAAP when applied to us differs in certain important respects from generally accepted accounting principles in the United States, or U.S. GAAP. See Item 3. Key information Selected financial data Brazilian GAAP and U.S. GAAP, Item 5. Operating and financial review and prospects Presentation of information, Item 5. Operating and financial review and prospects U.S. GAAP reconciliation.
In this annual report, except where otherwise specified, TNL, the Company, we, us and our refer to Tele Norte Leste Participações S.A. and its subsidiaries. Telemar Norte Leste S.A., our fixed-line subsidiary, is referred to as Tmar, and our mobile phone telecommunications subsidiary, TNL PCS S.A., is referred to as Oi. Our controlling shareholder Telemar Participações S.A. is referred to as TmarPart. References to the Companys businesses and operations are references to the businesses and operations of its subsidiaries and/or TNL, as the case may be. References to U.S. dollars, US$ or $ are to the lawful currency of the United States, and references to real, reais or R$ are to the lawful currency of Brazil. Any discrepancies in tables between totals and sums of the amounts listed are due to rounding.
This annual report is presented in reais. On June 11, 2007, the selling rate for reais was R$1.9473 to US$1.00.
References to American Depositary Shares or ADSs are to American Depositary Shares, each representing one preferred share of TNL. The ADSs are evidenced by American Depositary Receipts, or ADRs.
This annual report includes forward-looking statements. The words believe, may, will, estimate, continue, anticipate, intend, expect and similar words are intended to identify forward-looking statements. You should consider these cautionary statements together with any written or oral forward-looking statements that we may issue in the future. These forward-looking statements include, but are not limited to: (1) statements about current conditions and future trends in our industry and (2) statements about our financial condition, results of operations, cash flows, dividends, financing plans, business strategies, operating efficiencies, budgets, competitive position, growth opportunities, benefits from new technology, plans and objectives of our management and other matters.
These forward-looking statements are based largely on our current beliefs and expectations about future events and financial trends affecting our businesses and are subject to risks, uncertainties and assumptions, including, among other things:
Any or all of our forward-looking statements in this annual report may turn out to be inaccurate. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. They may be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties, including the risks, uncertainties and assumptions described in Item 3. Key information Risk factors. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this annual report may not occur as contemplated and actual results could differ materially from those anticipated or implied by the forward-looking statements.
You should not unduly rely on these forward-looking statements, which speak only as of the date of this annual report. Unless required by law, we undertake no obligation to publicly update or revise any forward-looking statements to reflect new information or future events or otherwise. You should, however, review the factors and risks we describe in the reports we will file from time to time with the Securities and Exchange Commission, or SEC, after the date of this annual report. See Item 10. Additional information Documents on display.
On April 20, 2007, the Board of Directors of our controlling shareholder, TmarPart, approved:
A) The making of a voluntary public tender offer for the acquisition of all of the outstanding preferred shares (including preferred shares represented by ADSs) in TNL, on the following general conditions:
B) The making of a voluntary public tender offer by TmarPart for acquisition of the whole of the outstanding preferred shares in Tmar (TMAR5), on the following general conditions:
On July 27, 2006, TNL PCS Participações S.A., a subsidiary of TNL, acquired, through an auction held on the BOVESPA, a single and undivided block of 44,428,569 common shares and 27,962,449 preferred shares issued by WAY TV Belo Horizonte S.A., or WAY TV, for the total price of R$133 million.
WAY TV is a company that provides subscription TV services and broadband internet access to the residential, commercial and corporate market segments. The company operates in the cities of Belo Horizonte, Poços de Caldas, Uberlândia and Barbacena, using a hybrid network of optic fiber and bidirectional coaxial cable (HFC) that allows it to offer a broad range of interactive services, such as distance learning, telephony and telemedicine, among others. The acquisition of WAY TV is part of the Companys strategy of offering complete and converging solutions to its clients.
The stock purchase agreement was signed on August 1, 2006 and the amount paid is currently held in a blocked account, pending Anatels approval of the acquisition. Under the current regulatory framework, it is disputable whether a telecommunication company could acquire a TV cable provider.
On March 19, 2007, Anatel denied our request for approval of the acquisition and, on April 13, 2007, we filed with Anatel a request for reconsideration. We cannot predict if and when Anatel will issue a final decision on the acquisition. If Anatel decides against us, the amount currently kept in the blocked account will be released to us without any further responsibilities to the parties.
The selected financial information presented below should be read in conjunction with our financial statements as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 and the notes thereto, or the consolidated financial statements. The consolidated financial statements have been audited by our independent auditors, and their report on the consolidated financial statements are presented in this annual report under Item 18. Financial statements. The selected financial information as of December 31, 2003 and 2002 and for the years ended December 31, 2003 and 2002 has been derived from the Companys consolidated financial statements prepared for those fiscal years and are not included in this annual report.
The following paragraphs discuss important features of the presentation of the selected financial information and the consolidated financial statements. These features should be kept in mind in evaluating the selected financial information and in reading Item 5. Operating and financial review and prospects.
The consolidated financial statements have been prepared in accordance with Brazilian GAAP. Brazilian GAAP differs in certain material respects from generally accepted accounting principles in the United States. See Item 5. Operating and financial review and prospects U.S. GAAP reconciliation and Note 35 to the consolidated financial statements for a summary of the differences between Brazilian GAAP and U.S. GAAP.
Selected financial information
We will pay any cash dividends or interest on capital and make any other cash distributions with respect to preferred and common shares in reais. Accordingly, exchange rate fluctuations will affect the U.S. dollar amounts received by the holders of our ADSs on conversion by The Bank of New York, as depositary, of dividends and other distributions in Brazilian currency on the preferred shares represented by our ADSs. Fluctuations in the exchange rate between the Brazilian real and the U.S. dollar will also affect the U.S. dollar equivalent of the price of the preferred shares on the BOVESPA.
Because we have a substantial amount of foreign-denominated debt and because a significant portion of our capital expenditures are denominated in U.S. dollars, exchange rate fluctuations may also affect our results of operations. We have entered into swap agreements to mitigate the risks of losses from foreign exchange variations relating to our foreign denominated debt in US dollars and Japanese Yens. See Item 5. Operating and financial review and prospects Liquidity and capital resources Overview.
Until March 4, 2005, there were two principal foreign exchange markets in Brazil: the commercial rate exchange market, or Commercial Market, and the floating rate exchange market, or the Floating Market. On January 25, 1999, the Brazilian government announced the unification of the exchange positions of the Brazilian financial institutions in the Commercial Market and the Floating Market, leading to a convergence in the pricing and liquidity of both markets. Previously, the Commercial Market was reserved primarily for foreign trade transactions and transactions that generally required prior approval from Brazilian monetary
authorities, such as the purchase and sale of registered investments by foreign persons and related remittances of funds abroad (including the payment of principal of and interest on loans, notes, bonds and other debt instruments denominated in foreign currencies and duly registered with the Brazilian Central Bank (Banco Central do Brasil)). The Floating Market rate was generally applied to specific transactions for which the Brazilian Central Bank approval was not required. Both the Commercial Market rate and the Floating Market rate were reported by the Brazilian Central Bank on a daily basis.
On March 4, 2005, the National Monetary Council (Conselho Monetário Nacional, or CMN), issued Resolution No. 3,265. introducing several changes in the Brazilian foreign exchange regime, including: (1) the unification of the foreign exchange markets (Commercial Market and Floating Market, as described below) to create a single foreign exchange market; (2) the relaxation of certain rules relating to the acquisition of foreign currency by Brazilian residents; and (3) the extension of the term for the internalization of proceeds derived from Brazilian exports. As of such date, all foreign exchange transactions are made through the foreign exchange market, by means of foreign exchange contracts signed with local institutions authorized to deal in foreign exchange. Under the new system, transfers of funds to and from Brazil can still be made through the international transfer of Brazilian currency mechanism (also known as Transferência Internacional de Reais, or TIR) but only for the transferors own funds. Accordingly, any and all transfers formerly effected by Brazilian resident individuals or companies via TIR using accounts held by foreign financial institutions in Brazil will be made directly through the foreign exchange market.
Foreign currencies may be purchased only through a Brazilian bank authorized to operate in the foreign exchange markets. Foreign exchange rates are freely negotiated, but may be strongly influenced by the Brazilian Central Bank intervention. The changes to the foreign exchange regulation introduced by the Brazilian authorities sought to make foreign exchange transactions simpler and more efficient.
Brazilian law also provides that, whenever there is a significant imbalance in Brazils balance of payments or reason to anticipate such an imbalance, temporary restrictions may be imposed on remittances of foreign capital abroad. There can be no assurance that such measures will not be taken by the Brazilian government in the future.
From its introduction on July 1, 1994 through March 1995, the real appreciated against the U.S. dollar. In 1995, the Brazilian Central Bank announced that it would intervene in the market and buy or sell U.S. dollars, establishing a band in which the exchange rate between the real and the U.S. dollar could fluctuate. This policy resulted in a gradual devaluation of the real relative to the U.S. dollar. On January 13, 1999, the band was set between R$1.20 and R$1.32 per US$1.00. Two days later, on January 15, 1999, due to market pressures, the Brazilian Central Bank abolished the band system and allowed the real/U.S. dollar exchange rate to float freely. Since then, the real/U.S. dollar exchange rate has been established by the interbank market, and has fluctuated considerably. In the past, the Brazilian Central Bank has intervened to control unstable movements in the foreign exchange rate. It is not possible to predict whether the Brazilian Central Bank will continue to let the real float freely. Accordingly, it is not possible to predict the Brazilian governments future exchange rate policies or what impact those policies may have on us. The Brazilian government could impose a band system in the future or the real could devalue or appreciate substantially. For more information on these risks, see Item 3. Key Information Risk factors Risks relating to Brazil.
The following table sets forth the foreign exchange market selling rates published by the Brazilian Central Bank at the close of business day, expressed in reais per U.S. dollar for the periods indicated.
Source: Brazilian Central Bank.
On June 11, 2007, the foreign exchange market selling rate was R$1.9473 to US$1.00.
The following risk factors should be carefully considered in addition to the other information presented in this annual report.
Of our two classes of shares outstanding, only our common shares have full voting rights. Our preferred shares will be entitled to unlimited voting rights only in certain limited circumstances, such as in the event that we fail to pay minimum statutory dividends for a period of three consecutive years. As a result, holders of our preferred shares generally will not be able to influence in corporate decisions requiring a shareholder vote, including the declaration of dividends. See Item 10. Additional information Voting rights.
Holders of ADSs are not entitled to attend shareholders meetings and may only vote through the depositary.
Under Brazilian law, only shareholders registered as such in our corporate books may attend shareholders meetings. All preferred shares underlying the ADSs are registered in the name of the depositary. A holder of ADSs is entitled to instruct the depositary as to how to vote the preferred shares represented by ADSs, in accordance with procedures provided for in the deposit agreement, but a holder of ADSs will not be able to vote the underlying preferred shares directly at a shareholders meeting or to appoint a proxy to do so. Additionally, if we do not request the depositary to provide you voting materials, you may not be able to provide instructions to the depositary on how to vote the preferred shares underlying your ADSs.
Holders of ADSs or preferred shares in the United States may not be entitled to participate in future preemptive rights offerings.
Under Brazilian law, if we issue new shares for cash and/or assets as part of a capital increase, we generally must grant our shareholders the right to purchase a sufficient number of shares to maintain their existing ownership percentage. We may not legally be permitted to allow holders of ADSs or preferred shares in the United States to exercise any preemptive rights in any future capital increase unless (1) we file a registration statement with the SEC with respect to that future issuance of shares or (2) the offering qualifies
for an exemption from the registration requirements of the Securities Act of 1933, as amended. At the time of any future capital increase, we will evaluate the costs and potential liabilities associated with filing a registration statement with the SEC and any other factors that we consider important in determining whether to file such a registration statement. We cannot assure the holders of ADSs or preferred in the United States that we will file a registration statement with the SEC to allow them to participate in a preemptive rights offering. As a result, the equity interest of such holders in us may be diluted proportionately.
If you exchange ADSs for preferred shares. you may risk losing the ability to remit foreign currency abroad and certain Brazilian tax advantages.
The Brazilian custodian for the preferred shares underlying the ADSs must register with the Brazilian Central Bank to remit U.S. dollars abroad. As an ADS holder you benefit from the electronic certificate of foreign capital registration from the Brazilian Central Bank obtained by the custodian for the depositary, which permits it to convert dividends and other distributions with respect to the preferred shares into U.S. dollars and remit the proceeds of such conversion abroad. If you decide to exchange your ADSs for the underlying preferred shares, you will only be entitled to rely on the custodians certificate of registration with the Brazilian Central Bank for five business days from the date of the exchange. Thereafter, you may not be able to obtain and remit U.S. dollars abroad unless you obtain your own electronic certificate of foreign capital registration, which may result in expenses and may cause you to suffer delays in receiving distributions. See Item 10. Additional information Exchange controls and other limitation affecting shareholders.
Also, if you do not qualify under the foreign investment regulations, you will generally be subject to less favorable tax treatment of dividends and distribution on, and the proceeds from any sale of, our preferred shares. See Item 10. Additional information Taxation Brazilian tax considerations.
Brazilian law provides that whenever there is a significant imbalance in Brazils balance of payments or a significant possibility that such imbalance will exist, the Brazilian government may impose temporary restrictions on the remittance to foreign investors of the proceeds of their investment in Brazil (as it did for approximately six months in 1989 and early 1990) and on the conversion of Brazilian currency into foreign currencies. These restrictions could hinder or prevent the Brazilian custodian of our preferred shares underlying the ADSs or holders who have exchanged the ADSs for our underlying preferred shares from converting dividends, distributions or the proceeds from any sale of such shares into U.S. dollars and remitting such U.S. dollars abroad. In such an event, the Brazilian custodian for our preferred shares will hold the reais that it cannot convert for the account of holders of the ADSs who have not been paid. Neither the custodian nor the depositary will be required to invest the reais or be liable for any interest.
The relative volatility and illiquidity of the Brazilian securities markets may adversely affect holders of ADSs.
Investments in securities, such as the preferred shares or the ADSs, of issuers from emerging market countries, including Brazil, involve a higher degree of risk than investing in securities of issuers from more developed countries. The Brazilian securities market is substantially smaller, less liquid, more concentrated and more volatile than major securities markets in the United States. There is also significantly greater concentration in the Brazilian securities market than in major securities markets in the United States. These features may substantially limit the ability to sell our preferred shares underlying the ADSs at a price and time at which holders wish to do so. The BOVESPA had a market capitalization of US$678 billion as of December 31, 2006, and an average monthly trading volume of approximately US$19 billion in 2006. In comparison, the NYSE had a market capitalization of approximately US$26 trillion (excluding funds and non-U.S. companies) as of December 31, 2006.
Changes in Brazilian tax laws may have an adverse impact on the taxes applicable to the disposition of the ADSs and preferred shares.
According to Law No. 10,833, enacted on December 29, 2003, if a nonresident of Brazil disposes of assets located in Brazil, the transaction will be subject to taxation in Brazil, even if such disposition occurs outside Brazil or if such disposition is made to another nonresident. Dispositions of ADSs between nonresidents, however, are currently not subject to taxation in Brazil. Nevertheless, in the event that the concept of disposition of assets is interpreted to include the disposition between nonresidents of assets located outside Brazil, this tax law could result in the imposition of withholding taxes in the event of a disposition of the ADSs made between nonresidents of Brazil. Due to the fact that Law No. 10,833 has been recently enacted and judicial guidance as to its application yet exists, we are unable to predict whether an interpretation applying such tax laws to dispositions of the ADSs between nonresidents could ultimately prevail in Brazilian courts. See Item 10. Additional information Taxation Brazilian tax considerations.
Holders of ADSs may face difficulties in serving process on or enforcing judgments against us and other persons.
We are organized under the laws of Brazil, and all of the members of our Board of Directors and all of our executive officers and our independent public accountants reside or are based in Brazil. The vast majority of our assets and those of these other persons are located in Brazil. As a result, it may not be possible for you to effect service of process upon us or these other persons within the United States or other jurisdictions outside Brazil or to enforce in Brazil against us or these other persons judgments obtained in the United States or other jurisdictions outside Brazil. Because judgments of U.S. courts for civil liabilities based upon the U.S. federal securities laws may only be enforced in Brazil if certain conditions are met, you may face greater difficulties in protecting your interests in the case of actions by us or our Board of Directors or executive officers than would shareholders of a U.S. corporation.
The number of fixed lines in service has stagnated for the past five years and there is no assurance that this market will grow in the future.
According to Anatel, from December 2004 to December 2006, the number of fixed-lines in service in Brazil decreased from 39.6 million to 38.8 million. In addition, installation of new fixed-lines are currently expected to be less profitable than existing ones. As we derive most of our revenue from our traditional fixed-line telephony services (for the year ended December 31, 2006, these services represented 85.7% of our gross revenues), growth in revenues and our profitability depend on our ability to improve revenue per line and maintain and improve our cost structure. Our future growth and profitability depend on many factors beyond our control, such as economic, social, technological or other developments, which may have a material adverse effect on our results of operations.
Our fixed-line services face increased competition from other fixed-line service providers and from mobile service provider and, more recently, cable TV providers, which may adversely affect our revenues.
Until 1999, we were the only telecommunications company authorized to provide fixed-line local services in substantially all of Region I. Since then, several companies, such as Empresa Brasileira de Telecomunicações -Embratel, or Embratel, Vésper S.A., or Vésper, Intelig Telecom S.A., or Intelig, Telecomunicações de São Paulo S.A., known as Telefónica, and Brasil Telecom S.A., or Brasil Telecom, have been authorized by Anatel to offer local and long-distance services in our region.
We also anticipate that our fixed-line services may face increasing competition from mobile services, as the prices for mobile services decline and approach those of fixed-line services, especially in the high-end, high minutes segment. Increased competition in our fixed-line services business, whether from (i) other fixed-line service providers (such as the Embratel/NET partnership described below); (ii) voice over internet protocol, or VoIP, or (iii) mobile service providers; may increase our marketing expenses and our capital
expenditures, reduce our rates, and may reduce our market share for fixed-line services, all of which would adversely affect our operating results. In addition, most of our main competitors are controlled by international telecommunications providers that may have easier access to less expensive capital than us.
In November 2005, Embratel, our primary competitor in fixed-line services, announced a telecommunication service agreement with NET, a TV cable company which is our primary competitor in the provision of broadband services. Both companies are affiliates of Telefonos de Mexico, S.A. de C.V., or Telmex, one of the leading telecommunication service providers in Latin America. Such agreement supports the launch of a triple play, offering integrated voice, broadband and video through a single network infrastructure to the residential market. This bundling strategy increased competition in our fixed-line services, which may require us to increase our marketing and capital expenditures, or reduce our rates to maintain market share, in each case leading to a reduction in our profitability.
Our mobile services face strong competition from other mobile service providers, which may adversely affect our revenues.
The market for mobile services in Region I is extremely competitive and fragmented. We have experienced increased competition in Region I from large players such as Vivo Participações S.A., or Vivo (controlled by Telefónica S.A. and Portugal Telecom S.A.), TIM Brasil S.A., or TIM, and Claro group (controlled by América Móvil, S.A. de C.V.), or Claro, each of which is owned by international telecommunications providers. By the end of 2006, Oi was the market leader in Region I with 27.4% market share, followed by TIM with 26.1%; Claro with 19%, and Vivo with 17%. We have experienced increased pressure to reduce our rates in response to pricing competition. This pricing competition often takes the form of special promotional packages. Our inability to compete effectively with our competitors special packages, prices, traffic usage promotions, and handset subsidies strategies, could affect our revenues and profitability and cause us to lose part of our market share. Additionally, increased competition in our mobile services business may increase our marketing expenses and our capital expenditures, which would adversely affect our operating results. For detailed description of our competition, see Item 4. Information on the Company Competition.
Data transmission services are not subject to significant regulatory restrictions and, as a result, we face an increasing amount of competition in this area.
Competition in data transmission services is not subject to significant regulatory restrictions and, therefore, the market is open to a great number of competitors. Some competitors offer telecommunication services through broadband, such as cable, which does not require them to use our network, allowing them to reach our clients without paying us interconnection and/or mobile network usage fees. Additionally, the introduction of Worldwide Interoperability for Microwave Access, or Wimax, wireless networks may allow other Internet Service Providers, or ISPs, to deploy wireless Internet Protocol, or IP, networks over a much greater distance, for a much lower cost, than previously possible. This reduced deployment cost may allow our competitors or new entrants into the data transmission market to provide VoIP and other data services over Wimax networks at lower rates than we are able to offer.
Increasing competition in data services may lead to rate reductions in this segment, also affecting the revenues we generate in this business. Additionally, increased competition for data transmission customers requires us to increase our marketing expenses and our capital expenditures and may reduce our market share for those services, in each case leading to a reduction in our profitability. For a detailed description of our competition, see Item 4. Information on the Company Competition.
High churn rates could negatively affect our revenues and profitability of our mobile services business.
Our ability to generate revenues is dependent on our ability to increase our customer base and retain it. Each additional customer subscribing to our service entails certain unrecoverable upfront costs, including costs for equipment installations, sales commissions and marketing. The ability to recover these costs is dependent
on our ability to retain such customers. Subscriber churn is the total number of net disconnected customers for a period as a percentage of the average number of customers for the same period. The fact that we incur significant upfront fixed costs for each new customer means that high rates of customer churn could have a material adverse effect on the profitability of our mobile services business. During 2006, our average monthly customer churn in the mobile segment was 2.3% per month. We cannot assure you that our churn rates will not increase in future periods.
In order to expand our business, we may take advantage of the consolidation of the telecommunications industry through the acquisition of other telecommunications companies.
We may acquire other companies in the telecommunications industry as part of our growth strategy. A growth strategy that involves acquisitions may present a series of risks to our financial condition and results of operations such as, among others: (1) difficulty in capturing synergies and integrating businesses, causing the acquisition to be more expensive then originally expected; (2) substantial costs associated with antitrust restrictions; (3) a failure to identify contingencies during the due diligence process; (4) uncertainty in relation to regulatory approval; and (5) costly distractions from our core business to pursue these acquisitions and implement the integration of acquired businesses. If investments in these acquisition opportunities cause us to incur costs due to any of the situations described above, we may have to dedicate more resources than we had originally planned for the investment and eventually face substantial losses as a result of failed acquisitive strategies, all of which would adversely affect our financial condition and results of operations.
Our failure to meet certain obligations set forth in Tmars 2006 Concession Agreement may result in various fines and penalties imposed on us by our regulators.
Tmars concession to operate fixed-line telecommunications services in Region I was renewed on December 22, 2005. Tmar and the Brazilian government agreed to extend this concession for another 20 years, beginning January 1, 2006 pursuant to a new Concession Agreement (the 2006 Concession Agreement).
The 2006 Concession Agreement contains new terms reflecting the adoption by Anatel of a new General Plan on Universal Service (Plano Geral de Metas de Universalização) and certain new regulations, the terms of which could affect our financial condition and results of operations. These terms include: (1) new universal service targets; (2) changes in local rate measurement criteria (from pulse to minute); (3) changes in rate adjustment formulas, including the creation of a telecommunications industry index and new parameters for local interconnection rates and new productivity factors; and (4) a new basic plan for fixed-line, low-income customers to be offered as a prepaid plan with a monthly fee that is 40% lower than the existing one. The 2006 Concession Agreement also requires us to meet certain network expansion and quality of service obligations in each of the states in Region I. In the event of noncompliance with Anatel targets in any one of the regions, Anatel can establish a deadline for achieving the targeted level of such service, impose penalties, and, in extreme situations, terminate Tmars concession for noncompliance with its quality and universalization obligations. See Item 4. Information on the Company Regulation of the Brazilian telecommunications industry. These changes could, in each case, adversely affect our profitability and results of operations.
On an almost weekly basis, we receive inquiries from Anatel requiring information from us on our compliance with the various service obligations imposed on us by our concessions to provide telecommunication services. When we are unable to satisfactorily comply with those inquiries or our service obligations under the concession, Anatel may issue assessments in connection with such noncompliance. Throughout 2006, we have received several assessments from Anatel, mostly due to the fact that we were unable to achieve certain targets established in the General Plan on Targets and Quality (Plano Geral de Metas e Qualidade) and the General Plan on Universal Services, among others. We have recorded provisions in the amount of R$215 million as of December 31, 2006 in connection with Anatels fines. Continued fines from Anatel or fines in excess of the provisioned amount, could adversely impact our financial condition. See Item 4. Information on the Company Regulation of the Brazilian Telecommunications Industry and Item 8. Financial information Legal proceedings Regulatory proceedings Fines from Anatel.
Our business is highly regulated. Changes in laws and regulations may adversely impact our business.
Our industry is highly regulated by Anatel. Anatel regulates rates, quality of service and universalization goals, as well as competition between carriers. Changes in laws and regulations, grants of new concessions or licenses or the imposition of additional costs of universalization, among other factors, may adversely affect our operations and financial results.
After the current government took office on January 1, 2003, some of its members advocated the need to revise the regulatory model followed by the regulatory agencies in Brazil, including Anatel, in order to make them more responsive to their respective ministries. The loss of Anatels independence could pose a material risk to our business, given the potential for undue political influence that this new regulatory model could exercise over Anatel.
Also, a number of bills affecting telecommunications policy have been submitted to the Brazilian Congress with an aim to make telecommunications services more accessible to Brazils low-income population. These bills have proposed to: (1) eliminate the monthly subscription fee (assinatura mensal) that compensates telecommunications companies for extending and maintaining fixed-line telecommunications services for their customers; and (2) impose inexpensive fixed-line telephone plans (telefone social) that telecommunications companies would be required to provide to certain eligible low-income residential users. The enactment of these and similar proposed legislation may increase our operating costs and/or reduce the amount of fees we charge our consumers, which could adversely affect our profitability.
We depend on our ability to enter into interconnection agreements with other telecommunications services providers. We may not be able to enter into favorable interconnection agreements with them in the future.
In order to receive or send calls from or to customers of other fixed-line and mobile Brazilian networks and international networks, we must interconnect with the networks of our competitors. The Brazilian General Telecommunications Law (Lei Geral das Telecomunicações) requires all telecommunications service providers to interconnect their networks with those of other providers on a non-discriminatory basis. Anatel sets the interconnection rates for the fixed-line network.
Since July 2004, a specific regulation established that mobile interconnection rates should be freely negotiable. Brazilian telecommunications laws and regulations also establish that if new interconnection rates for mobile operators are not agreed among telecommunications service providers, Anatel is empowered to arbitrate, at its discretion, the interconnection rates that mobile telecommunications companies may charge.
In February 2005, Tmar and the mobile telecommunications providers could not reach an agreement regarding the adjustment of the interconnection rate. The parties agreed to establish a temporary adjustment and to submit the adjustment to Anatels arbitration. We cannot predict whether the interconnection rates arbitrated by Anatel will be substantially different from those currently applied. If Anatel sets interconnection rates that differ substantially from those currently applied, the operating and financial results of Tmar and, consequently, of the Company, may be adversely affected.
The telecommunications industry is subject to frequent changes in technology. Our ability to remain competitive depends on our ability to implement new technology, and it is difficult to predict how new technology will affect our business
Companies in the telecommunications industry must adapt to rapid and significant technological changes that are usually hard to anticipate. Technological changes may render our equipment, services and technology obsolete or inefficient, requiring us to increase our capital expenditures, which may adversely affect our competitiveness. Even if we adopt such new technologies in a timely fashion, we may not be able to remain competitive and the cost of such technology may exceed the benefit to us.
The mobile telecommunications industry is experiencing significant technological development and ongoing improvements in the capacity, quality and data-transmission speed of digital technology, along with shorter development cycles for new technologies and changes in end-user needs and preferences. Alternative
technologies may be developed that are more advanced than those Oi provides today. In addition, Anatel is expected to auction third generation (3G) mobile telecommunications licenses in 2007, which will allow purchasers of such licenses to adopt technology platforms that will offer more advanced mobile services than Ois current global system mobile, or GSM, technology platform. Even if we adopt these technologies in a timely manner as they are developed, we cannot assure you that we will be able to remain competitive.
We have a substantial amount of existing debt, which could restrict our financing and operating flexibility and have other adverse consequences.
As of December 31, 2006, we had total consolidated debt of R$9,570 million and a ratio of debt to equity of 1.07:1. We are subject to certain financial covenants that limit our ability to raise additional debt. Our existing level of indebtedness and the requirements and limitations imposed by our debt covenants could adversely affect our financial condition or results of operations. Our inability to incur additional debt may impede our ability to invest in our business and make necessary or advisable capital expenditures, which could reduce future sales and adversely affect our profitability. In addition, cash required to serve our substantial indebtedness reduces the amount available to us to pay dividends or make capital expenditures.
If our growth in revenues slows or declines in a significant manner, for any reason, we may not be able to continue servicing our debt. If we are unable to meet our debt service obligations or comply with our debt covenants, we could be forced to restructure or refinance our indebtedness, seek additional equity capital or sell assets. We may be unable to obtain financing or sell assets on satisfactory terms, or at all. For more information regarding our loan agreements and debt covenants contained therein, see Item 5. Operating and financial review and prospects Liquidity and capital resources.
We are subject to several legal and administrative proceedings and delinquencies on accounts receivables.
Based on advice from our external legal consultants, we classify our risk of loss from legal and administrative proceedings as probable, possible and remote. We make provisions for probable claims but do not make provisions for possible and remote claims. We currently have provisioned R$2,428 million for probable claims as of December 31, 2006 relating to various tax, labor, civil and regulatory claims against us. If our liability exceeds the provisioned amount, our financial condition may be adversely impacted. See Item 5. Operating and financial review and prospects Critical accounting policies Contingencies and Item 8. Financial information Legal proceedings.
In 2006, we recorded expenses with provisions for doubtful accounts in the amount of R$475, primarily due to subscribers delinquencies. Strict regulation from Anatel prevents us from implementing certain policies that could have the effect of reducing delinquency, such as service restrictions or limitations on the types of services provided based on a subscribers credit record. If we are unable to implement policies to limit subscriber delinquencies or otherwise select our customers, persistent subscriber delinquencies and bad debt will continue to adversely affect our financial results. See Item 5. Operating and financial review and prospects Critical accounting policies Provision for doubtful accounts.
We have been subject in the past to financial covenants and other contractual provisions under our existing indebtedness.
In the past, certain agreements that governed our debt contained a number of significant covenants, such as a 1.75:1 EBITDA to interest expense ratio, which could adversely impact our business. In December 2000, Tmar renegotiated the terms of a bridge loan agreement it had with the BNDES, permitting it to enter into two new loan agreements, or the BNDES Facilities, which together provided for a credit line of up to R$2.7 billion, of which 30% was disbursed directly from the BNDES and 70% through a syndicate of banks led by Banco Itaú S.A. and Banco do Brasil S.A. The BNDES Facilities required that we comply with certain financial covenants, some of which we did not meet as of December 31, 2004. However, in February 2005, Banco Itaú S.A. and Banco do Brasil S.A., as leaders of the syndicate of lenders, and the BNDES granted us a waiver from these covenants in exchange for a fee, which allowed us to amend such covenants on more favorable terms with
which we were in compliance at December 31, 2006. Nevertheless, we cannot assure you that in the future we will not need to raise funds subject to more restrictive financial covenants with which we may have difficulty in complying. See Item 7. Major shareholders and related party transactions Related party transactions.
Our operations are dependent upon our ability to protect our network. A system failure could cause delays or interruptions of service, which could cause us to lose customers.
Damage to our network and backup systems could result in service delays or interruptions and limit our ability to provide customers with reliable service over our network. Some of the risks to our network and infrastructure include: (1) physical damage to access lines; (2) power surges or outages; (3) software defects; (4) disruptions beyond our control; (5) breaches of security; and (6) natural disasters. The occurrence of any such event could cause interruptions in service or reduce capacity for customers, either of which could cause us to lose customers and incur additional expenses. In addition, the occurrence of any such event may subject us to penalties and other sanctions imposed by Anatel. The occurrence of any such event may adversely affect our business, financial condition or operating results.
Our operations depend on our ability to maintain, upgrade and efficiently operate accounting, billing, customer service, information technology and management information systems.
Sophisticated information and processing systems are vital to our growth and our ability to monitor costs, render monthly invoices for services, process customer orders, provide customer service and achieve operating efficiencies. There can be no assurance that we will be able to successfully operate and upgrade our accounting, information and processing systems or that they will continue to perform as expected. Any failure in our accounting, information and processing systems could impair our ability to collect payments from customers and respond satisfactorily to customer needs, which could adversely affect our business, financial condition and operating results.
We incur costs associated with the unauthorized and fraudulent use of our networks, including administrative and capital costs associated with detecting, monitoring and reducing the incidence of fraud. Fraud also affects interconnection costs and payments to other carriers for non-billable fraudulent roaming. Improper use of our network can also increase our selling expenses if we have to increase our provision for doubtful accounts to reflect amounts we do not believe we can collect for improperly made calls. Any unexpected increase in the improper use of our network in the future could materially adversely affect our costs and results of operations.
The mobile telecommunications industry, including us, may be harmed by reports suggesting that radio frequency emissions cause health problems and interfere with medical devices.
Media and other reports have suggested that radio frequency emissions from wireless handsets and base stations may cause health problems. If consumers harbor health-related concerns, they may be discouraged from using wireless handsets. These concerns could have an adverse effect on the mobile telecommunications industry and, possibly, expose mobile service providers, including us, to litigation. We cannot assure you that further medical research and studies will refute a link between the radio frequency emissions of wireless handsets and base stations and these health concerns. Government authorities could increase regulation of wireless handsets and base stations as a result of these health concerns or mobile service companies, including us, could be held liable for costs or damages associated with these concerns, which could have an adverse effect on our business, financial condition and results of operations. The expansion of our network may be affected by these perceived risks if we experience problems in finding new sites, which in turn may delay the expansion and may affect the quality of our services. On July 2, 2002, Anatel published Resolution No. 303 that limits emission and exposure for fields with frequencies between 9 kHz and 300 GHz. In addition, the Brazilian government is developing specific legislation for the deployment of radio frequency transmission
stations that will supersede existing state and municipal laws. The new laws may create additional transmission regulations, which, in turn, could have an adverse effect on our business.
Risks Relating to Brazil
The Brazilian government has exercised, and continues to exercise, significant influence over the Brazilian economy. This involvement, as well as Brazilian political and economic conditions, could adversely impact our business, operations and the market price of our preferred shares and ADSs.
The Brazilian government frequently intervenes in the Brazilian economy and occasionally makes drastic changes in policy and regulations. The Brazilian governments actions to control inflation and implement macroeconomic policies have often involved wage and price controls, currency devaluations, capital controls and limits on imports, among other things. Our business, financial condition, results of operations and the market price of our preferred shares and ADSs may be adversely affected by changes in policies or regulations, or by other factors such as:
Uncertainty over whether possible changes in policies or rules affecting these or other factors may contribute to economic uncertainties in Brazil and to heightened volatility in the Brazilian securities markets and securities issued abroad by Brazilian issuers. Moreover, presidential elections were held in Brazil in October 2006, and President Luiz Inácio Lula da Silva was reelected for another four-year term. The President of Brazil has considerable power to determine governmental policies and actions that relate to the Brazilian economy and, consequently, affect the operations and financial performance of businesses, such as our company. In his new term, President Lula may seek to implement new policies. Any substantial negative reaction to the policies adopted by the Brazilian federal or state government from time to time could adversely affect our business, financial condition and results of operations and would likely lead to a decrease in the market price of our preferred shares.
An increase in taxes levied on the telecommunications sector could affect the financial results of our operations.
Fixed-line telecommunications services are subject to certain taxes which are levied exclusively to their business segment. The current specific contributions that these concessionaires have to pay are (i) the Fund for Universal Telecommunications Services (Fundo de Universalização dos Serviços de Telecomunicações, or Fust) and (ii) the Fund for Technological Development of Brazilian Telecommunications (Fundo para o Desenvolvimento Tecnológico das Telecomunicações Brasileiras, or Funttel). The contributions to Fust and Funttel, which began in 2000, are charged at the rate of 1% and 0.5% of the concessionaires gross revenues, respectively, and are prohibited from being passed on to customers of telecommunications services. If further taxes specific to telecommunications services are created or if the existing such taxes, such as Fust and
Funttel, are increased, our profit margin would be adversely affected in light of the already high level of overall taxation to which we are subject. As of December 31, 2006, we were contesting approximately R$6.3 billion in taxes for which we have taken no provision. That, if decided against us, would adversely affect our operating results. See Note 26 to our consolidated financial statements.
Devaluation of the real may lead to substantial losses on our liabilities denominated in or indexed to foreign currencies.
During the four decades prior to 1999, the Brazilian Central Bank periodically devalued the Brazilian currency. Throughout this period, the Brazilian government has implemented various economic plans and used various exchange rate policies, including sudden devaluations, periodic mini-devaluations (such as daily adjustments), exchange controls, dual exchange rate markets and a floating exchange rate system. Since 1999, exchange rates have been set by the market. The exchange rate between the real and the U.S. dollar has varied significantly in recent years. For example, the real/U.S. dollar exchange rate increased from R$1.9554 per U.S. dollar on December 31, 2000 to R$3.5333 on December 31, 2002. The real depreciated against the U.S. dollar by 18.7% and 52.3% in 2001 and 2002, respectively, and appreciated 18.2%, 8.1% and 11.8% in 2003, 2004 and 2005, respectively. On June 11, 2007, the real/U.S. dollar exchange rate was R$1.9473 per U.S. dollar. See Exchange rates.
A significant amount of our financial assets and liabilities are denominated in or indexed to foreign currencies, primarily U.S. dollars. When the real depreciates against foreign currencies, we incur losses on our liabilities denominated in or indexed to foreign currencies, such as our U.S. dollar-denominated long-term debt and foreign currency loans, and we incur gains on our monetary assets denominated in or indexed to foreign currencies, as the liabilities and assets are translated into reais. If devaluation occurs when the value of such liabilities significantly exceeds the value of such assets, including any financial instruments entered into for hedging purposes, we could incur significant losses, even if their value has not changed in their original currency. We currently swap most of our foreign currency loans. If the cost of swap instruments increases substantially, we may be unable to fully hedge ourselves, resulting in an increased foreign currency exposure which could in turn lead to substantial foreign exchange losses.
Devaluation of the real relative to the U.S. dollar could create additional inflationary pressures in Brazil by increasing the price of imported products and requiring recessionary government policies including tighter monetary policy. On the other hand, appreciation of the real against the U.S. dollar may lead to a deterioration of the countrys current account and balance of payments, as well as to a dampening of export-driven growth. Devaluations also reduce the U.S. dollar value of distributions and dividends on the common shares, preferred shares and ADSs, if any, and the U.S. dollar equivalent of the market price of our shares and, as a result, the ADSs.
In addition, a significant portion of our capital expenditures are linked to the exchange rates of foreign currencies, most of which closely follow the real/U.S. dollar exchange rate. We generally do not hedge these risks. To the extent that the value of the real decreases relative to the U.S. dollar, it becomes more costly for us to purchase these items, which could adversely affect our business and financial performance.
In the past, the Brazilian economy has experienced a balance of payment deficits and shortages in foreign exchange reserves, and the government has responded by restricting the ability of Brazilian or foreign persons or entities to convert reais into foreign currencies. In the event of an economic crisis, the government may institute a restrictive exchange control policy. Any restrictive exchange control policy could prevent or restrict our access to U.S. dollars to meet our U.S. dollar obligations (including our dividend payment obligations) and could also have a material adverse effect on our business, financial condition and results of operations.
If Brazil experiences substantial inflation in the future, our margins and our ability to access foreign financial markets may be reduced. Government measures to curb inflation may have adverse effects on the Brazilian economy, the Brazilian securities market, our business and operations and the market price of our preferred shares and ADSs.
Brazil has, in the past, experienced extremely high rates of inflation, with annual rates of inflation during the last 10 years reaching as high as 2.708% in 1993 and 1.093% in 1994. Inflation and some of the Brazilian governments measures taken in an attempt to curb inflation have had significant negative effects on the Brazilian economy.
Since the introduction of the real in 1994, Brazils inflation rate has been substantially lower than in previous periods. However, inflationary pressures persist, and actions taken in an effort to curb inflation, coupled with speculation about possible future governmental actions, have contributed to economic uncertainty in Brazil and heightened volatility in the Brazilian securities market. More recently, Brazils rates of inflation, as measured by the Índice Geral de Preços, or IGP-DI Index, published by Fundação Getúlio Vargas, were 12.1% in 2004, 1.2% in 2005 and 4.7% in 2006. According to the Índice Nacional de Preços ao Consumidor Ampliado, or IPCA Index, published by the Brazilian Institute for Geography and Statistics (Instituto Brasileiro de Geografia e Estatística, or IBGE), the Brazilian consumer price inflation rates were 7.6%, 5.7% and 3.1 in 2004, 2005 and 2006, respectively.
If Brazil experiences substantial inflation in the future, our costs may increase and our operating and net margins may decrease. Inflationary pressures may also curtail our ability to access foreign financial markets and may lead to further government intervention in the economy, including the introduction of government policies that may adversely affect the overall performance of the Brazilian economy.
Adverse changes in Brazilian economic conditions could cause an increase in customer defaults on their outstanding obligations to us, which could materially reduce our earnings.
Our business is significantly dependent on our customers ability to make payments on their accounts and meet their other obligations to us. If the Brazilian economy declines because of, among other factors, the level of economic activity, devaluation of the real, inflation, or an increase in domestic interest rates, a large portion of our customers may not be able to pay their accounts when due, which would increase our bad debt expense and could reduce our net earnings.
Economic and market conditions in other emerging market countries may adversely affect the Brazilian economy and, therefore, the market value of our preferred shares and ADSs and our ability to access the capital markets.
The market for securities issued by Brazilian companies is influenced by economic and market conditions in Brazil, and, to varying degrees, market conditions in other Latin American and emerging market economies. The reaction of investors to developments in one emerging market country may cause the capital markets in other countries to fluctuate. Developments or conditions in other emerging market countries have at times significantly affected the availability of credit in the Brazilian economy and resulted in considerable outflows of funds and declines in the amount of foreign currency invested in Brazil, as well as limited access to international capital markets, which may adversely affect our ability to borrow funds at an acceptable interest rate or to raise equity capital when and if there should be a need for us to do so. Such developments have included the devaluation of the Mexican peso in December 1994, the Asian economic crisis of 1997, the Russian currency crisis of 1998 and the 2001 economic and political crisis in Argentina. The continuing political crisis in Venezuela and the newly elected socialist-oriented government of Bolivia may also influence investors perceptions of risk in Brazil. Similar developments could occur in Brazil and other Latin American and emerging market economies and the volatility in market prices for Brazilian securities could vary from time to time as a result.
We are the leading telecommunications services provider in Region I of Brazil, offering an integrated communications product portfolio that includes traditional fixed-line, mobile, broadband, ISP, and other services to residences, consumers, small, midsize and large business users, and government entities. In 2006, approximately 86% of our consolidated revenues were generated through our operations in the stable fixed-line sector and the rapidly growing data market. The mobile segment, which has also shown growth in 2006, was responsible for the remaining 14%. The 16 Brazilian states that comprise Region I have a combined population of 101.5 million, representing 54% of the Brazilian population, and according to IBGE, comprising approximately 41% of the countrys overall GDP.
Our integrated product portfolio, scale and leading market position, provide us a solid structure to reach our operational and strategic goals. Our revenues show a healthy balance between stable cash-generating services, such as fixed-line telephony, and high-growth services, such as mobile and broadband.
Beginning in 2004, we unified Oi and Tmar under the same organizational structure and began offering bundled packages, including fixed-line, mobile and broadband services. In February 2007, we adopted the Oi brand name for all our products.
Our traditional fixed-line business includes local, long-distance, public telephone and network usage services in Region I pursuant to concessions from the Brazilian government. We are currently the largest fixed-line provider in South America (based on the total number of lines in service). Our 14.4 million digitally capable fixed-lines in service (as of December 12, 2006) enable us to maintain our long-standing status as the main fixed-line provider in Region I with an estimated market share of over 95% (calculated as a percentage of total fixed-lines in service). For the year ended December 31, 2006, this business segment, characterized as highly stable with a predictable and recurring revenue stream, generated R$17.1 billion of revenue, translating into a contribution of 70.7% of our consolidated gross revenue, but a 3.9% decrease over the prior year.
Utilizing the GSM technology platform, our mobile telecommunications business is also marketed in Region I. As of December 12, 2006, we had approximately 13 million mobile subscribers, representing an estimated market share of 27.4% (calculated as a percentage of total mobile subscribers), according to public data provided by Anatel. We believe that we are one of the leading mobile providers in Region I. For the year ended December 31, 2006, this business segment, characterized by high growth and low penetration, generated R$3.5 billion of revenue, translating into a contribution of 14.0% of our consolidated revenue and a 26.1% increase over the prior year.
Our broadband services business, utilizing Asymmetric Digital Subscriber Line, or ADSL, technology, is marketed under the Oi Velox brand name. As of December 12, 2006, we had approximately 1.1 million broadband subscribers representing 7.8% penetration (calculated as a percentage of our total fixed-lines in service). We believe we are the largest provider of broadband services in Region I. For the year ended December 31, 2006, broadband revenue increased 37.0% compared to the same period in 2005.
We also provide voice and data services to corporate customers throughout Brazil via our own networks in Region I and in other regions, and via cooperative arrangements with other network operators in Brazil.
We intend to maintain our current market position and build on our competitive strengths to expand our operations and improve our financial performance. Our overall strategy includes the following:
We have a diversified product portfolio, incorporating fixed-line telephony, mobile telephony, broadband internet, ISP, and data services. We changed our marketing strategy from a product-oriented to a client-oriented approach aimed at providing the best services. We tailor our communications solutions to our consumer and customer groups by segmenting the markets in which we operate. We offer bundling
opportunities that are in line with our clients needs, which allow us to increase our revenues and market share, while reducing our churn rate. As the first integrated telephony company in Brazil and a leader of telecommunication services in our region, we are very competitive in bundled fixed-line, mobile, broadband and public telephone services. The following products are examples of our bundled services (for more information, see Item 4. Information on the Company Our Operations.
We also stimulate the recharge of prepaid mobile minutes through our fixed-line bills, grant postpaid mobile subscriptions to new ADSL subscribers, and combine household and business telephony needs. In addition to providing value for our customers, bundling allows us to optimize the use of our fixed and mobile networks and take advantage of our unique position as the wireline incumbent in Region I.
We have successfully grown our mobile subscriber base since we launched our mobile business, Oi, in June 2002. In less than five years, our mobile subscriber base has grown from zero to over 13 million, resulting in the highest growth rate in Brazil among mobile providers during this time period. 2002 through 2005 was a period of high growth, and we spent heavily on customer acquisition and we focused primarily on building scale and capturing market share. This strategy gave us a first place position in the mobile services market and, by the end of 2006, we had 27.4% of the market share in Region I. During 2006 the mobile telephony market began to decelerate and we decided to shift to a strategy of segmentation in the acquisition of new clients, which helps to reduce handset subsidies primarily in the low-end segment. In addition, we expect to improve our mobile telephony margins by reducing distribution and commission expenses and improving average revenue per user, as well as a creating a more favorable mix of post and prepaid subscribers. Furthermore, the penetration rates are still relatively low in our region, which growths faster than the national average. This allows us to improve growth and margins in this business. For corporate data clients, we are focused on expanding our market share by offering bundled services, providing third party network management (outsourcing), continuously improving the quality of our service and consolidating our customer relationships through focused business units. Our broadband business is also a driver for our growth, due to the low penetration in our region. We plan to follow an aggressive strategy by offering a broad selection of services to increase penetration of broadband service in residences and in small and mid-size companies.
As part of the changes introduced by the 2006 Concession Agreement, fixed telephony providers will have to charge for their services based on minutes. For detailed information regarding the pulse-minute conversion, see Item 4. Information on the Company Regulation of Brazilian Telecommunication Industry The 2006 Concessions Agreement. As a result, during the second half of 2006, we began to offer alternative fixed telephony plans in minutes to anticipate the regulatory requirement and to further adjust our plans to the actual needs of our clients. These plans vary both in the number of minutes included in the subscription, as well as with respect to the inclusion of dial-up internet access. As of December 31, 2006, our subscriber base of alternative plans totaled 1,653 thousand subscribers, corresponding to 11.5% of our total lines in service.
We plan to continue to improve our capital allocation strategy as part of our ongoing effort to improve operational efficiency, with the goal of reducing costs while pursuing economies of scale. Our ongoing efforts to reduce costs and improve the quality of our services include standardization of internal processes, streamlining our outsourced service providers in order to improve our network management process and reduce our contingency provisions, and decreasing handset subsidies and selling expenses in the low-end segment of mobile prepaid subscribers.
The Brazilian telecommunications industry has suffered a strong consolidation process since the early 2000s, which we expect to continue in the future. We continue to analyze consolidation opportunities in Brazil, which may include acquisitions or other joint ventures aimed at increasing our market share, expanding our product portfolio, or improving efficiency through potential synergies.
We will continue to stay competitive in the technological marketplace. We continually study and explore new technologies for implementation in the near future. Among these new technologies, we are considering adopting Wimax technology and Internet Protocol Television Platform, or IPTV. In July 2006, Anatel began an auction process for the use of blocks of radiofrequency of 3.5GHz and 10.5GHz required for Wimax. The auction rules prevented the participation of incumbent telecommunications operators. Nonetheless, we and other incumbent telecommunications operators presented bids supported by injunctions. As a result, Anatel suspended the auction, which is expected to resume before the end of the year.
Prior to the merger of Telebrás in 1972, there were more than 900 telecommunications companies operating throughout Brazil. Between 1972 and 1975, Telebrás and its operating subsidiaries acquired almost all the other telephone companies in Brazil and thus achieved a monopoly in providing public telecommunications services in almost all areas of the country. Beginning in 1995, the Brazilian government undertook a comprehensive reform of Brazils telecommunications regulatory system. In July 1997, Brazils Congress adopted the Brazilian General Telecommunications Law (Lei Geral de Telecomunicações, together with the regulations, decrees, orders and plans on telecommunications issued by Brazils executive branch, the Telecommunications Regulatory Framework), which provided for the establishment of a new regulatory framework introducing competition into the Brazilian telecommunications industry and promoting the privatization of Telebrás and its subsidiaries.
In January 1998, in preparation for the restructuring and privatization, Telebrás spun-off its mobile telecommunications operations from its existing integrated operations (fixed-line and mobile) into separate companies. In May 1998, Telebrás was restructured to form the New Holding Companies by means of a procedure under Brazilian corporate law called cisão, or split-up. Virtually all of the assets and liabilities of Telebrás were allocated to the New Holding Companies, including Telebráss interest in its operating subsidiaries.
The New Holding Companies consisted of:
TNL is one of the New Holding Companies. In the restructuring and privatization of Telebrás, TNL was allocated all the share capital held by Telebrás in the operating subsidiaries that provided fixed-line telecommunications service in Region I. In July 1998, the Brazilian government privatized Telebrás by selling all its voting shares in the New Holding Companies, including TNL, to private-sector buyers. The Brazilian governments shares in TNL, which amounted to approximately 52% of TNLs voting shares, were purchased by Consortium Telemar, a consortium comprising Construtora Andrade Gutierrez S.A., Inepar S.A Indústria e
Construções, Macal Investimentos e Participações Ltda., Fiago Participações S.A., Brasil Veículos Companhia de Seguros and Companhia de Seguros Aliança do Brasil. Consortium Telemar paid R$3.4 billion for the Brazilian governments shares of TNL.
All of the interest in TNL held by the members of Consortium Telemar was acquired by TmarPart, a closely-held Brazilian CVM reporting company, in July 1999, in exchange for cash, capital stock of TmarPart and the assumption of certain debts. The main purpose of TmarPart is to hold shares of TNL. For a discussion of the entities that own interests in TmarPart, see Item 7. Major shareholders and related party transactions TmarPart and Item 3. Key information Recent developments.
In November 1999, we implemented a restructuring plan as permitted under Brazilian Law No. 9532/97 in a manner that complied with Brazilian corporate law and CVM regulations, which resulted in the transfer from TmarPart to TNL of goodwill in the amount of R$2,465 million. This goodwill originally was recorded on the books of TmarPart in connection with the acquisition of TNL shares from Consortium Telemar. The restructuring plan enabled us to increase cash flow by allowing us to use tax credits generated by the amortization of the downstream merger goodwill. See Item 5. Operating and financial review and prospects Amortization of downstream merger goodwill.
Following its formation, TNL provided fixed-line telecommunications services through 16 separate operating subsidiaries which provided telecommunications services in the 16 states of Region I. In August 2001, we implemented a corporate reorganization, which resulted in the operating subsidiaries being merged into a single operating company called Telemar Norte Leste S.A., our operational telecommunications subsidiary.
On May 30, 2003, TNL sold to Tmar all of the shares of Oi held by TNL, representing 99.99% of the share capital of Oi. The aggregate sale price was fixed at R$1.00, which is equal to the net equity value of Oi at market price, on the base date of March 31, 2003, as determined by an independent fair value valuation procedure undertaken by an independent public accounting firm in accordance with Brazilian corporate law, adjusted to reflect Ois April 2003 results and the capitalization of Oi in the amount of R$562 million through the conversion of part of Ois debt held by TNL prior to the sale.
Since the sale price of R$1.00 was higher than Ois book value (based on Ois presented unsecured liabilities at April 30, 2003), and considering Tmars capitalization of R$600 million on May 30, 2003, Tmar recorded goodwill of R$500 million under Brazilian GAAP. For consolidation purposes, in accordance with Brazilian GAAP, this goodwill was eliminated with the resulting unrealized profit at TNL in connection with the sale.
We believe that the benefits resulting from the optimization of Tmars and Ois auxiliary and operating sectors, as well as from the alignment of the interests and commercial strategies of the two companies, resulted in a more rational use of sources available, with consequent reductions in costs and productivity gains and better use of synergies between the companies. For information on the lawsuits relating to the sale of Oi to Tmar, please see Information about TNL business Legal proceedings Sale of Oi to Tmar.
In August 2005, TNL consummated a spin-off to all its shareholders of its former contact center subsidiary, Contax Participações S.A., or Contax, which had been approved by TNLs shareholders at a shareholders meeting held on December 29, 2004. As the corporate approval for this spin-off was obtained in
2004, Contaxs financial statements ceased being consolidated into TNLs financial statements beginning in 2005. With the spin-off of Contax to TNLs shareholders, TNLs shareholders equity account was reduced by R$277 million, which was equivalent at the time to the value of Contax in TNLs books, as determined by an independent valuation report dated November 30, 2004 as required by Brazilian corporate law. With this spin-off, TmarPart became the controlling shareholder of Contax, and Contax became a sister company of TNL.
The purpose of the spin-off was twofold: (1) to allow the management of both companies to focus on their respective businesses and (2) to enable TNLs shareholders to realize the full value of these two businesses by allowing a separate, more objective valuation by the market of each business.
With the spin-off, shares and ADSs of Contax were distributed to the shareholders of TNL at the ratio of one share or ADS of Contax for each share or ADS of TNL, respectively. Contaxs shares trade on the BOVESPA while its ADSs trade on the U.S. over-the-counter market.
At the Extraordinary Shareholders Meetings held at Oi and Pegasus on November 30, 2005, the merger of Pegasus into Oi was approved by the respective shareholders of each company. This merger aims to take advantage of operational and financial synergies that exist between the two companies. The transaction was previously approved by Anatel.
HiCorp Comunicações Corporativas S.A., or HiCorp, has the corporate purpose of providing internet access to ISPs and e-marketplaces. HiCorp was merged into TNL, as provided for in a Protocol and Justification of Merger dated as of March 31, 2006, which was approved at a shareholders meeting of TNL held on April 28, 2006.
The following table sets forth our shareholding, direct or indirect, in each of our significant subsidiaries as of December 31, 2006 (no change has occurred since then). See Note 1 to the consolidated financial statements of TNL for more information on our other subsidiaries.
Tmar is a listed corporation (sociedade anônima) reporting to CVM and trading on BOVESPA. It is organized and incorporated in Brazil and controlled by TNL. Tmar has 16 local service and 16 domestic long-distance concessions under which it provides telecommunications services through a public-switched telephone network. Such services are described below in detail under Our operations Fixed-line services.
A large part of TNLs assets consist, directly or indirectly, of Tmars shares. TNL relies almost exclusively on distributions (in the form of dividends and interest on capital) from Tmar and interest on loans granted to its subsidiaries to meet its needs for cash, including the cash needed to pay dividends and interest on capital to its shareholders. See Item 5. Operating and financial review and prospects Liquidity and capital resources.
For approximately R$1.1 billion, TNL PCS S.A., or Oi, was the successful bidder in the public auction for a license to provide personal mobile telecommunications services (Serviço Móvel Pessoal), in Region I. This license utilizes a frequency band referred to as Band D. Oi began providing mobile services on June 26, 2002. In May 2003, the sale of all of TNLs shares in Oi to Tmar was consummated following the approval of the Board of Directors of both TNL and Tmar.
Companhia AIX de Participações S.A., or AIX, provides infrastructure services to Tmar and it is engaged in the supply of ductwork for the installation of fiber-optic cables along highways of the state of São Paulo.
Telemar Internet Ltda., or Telemar Internet, is an internet access provider, wholly-owned by Tmar, which started operations in February 2005 under the brand name Oi Internet. Oi Internet was formed as ABS 52 Participações, or ABS 52 and it was acquired by Tmar with the purpose of services of installation, maintenance and network construction.
Set forth below is our organizational chart, showing our principal subsidiaries as of December 31, 2006 (no change has occurred since then).
Our concessions and authorizations from the Brazilian government authorizes us to provide fixed-line, data and mobile telecommunications services in Region I, which consists of 16 states of Brazil located in the northeastern and part of the northern and southeastern regions of Brazil, excluding an area in the state of Minas Gerais where Companhia de Telecomunicações do Brasil Central, a company that was not part of Telebrás, continues to operate independently. The excluded area in Minas Gerais represents approximately 2.7% of total lines installed and 1.5% of the total population of Region I as of 2006. Region I covers an area of 5.4 million square kilometers, which represents approximately 64% of the countrys total area and generates approximately 41% of Brazils gross domestic product. The population of Region I is 101.5 million, which represents 54% of the total population of Brazil. As of 2004, Region I had 119 municipalities with populations in excess of 100,000 inhabitants. In 2004 (the last year for which official data is available), per capita income in Region I was approximately R$7,563 per year, varying from R$2,748 in the state of Maranhão to R$14,639 in the state of Rio de Janeiro.
The following table sets forth key economic data, compiled by the IBGE for the states in which Tmar operates.
Set forth below is a map of Region I, which is covered by Tmars fixed-line concession:
Our business, financial condition, results of operations and prospects depend in part on the performance of the Brazilian economy and the economy of Region I in particular. See Item 3. Key information Risk factors Risks relating to Brazil.
Our telecommunications services consist of:
Local services include installation, monthly subscription, measured service, collect calls and supplemental local services. Measured service includes local calls that originate and terminate within a single local area. Until February 1999, we were the only authorized company allowed to provide local fixed-line and intrastate telecommunications services in Region I. In February 1999, Anatel, pursuant to the Brazilian Telecommunications Regulations, awarded Vésper S.A. an operating license to provide local fixed-line and intraregional long-distance telecommunications services in Region I. In 2002, the market was open to all telecommunications providers. Embratel has also been selling lines under a local fixed-line project since 2002, pursuant to an authorization granted by Anatel on August 9, 2002. Both these companies are controlled by Telmex, the leading telecommunications provider in Mexico. As of December 31, 2006, Embratel and Vésper had an approximate 7.2% market share of the local services market in Region I. See Competition.
Local services also include in-dialing service (direct transmission of external calls to extensions) to corporate clients. For corporate clients in need of a large quantity of lines, we offer digital trunk services, which optimize and increase the speed of the clients telephone system.
On August 7, 2002, as a result of our early satisfaction of Anatels universal service targets from December 2003 to December 2001, Anatel provided Tmar with an authorization to provide local services in Region II and Region III. Although we continue to assess our strategic plans with regard to providing such services, given the investment costs to reach customers in such regions, we do not plan to focus our efforts in offering local services to residential customers in Region II and Region III at this time.
Each state in Region I is divided into a number of local areas. Calls from one local area in Region I to another are referred to as intraregional long-distance calls. Intraregional long-distance services include intrastate long-distance calls (non-local calls within a given state) and interstate long-distance calls (calls between states within Region I). Prior to the formation of the New Holding Companies in 1998, fixed-line
operating subsidiaries within each state were the exclusive providers of intrastate long-distance service in each state. At that time, Embratel was the exclusive provider of interstate long-distance service and was not authorized to provide intrastate long-distance service. However, Anatel implemented a numbering plan to promote competition among providers of fixed-line long-distance services by requiring that the caller choose, for each long-distance call, their preferred long-distance carrier by dialing such carriers respective long-distance Carrier Selection Code, which for Tmar is 31. In July 1999, in conjunction with the implementation of the numbering plan, Embratel began providing intrastate long-distance services throughout Brazil, including within the states contained in Region I, and we began providing interstate long-distance services between the states in this region. On June 7, 2004, Anatel released new rules redefining the number of local areas for fixed-line calls in Brazil. According to these rules, which reduce the number of local areas in Brazil, certain long-distance calls between neighboring areas started being charged as local calls. In Region I, the number of local areas was reduced from 4,289 to 2,920. Since Tmar had anticipated the consequences of these new rules, Tmar has been rebalancing its rates for long-distance calls between neighboring areas to a level close to the rates charged on local calls. For a discussion of the Numbering Plan, see Competition Long-distance.
Our interregional long-distance services consist primarily of calls between a location within Region I and a location in Region II or Region III. International long-distance services consist primarily of calls between a location within Region I and a location outside Brazil.
In July 2002, upon meeting certain universal service targets in the second quarter of 2002, Tmar acquired the right to provide interregional long-distance services originating from Region I. For that purpose, we entered into interconnection agreements, mainly with Telesp (Region III) and Brasil Telecom (Region II), to interconnect directly with their networks.
In addition, we started to provide international long-distance services originating from Region I in July 2002 using the mobile telecommunications services license granted to Oi. Our fixed-line customers access these services through the use of Carrier Selection Code 31, our long-distance Carrier Selection Code. For that purpose, we entered into several international agreements to interconnect our network with those of the main telecommunications services providers worldwide.
Since February 2003 we have offered fixed-line interregional and international long-distance services originating in Region II and Region III using the same mobile telecommunications services license granted to Oi. The license acquired by Oi includes an authorization to provide mobile telecommunications services in Region I.
At the end of 2006, Oi requested that Anatel transfer to Tmar its authorizations to provide domestic fixed-line services in Regions II and III and international services in all regions. The request has been approved by Anatel and we are awaiting the enactment and publication of the terms for its implementation.
Long distance carriers and mobile operators may avoid paying long distance network usage to Tmar by establishing a presence in direct interconnection routes with Tmars last mile network. In order to protect its network usage services, in 2002 Tmar created a new type of long-distance usage service, called National Transportation, which established a competitive alternative to flat long-distance network usage fees as a result of discounts based on the volume of traffic and geographic distribution.
Also in 2002, Tmar started to offer international operators the option to terminate their Brazilian inbound traffic through our network, as an alternative to Embratel and Intelig. We charge international carriers a per minute rate, base on terminal type (fixed or mobile) and local area destination, on a nationwide basis.
The general rules for interconnection are set forth in the General Interconnection Regulation approved by Anatel. All the telecommunications service providers must make their networks available for interconnection,
as much as technically feasible, without discriminating and whenever requested by another telecommunications service provider.
Anatel sets the interconnection rates for the fixed-line network, however, in July 2004, a specific regulation established that mobile interconnection rates should be freely negotiable. Brazilian telecommunications laws and regulations also establish that if new interconnection rates for mobile operators are not agreed among the telecommunications service providers, Anatel is empowered to arbitrate, at its discretion, the interconnection rates that mobile telecommunications companies may charge.
Tmar, as the incumbent operator of the Public-Switched Telephone Network, which provides local services within Region I, is authorized to charge local network usage on a per-minute basis, or TU-RL, for all local and long-distance calls (national and international) originated or terminated on its fixed-line network. In accordance with the 2006 Concession Agreement, the TU-RL will eventually be lowered to the international benchmark which is around US$0.01; on January 1, 2006, the TU-RL was reduced by 50%, and was again reduced by another 40% on January 1, 2007. The TU-RL currently set by Anatel is R$0.026. The TU-RL will be recalculated using a cost methodology (Long Run Incremental Costs LRIC) in 2008 or 2009, as set forth in the 2006 Concession Agreement. Companies holding an authorization may charge an interconnection fee 20% higher than the incumbent companies.
Due to Tmars incumbent position in local fixed-line services in Region I, we are the leader in the network usage services market of this region. Similarly, Tmar also charges network usage on a per-minute basis for local and long-distance calls originated by mobile phones, in addition to Personal and Specialized Mobile Services, terminated on Tmars fixed-line network.
Tmar also charges long-distance network usage for all national and international long-distance calls that are: (1) terminated on Tmars network and delivered by a long-distance carrier for completion in a local area that is different from the final destination of the call, or (2) originated on Tmars network and captured for completion by other long-distance carriers in a different local area from where the call originated.
Ois mobile telecommunications services network is directly interconnected to the national and international long-distance networks of all companies operating in Region I and all mobile operators of Bands A, B and E in Region I, and Band D in Regions II and III, thus providing its customers with automatic access to roaming services when traveling to Brazilian areas where mobile telecommunications services are available on GSM technology. For the most part, revenues arising from the growth in the prepaid service customer base consist of interconnection fees charged per minute, when customers of other fixed-line or mobile operators use the mobile network to complete a call to Ois customers in Region I, or to originate long-distance calls using the Carrier Selection Code of another provider.
As of December 31, 2006, Oi had a presence in some 824 municipalities in the 16 states of Region I. As of December 31, 2006 , Oi had approximately 13.1 million subscribers. According to Anatels estimates, Oi had a market share of 27.4% in Region I, and the penetration rate of mobile telecommunications services in the total population of our region was 46.8%. Revenues from mobile telecommunications services arise from (1) usage fees for outgoing and collect calls made and value-added services such as access to the internet, data transmission, short messages, call forwarding, call waiting and call blocking; (2) monthly subscriptions; (3) roaming; (4) interconnection fees received from other mobile operators for calls that use our network; and (5) sales of handsets. As of December 31, 2006, the customer base of Oi was divided into approximately 82% prepaid and 18% postpaid plans. Postpaid plans include mailbox, caller ID, conference, follow-me, calls on hold and special services, depending on the type of handset, such as Wireless Application Protocol (a protocol which simplifies standard internet codes for the more limited transmission features of a mobile handset), General Packet Radio Service (providing speeds in the range of 115 kilobytes per second (Kbps)), and Enhanced Data Rates for GSM Evolution EDGE, which allows speed in the range of 230 Kbps.
Postpaid service customers pay a monthly subscription fee and are billed on a monthly basis for services provided during the previous month, while prepaid plan customers buy cards whose price varies according to
the amount of minutes available. Such cards are valid for a stated period of time following activation, and now contain a converging feature, called Oi Cartão Total (Oi Total Card).
Oi Cartão Total is an innovative service that integrates mobile, fixed, and public telephony through a single card. Particularly focused on Oi prepaid clients and on public telephone users, the Oi Cartão Total allows these clients to use their available credits to make any type of call from mobile, fixed or public telephones. Oi Cartão Total represents a big step towards converging our telecommunications services and satisfies the needs of a common profile of our prepaid clients who use the cell phone to receive calls and the public telephone to make calls. Aggressive offers have been made with the purpose of promoting and stimulating the use of the Oi Cartão Total. We have also developed the following services and/or applications:
Following this new concept of prepaid packages, we have developed new sales channels with the purpose of increasing penetration and reducing sales costs, including selling cards in small retail shops (newsstands, drugstores, supermarkets, among others). Currently, the stand-alone chip accounts for more than 90% of prepaid sales, which eliminates the need to subsidize the handset. Over 30% of these sales occur in small retail shops.
Mobile telecommunications services in Brazil are offered on a calling-party-pays basis, under which subscribers pay only for calls that they originate, in addition to possible roaming charges.
The amounts vary according to the subscribers service plan, and the call origin, destination and length. Subscribers pay for at least 30 seconds, even if the call lasts for less than that. After the first 30 seconds of the call, users are billed for every additional six seconds. Under Ois postpaid plans, customers pay subscription fees (which include certain usage minutes) in addition to usage fees. During 2006, monthly subscription fees accounted for 29.3% of mobile service revenues, excluding handset sales.
Depending on the handset model, customers have access to General Packet Radio Service and EDGE services available in the main cities of Region I. These services allow for mobile access to the internet through mobile telephones, laptops or personal digital assistants. They also enable customers simultaneously to use voice and data services, because the connection to the internet remains active even when the customer is speaking on the phone. This means that the customer can remain continuously online and, at the same time, place or receive calls.
The Wireless Application Protocol portal is a service and contents channel available to our customers. Some of its features include: sending and receiving e-mails, forming contact groups, accessing banks and buying tickets. The Wireless Application Protocol portal can also be used on the internet, for instance, to schedule personal activities and join or initiate contact groups.
We also receive revenues from roaming agreements with other local and international mobile telephone providers. When a subscriber to another mobile service provider originates a call within Region I, the other mobile service provider pays us the applicable roaming rate.
We own and operate public telephones throughout Region I. As of December 31, 2006, we had 577 thousand public telephones in service, all of which are operated by a prepaid card. For a discussion of how we account for the sale of the prepaid cards, see Item 5. Operating and financial review and prospects Critical accounting policies and estimates Revenue recognition and accounts receivable.
We provide a variety of customized, high-speed data transmission services to our customers. Our data transmission services include interconnectivity between local area networks at data transmission speeds of
34Mbps and 155Mbps, videoconferencing, video/image transmission and multimedia applications. We lease dedicated lines to other telecommunications service providers, ISPs and corporate customers. Other telecommunications service providers, particularly mobile service providers and ISPs, lease trunk lines from us for use within their stand-alone networks, also known as Internet Protocol Solutions, or IP Solutions, and many of our large corporate customers lease lines for use in private networks that link different corporate websites. We also provide large scale IP Solutions (dedicated, dial-up and broadband) to most of the leading ISPs in Brazil. We offer high-speed internet service and other data transmission services using ADSL technology to residential customers, as well as small and medium-sized business customers.
We provide these data transmission services using a service network platform in our region and our nationwide fiber-optic and radio network.
We expect the internet service market to be a priority for our future expansion as competition from cable operators and other telecommunications service providers increases. Tmar holds agreements for the joint provisioning of international data services with several relevant international carriers. These international alliances will further enhance our strategy of offering bundled telecommunications services to Brazilian customers. We provide broadband internet access services using ISDN and ADSL technology in the primary cities in Region I. We began offering ISDN lines to residential customers in January 2000 and began offering ADSL subscriptions to small and medium-sized business customers in April 2001. As of December 31, 2006, we had sold 82,120 ISDN and 1,128 thousand ADSL subscriptions.
The ADSL technology allows high-speed transmission of voice and data signals on a single copper wire pair for access to the network. In 2002, Tmar began offering an ADSL broadband product allowing high-speed internet service under the brand name Oi Velox, targeting the residential market. Since voice transmission through telephone lines uses only one of many available frequency bands, the remaining frequency bands are available for data transmission. An ADSL modem is installed using the customers conventional line, which, in turn, is connected to certain DSLAM (Digital Subscriber Line Access Multiplexer) equipment at the switching station. As a result, customers can use the telephone line simultaneously with the internet. Customers pay a rental rate for the modem equipment and a fixed monthly subscription fee, irrespective of their actual connection time to the internet.
Rates for fixed-line telecommunications services are subject to comprehensive regulation. The 2006 Concession Agreement established a price-cap for Tmar services, adjusted on an annual basis and based on inflation and productivity gains. The basket of services covered by the maximum rate includes local and long-distance calls and interconnection fees, including installation fees, subscription fees, and domestic, international and public telephone measured services. The price-cap is based on the weighted average rate of the rates included in the basket. The rates for individual services within the basket may be increased by up to 9% above the limit established by the 2006 Concession Agreement, so long as the weighted average rate for the entire basket does not exceed such limit.
Our revenues from local services consist principally of monthly subscription charges, measured service charges and installation charges. Monthly subscription charges are fixed amounts charged in connection with the use of fixed-line services. The charges vary depending on whether the use is residential, commercial or trunks. As established in the 2006 Concession Agreement, as of March 2006, the monthly subscription charge includes the use of 200 minutes per month for residential users and 150 minutes for nonresidential users and trunks. If those limits are exceeded, customers will incur additional measured-minute charges. If a customer does not use all of the minutes covered by the fixed charge in a month, the minutes cannot be carried over to the next month and will be lose. The monthly subscription charges vary in accordance with the subscribers profile, as defined in the applicable regulation.
The calculation of rates is based on the period of use; the rate unit is a tenth of a minute (six seconds), rounding permitted for the tenth minute immediately above. There is a Minimum Rate Period (TTM) of
30 (thirty) seconds and an Incoming Call Rate (TCA), where cost is based on the application of an Amount per Incoming Call (VCA). For calls made during period in which this rate is in effect (Monday to Friday, from midnight to 6 am; Saturdays, from midnight to 6 am and from 2 pm to midnight; and Sundays and Brazilian holidays, from midnight to midnight), the caller is charged 2 (two) minutes regardless of the duration of the call. Calls of 3 (three) seconds or less are not charged, except in certain specific instances as provided for in the regulation.
Tmar must changeover its rates from pulse to minute on a gradual basis, from March 1 to July 31, 2007. In the locations where Tmar will not implement the minute-based rates due to technical or economic unfeasibility, Tmar will not be allowed to charge additional fees for local calls made to another fixed telephone and will instead be limited to the basic monthly subscription fees.
Mobile telecommunications service in Brazil, unlike in the United States, is offered on a calling-party-pays basis under which subscribers pay only for calls that they originate (in addition to roaming charges paid on calls made or received outside the subscribers home registration area). Under the calling-party-pays policy, a mobile service subscriber generally pays mobile usage charges only for calls made by the mobile service subscriber and not for calls received. Aside from the calling-party-pays system, there is also the possibility of making collect calls, in which the party receiving the call will pay. Calls received by a mobile service subscriber are paid for by the party that places the call, in accordance with a rate based on mobile per-minute charges. We charge per-minute charges based on either VC1 (local), VC2 (intrastate) or VC3 (interstate) rates when a fixed-line service customer calls a mobile subscriber within Region I. In turn, we pay the mobile service provider a charge for the use of the mobile network in completing the call.
Effective July 15, 2005, upon authorization received from Anatel, we increased our local fixed-to-mobile service (VC1) rates by an average of 7.99%. We did not increase our VC2 and VC3 rates in 2005.
The following table sets forth the average per-minute rates that we charged for fixed-to-mobile services during the years indicated.
Rates for intraregional and interregional long-distance calls (intrastate as well as interstate) are computed on the basis of the time of day, day of the week, as well as duration and distance of the call and vary depending on whether special services, such as operator assistance, are used. The following table sets forth selected information on our domestic long-distance rates during the periods indicated.
Our revenues from network usage rates consist primarily of payments on a per-minute basis from:
The network usage rate varies depending on whether the telecommunications service provider uses our local or long-distance network. We pay other telecommunications service providers a network usage charge for the use of their networks.
The following table sets forth the average per-minute rates we charged for the use of our fixed-line network during the years indicated.
With respect to Oi, we charge the service provider on whose network the call originated a rate per each minute of usage of our mobile network. On July 15, 2005, Anatel authorized a rate adjustment increasing the mobile network usage rate for VC1 calls by 4.5%, to R$0.3897 per minute, net of taxes. There was no rate adjustment for VC2 and VC3 calls in 2005, and the mobile network usage rate was maintained at R$0.3729 per minute, net of taxes.
On March 23, 2006, Anatel approved a rate adjustment of 7.99% for long distance calls between fixed and mobile phones (VC2 and VC3). Anatel also approved a 4.5% increase in the mobile network usage rate (interconnection fees charged per minute) relative to these calls.
Since 2006, Anatel has been using a specific rate adjustment index based on a rate basket for telecommunication services, referred to as the IST index. The IST index allows for a greater balance in the evolution of the prices charged from retail and wholesale subscribers than the former inflation rate used in the telecommunications industry, the IGP-DI, which is more focused on the evolution of wholesale prices.
The 2006 Concession Agreement sets forth the general guidelines for the adjustment of rates in 2006, based on the following factors:
On July 10, 2006, Anatel authorized an adjustment in the rates based on the variation of the IGP-DI (May/2005 to December/2005, when the previous Concession Agreement was still in effect) and of the new IST Index (December/2005 to May/2006) in connection with local, long-distance and network use services. The discount factor was applied on this accumulated variation based on the productivity (weighted average of the amounts set forth in the previous agreement and of the X Factor arising out of the calculation of the industry companies factors) in the percentage of 1.13% for local and 3.46% for long-distance services. The adjustment resulted in average reductions of 0.51% for local and 2.86% for long-distance domestic services.
The following table sets forth the adjustments in the rates of a number of services approved by Anatel in 2006.
Rates in the data transmission segments to final costumers are market-driven and outside Anatels usual public regime regulatory purview. In 2005, Anatel published Normative Nr. 50,065 containing reference amounts for the provision of data transmission services to other telecommunication service providers to be used in the event of lack of agreements between the providers of this service. It is not possible to estimate how such reference amounts will affect our revenues. See Competition - Data Transmission Services.
The majority of revenues from data transmission services are generated by monthly line rental charges for private leased circuits to corporate customers, internet service providers and other telecommunications service providers. These revenues are based on contractual arrangements for use of part of our network. Other telecommunications service providers, such as providers of trucking and paging services, may use our network to connect a central switching station to our network. Some mobile service providers use our network to connect mobile central switching stations to mobile radio base stations. We also lease transmission lines, certain infrastructure and other equipment to other providers of telecommunications services. The balance of such revenues consists mainly of charges for access to the data transmission network and measured service charges based on the amount of data transmitted.
Mobile telecommunications service providers are authorized to establish rates for their mobile telecommunications services, provided that offers are part of a service plan approved by Anatel. Providers must offer their users a basic service plan, or Basic Service Plan. Providers also may offer non-discriminatory alternative plans to the Basic Service Plan. Although subscribers of a plan cannot be forced to migrate to new plans, existing plans may be discontinued as long as all subscribers receive a notice to that effect and migrate to new plans within six months.
The following table sets forth the average per minute rates we charged for prepaid and postpaid plans during the years indicated below.
The cost of telecommunications services to the client includes several taxes and contributions. The rates we charge our clients include the remuneration for our services and state and federal taxes and contributions. The average rate of all these taxes and contributions, as a percentage of the consolidated gross operating revenue, was 27.8% in 2005. The primary tax on telecommunications is the value-added tax (Imposto sobre a Circulação de Mercadorias e Serviços, or ICMS), assessed by states at varying rates. The ICMS rate is set at 25% on average, except in the states of Rondônia (35%), Mato Grosso, Pará, Paraíba and Rio de Janeiro (30%), Goiás and Rio Grande do Sul (29%), Pernambuco (28%) and Alagoas, Bahia, Ceará, Mato Grosso do Sul, Paraná, Rio Grande do Norte and Sergipe (27%). In June 1998, the State Secretaries of Treasury (Secretarias da Fazenda Estadual) approved an interpretation agreement charging ICMS on certain services other than telecommunications, which included the installation and the monthly subscription fees which were until then exempted from such taxes.
Telecommunications services revenues also take into account two federal contributions levied on gross operating revenue at a combined rate of 3.65%: the Program for Social Integration (Programa de Integração Social, or PIS), and the Contribution for Financing of Social Security (Contribuição para Financiamento da Seguridade Social, or Cofins). However, revenues from sales of mobile handsets and other revenues, aside from telecommunications services, are subject to PIS and Cofins at a combined rate of 9.25%.
Tmar sends each customer a monthly bill covering all the services provided during the prior period. Customers are grouped in billing cycles based on the date their bills are issued. The telephone bill separately itemizes local calls, long-distance calls, calls terminating on a mobile network, toll free services and other services such as call waiting, voicemail and call forwarding. With respect to the settlement of our telephone bills, we have agreements with several banks and other vendors such as drugstores, lottery houses and government bureaus that agree to receive and process payments from our customers on our behalf.
Payments are due within an average of 13 days of the billing date. We charge late-payment interest at a rate of 1% per month plus a one-time late charge of 2% of the amount outstanding. At December 31, 2006, 10.2% (9.7% in 2005) of all accounts receivable were outstanding for more than 30 days, and 5.0% (4.6% in 2005) were outstanding for more than 90 days. In line with rules established by Anatel, we may restrict a customer from making outgoing calls when an account is over 31 days past due, restrict a customer from receiving incoming calls when an account is over 61 days past due and completely disconnect a customer when an account is over 91 days past due, provided a 15-day warning has been issued to such customer in every step of the restriction process. The disconnection process thus comprises several stages, including customers notification regarding the referral of their situation to credit bureaus, until the line can be ultimately disconnected due to non-payment. The collection system used by Tmar enables it to access delinquent subscribers in accordance with their payment profile. This profile may take into consideration, without limitation, the length of subscription, the outstanding balance of the bill and the longest payment delays. The notices range from voice messages to active calls for negotiation with the client.
Tmar is remunerated by other telecommunications operators for each call originating from the network of another provider, regardless if from a fixed or mobile telephone network, and routed through Tmars network. The payments for the use of our fixed network in connection with local calls originating from other fixed telephone providers are only billed and due from the balance of traffic exceeding 45%-55% between the interconnection operators.
The long-distance providers pay an interconnection fee for each call to which revenue they are entitled, regardless if such call is originated from, or ends in, our network. We have billing agreements with the long-distance providers, so that when a long-distance call carried by another telecommunications provider is originated on our network, we bill that providers customer, retain any access fee for use of our network and transfer the balance to such providers.
Oi bills its mobile postpaid customers on a monthly basis and itemizes charges in the same manner as Tmar bills its fixed-line customers. See Fixed-line services. In addition, the monthly bills also provide details regarding minutes used and national and international roaming charges. The payments are due, on average, up to 13 days after the billing date. We charge a fee for each late payment of 1% per month plus a one-time late charge of 2% of the amount outstanding. As of December 31, 2006, 7.8% (9.6% in 2005) of all accounts receivable were outstanding for more than 30 days, and 3.7% (4.4% in 2005) were outstanding for more than 90 days.
The collection policy adopted by Oi, following rules established by Anatel, provides that when a bill is more than 15 days overdue and the customer takes no action after receiving notification requesting payment, services will be partially suspended until full payment of all amounts due is received. The policy also states that all incoming and outgoing calls will be restricted when bills are more than 45 days overdue. Services will be cancelled when bills are more than 75 days overdue, and in this event, the subscribers name will be recorded by credit bureaus until such time as the subscriber negotiates the outstanding debt. The collection system used by Oi allows for accessing delinquent subscribers according to their payment profile. Such profile can take into account, among other things, the length of the subscription, bill amount and greatest delays. Oi has also implemented an information tool to assist with bill management, designed to warn subscribers of high outstanding amounts due and unpaid. Warnings range from text messages to educational calls to the customer, including active contacts with debt renegotiation proposals.
Oi is remunerated by other providers for each call originating from another providers network, regardless if from fixed or mobile telephone networks, and routed through Tmars network.
The most important is the remuneration it receives from Tmar, which derives from fixed-to-mobile calls originated on Tmars network and terminated on Ois network. These revenues and costs, for Oi and Tmar respectively, are eliminated in our consolidated results.
Until June 2006, the payments due for the use of our mobile network in connection with local calls originated from other mobile telephone providers were only billed and due from the balance of traffic exceeding 45%-55% between the interconnection operators. Since July 2006, the full billing system has been adopted, where the payments and receipts are made considering the local traffic.
Our fixed-line network includes installed lines and exchanges, a network of access lines connecting customers to exchanges, trunk lines connecting exchanges and long-distance transmission equipment. As of December 31, 2006, the access network connected approximately 14.4 million fixed-telephone lines and
1,128 thousand installed ADSL. ADSL is already present in 222 localities. Our fixed-line installed network increased by 107 thousand lines during 2006, and total lines in service decreased by approximately 460 thousand as a result of: (1) several measures taken during 2006 to optimize investments made; (2) the disconnection of analog terminals in order to reduce network maintenance costs; and (3) customer migration to mobile and broadband networks.
Our public-switched telephone network is almost fully digitalized and, as of December 31, 2006, connected homes and businesses in 9,697 cities, towns and villages to 20 thousand digital telephone switches and concentrators across our coverage area. As of December 31, 2006, another 11,209 villages were served by public telephones. Our transmission infrastructure connects these digital switches to two international gateway switches. Additionally, our network supports advanced services, including prepaid and toll-free products.
The following table sets forth selected information about our fixed-line network at the dates and for the years indicated.
As of the privatization of Telebrás, our long-distance network consisted primarily of the transmission resources that the 16 operating subsidiaries used to support intrastate transmission. During 2000, in order to provide interstate long-distance service between the states in Region I, we began to integrate the intrastate transmission networks of Tmar by investing in a national network. The deployment and expansion of the interstate backbone required an investment of R$954 million and involved the installation of 21 thousand km of new fiber-optic cables connecting the major capitals and large cities located in Region I. The network of fiber-optic cables permitted the reduction of the bit/cost of providing service, the increase of the traffic and the increase of the services reliability and the provision of broadband services in the long-distance network.
Our long-distance network is one of the most modern in Latin America. It has an initial capacity of 30 gigabytes per second (Gbps) and is equipped with a control system that guarantees a high level of availability and flexibility for configuration and provisioning. This transmission infrastructure has the capacity to accommodate customers demand for long-distance, internet and data transmission services and other telecommunications providers demand for transmission facilities.
We have deployed an expanded range of satellite-based services to continue our commitment to the rural and remote areas of northern Brazil, including the Amazon rainforest region. These satellite services may include internet access and access to corporate data applications. Hispamar Ltda., a Spanish-Brazilian consortium created in November 1999 by Hispasat (the leading satellite telecommunications provider in the Iberian Peninsula), and Tmar invested nearly R$1.0 billion in the construction of the Amazonas satellite, which was manufactured by Astrium (EADS Space Company). The Amazonas satellite was launched into geostationary orbit over the Americas and started to operate in November 2004. The launch of the Amazonas satellite has put Hispamar into direct competition for satellite services with StarOne, a subsidiary of Embratel.
The Amazonas satellite provides both C and Ku bands and on-board switching. Tmar entered into an agreement with Hispamar in December 2002 which granted and transferred to Hispamar the rights to exploit geostationary orbital position 61 W, C band. The price assigned to the orbital position was set at R$29 million according to an independent appraisal. In December 2002, Tmar obtained a minor shareholding stake in Hispamar.
In 2000, we began implementation of the land-based segment of a satellite network in order to extend transmission to remote areas in the states of Pará, Amazonas, Amapá and Roraima, as well as to other areas with limited access due to geographical conditions. The satellite network comprises satellite earth stations located in lesser-populated rural areas, as well as hub stations in the cities of Manaus, Boa Vista, Macapá, Belém, Salvador and Rio de Janeiro. This satellite network uses digital technology and began operating in August 2000. The optical and satellite backbones are interconnected in Belém, Fortaleza, Salvador and Rio de Janeiro (located in the states of Pará, Ceará, Bahia and Rio de Janeiro, respectively). The integration of this land-based segment of the satellite network allows us to service our subscribers in any area in Region I, enabling us to integrate customers into our multi-service platform.
Until December 2001, we had 10 network management structures. From January through April 2002, a national network operations center was completed in Rio de Janeiro to centralize Tmars network remote monitoring activities. Network operating and configuration platforms, located at our network operations center in Rio de Janeiro, perform failure monitoring, database and configuration management, security management, performance analysis for the entire network.
Our Asynchronous Transfer Mode ATM network with its fully integrated management system provides:
These features allow our integrated Asynchronous Transfer Mode network to service each of the different types of data applications used by our customers. Asynchronous Transfer Mode is essentially a technology that converts existing twisted-pair telephone lines into access paths for high-speed communications.
We were the first telecommunications company in Latin America to implement Metro Ethernet technology for high speed internet access. This is one of the latest technologies in the data transmission industry. With the implementation of this technology, we are now able to offer IP TV, a television service that is based on broadband internet access.
Our dial-up IP platform supports dial-up access from the public-switched telephone networks.
We operate an internet backbone network and a fully IP-routed network, which provides a backbone for all internet dedicated and dial-up services and virtual private network offerings. Our internet backbone connects to the public internet via international links that we maintain abroad. With these international links, we do not need to rely on other companies to connect our outbound internet traffic with the internet backbones of international ISPs.
Our broadband network uses ADSL as a broadband access technology using existing PSTN access infrastructure with speeds of up to 8Mbps (download) and 512Kbps (upload). We have three broadband service options available to customers in ADSL-enabled areas:
As of December 31, 2006, Ois mobile network covered 852 municipalities, over 78.9% of the urban population in Region I, consisting of 4,498 active radio base stations. Ois network is directly interconnected to the national and international long-distance fixed-line telephone networks of the companies operating in Region I and all mobile operators of Band A, B, C and E in Region I. In Regions II and III, we have roaming agreements with several GSM mobile operators, thus providing our customers with automatic access to roaming services when traveling in Brazilian areas where mobile telecommunications services are available on GSM technology. Most interconnections between our switching stations and the fixed and mobile telephone networks and the connections linking our radio base stations and switching stations are made through resources leased from Tmar. Nokia, Siemens, Alcatel and Huawei are the suppliers of our network equipment.
We have made significant investments in modernizing the network, replacing analog switches with digital switches, increasing the supply and quality of services provided to the clients, as well as reducing maintenance costs. Since 1997, all new lines that we installed have been connected to digital exchanges. As of December 31, 2005, all of our installed lines were connected to digital switching centers. Compared to the older analog technology, digital systems improve the quality and efficiency of the network, accommodate higher traffic levels, require less maintenance and permit us to offer a broad range of value-added services, such as voice, text and data applications.
In 2002, we also established our network operations center located in Rio de Janeiro to improve network monitoring and quality of our services.
We must also comply with the provisions of the General Plan on Quality Goals and with the terms of our Concession Agreement 2006. See Regulation of the Brazilian telecommunications industry Quality of services General Plan on Quality Goals.
Our efforts in relation to competition are focused in ensuring that we maintain our position as the leading telecommunications company in the region where we are the incumbent carrier, namely Region I. This means that we are always closely monitoring the demand for telecommunications services of the customers in Region I, as well as the strategies and results of our competitors in this region.
The implementation of the Brazilian Telecommunications Regulations brought dramatic changes in the marketplace for Brazilian telecommunications services as of 1999. In general, the increasingly competitive marketplace has resulted in a decrease in prices, in real terms, for telecommunications services driven by increasing competition, implementation of new technologies and regulatory oversight. Until 1999, we were the only authorized supplier of fixed-line and intrastate telecommunications services in Region I. Since then, a series of competitors have come to our region to provide fixed-line, mobile, long distance and data transmission services.
The increased interest of foreign players in the Brazilian telecommunications market is also expected to strengthen competition for these services in Region I. Of these foreign players, Telmex has arisen as a strong competitor, as evidenced by: (1) their entry in the Brazilian long-distance market through the purchase of Embratel in 2004, which strengthened Embratels financial position by means of a capital increase and debt refinancing; (2) their affiliation with Telecom Americas, which holds investments in the mobile telephone market through the brand name Claro, which reached the second and third position in Brazils mobile
telecommunications market in December 2004 and March 2005, respectively; and (3) their investment in cable and broadband through the acquisition of a stake in the Brazilian cable and broadband operator, Net Serviços de Comunicação S.A., or Net, a subsidiary of Organizações Globo, one of the largest media conglomerates in Latin America. Telmexs investment in Net will allow this company to be more aggressive in broadband investments and acquisition policies. The potential synergies between Telmexs telecommunications activities and media investments in Region I can be expected to increase competition in this region, especially in the corporate and long-distance markets. Moreover, Telmex may increase its stake in Net pending approval of a bill under the review of the Brazilian Congress, which if passed, would allow foreign players to control media companies.
In March, 2007, the Number Portability Rules (Regulamento de Portabilidade Numérica), or Normative 460, were enacted. Pursuant to Normative 460, users can keep their telephone number when changing: (i) fixed-line providers; (ii) mobile providers; (iii) toll free numbers (0800); and, (iv) address . Telephone providers will have 24 months to implement and make this service available to their customers. Although number portability may negatively affect our fixed-line business, we believe our mobile business, Oi, will benefit from number portability since Oi was the third company to offer mobile services in its region and there is a resistance from the first users (usually high-end clients) to change their telephone numbers.
On April 28, 2007, a consortium led by Telefónica announced the acquisition of a controlling stake in Telecom Italia, the controlling shareholder of TIM. Telefónica has announced that the two companies (Telefónica and Telecom Italia) will be managed separately and independently but this consolidation may increase the competition for us in the mobile services.
Finally, new technologies that serve as substitutes for the telecommunications services we provide also affect our competitiveness. We also watch closely the evolution of these technologies and the impact that they exercise in the competition for the telecommunications services we offer. Technological barriers between video and voice services are increasingly lower. However, fixed incumbents in Brazil still have to overcome regulatory barriers to be able to offer video services, other than under very specific circumstances. This fact may delay the offering by fixed concessionaires of triple and quadruple-play offers.
In February 1999, Vésper was granted the authorization to provide local, intra-regional and long-distance fixed-line services in competition with Tmar, upon payment of R$60 million to the Brazilian government. Vésper also received permission from Anatel to implement a network expansion plan. In order to allow for effective competition in the local fixed-line service, Anatel authorized the use of the Wireless Local Loop Technology, which permits the installation of fixed-telephones without the use of telephone cables, expediting installation and the expansion procedures, as well as reaching remote areas where the access to cable is limited or unfeasible. Vésper began its operations in January 2000, in the major cities of Region I, including the 16 capitals of the states that comprise the region. We believe that as of December 31, 2006, Vésper had 600 thousand local lines in service in Region I.
In 2002, Embratel and Telesp obtained authorization to provide local telephone services in Region I. In December 2003, Embratel concluded the acquisition of Vésper. With the acquisition of Vésper, Embratel, which has been previously focusing on the corporate segment for local services, started to use Véspers penetration in residential markets as a mean to increase revenues in those segments.
In January 2004, Brasil Telecom was certified by Anatel in connection with the universalization goals and was authorized to provide local telephone services in Region I. However, it has not yet begun to operate in Region I.
Since 2002, any company can offer fixed-line telecommunication services in a private regime. There are several small local fixed-line service providers in each region, providing fixed-line local, national and international long-distance services.
Also, in order to stimulate competition in local telephone services, Anatel imposed the unbundling of the providers network, allowing other companies to offer services using Tmars local platform. On May 12, 2004,
Anatel established certain terms and conditions to be followed for making Tmars local access network available to competitors. The two types defined by Anatel were line sharing and full unbundling. Line sharing is the sharing of the infrastructure of access to customers between the fixed telecommunications company, which continues providing local services through that infrastructure, and another company that will use it to provide broadband services through ADSL. Full bundling is the lease of the infrastructure to other companies, in which case the leased network infrastructure is fully dedicated to such other companies. However, no company has shown interest in using these services.
Although there has been some competition for local services in Region I from the companies controlled by Telmex, we do not expect to face major threats from our local services competitors in this region, except for very specific cases. So far the competition trend in this segment has been low, in a manner that fixed concessionaires tend to lead the local service market within the region where they have been originally authorized to operate. An exception is fixed-line services for the corporate segment where competition is expected to increase.
The main source of competition in the local service market does not come from competing local service providers but from mobile services. At the end of 2006 there were 47.7 million mobile subscribers in Region I, a 21.4% increase over December 2005. This number represents more than three times of the number of fixed-lines in service in Region I. The expansion of mobile customers, in addition to reduced mobile service rates, may impact local fixed-line traffic.
Furthermore, we believe that major technological innovations, such as instant messaging services and VoIP, may impact local traffic in the future. In Brazil, those services have been experiencing an increase in popularity, which could further pressure the size of the local telecommunication market. The partnership between Net and Embratel for the provision of fixed-line services using VoIP is an example of this type of competition. The focus of this competitor is on areas with a large concentration of upper-class households in Region I. However, it must be noted that Region I, as well as other parts of the country, has limitations regarding the penetration of computers and broadband, in view of the populations average income. Such fact constitutes a limiting factor to competition in this type of service.
In an effort to promote competition in the long-distance market, Anatel implemented a numbering plan that requires callers to choose their preferred long-distance carrier by dialing such carriers respective long-distance Carrier Selection Code before each long-distance call.
The competition for long-distance service is fragmented within the different sub-segments in which this market is divided, namely intraregional, interregional, international and mobile long-distance services. Tmar is the leader in long-distance services provided to the telecommunications customers of Region I in terms of traffic from calls originated in the region.
New technologies that serve as an alternative to long-distance telephone calls, such as VoIP, may start capturing part of the long-distance traffic. However, contrary to what was seen in other countries such as the United States, we do not expect to see this trend materialize soon in Brazil due to two main reasons. The first of them relates to the limitation of the broad band penetration in the country in view of the populations per capita income. The second occurs due to the fact that the main provider with the ability to offer alternatives through VoIP, Net, is affiliated with the long-distance incumbent Embratel, which, therefore, would have a lot to lose in its long-distance call margins.
Intraregional service consists of long-distance calls within a state (interstate) or between states (intrastate) inside one of the three regions for fixed-line services created with the privatization of Telebrás. Embratel, Intelig, Telesp and Brasil Telecom are all authorized to provide intrastate long-distance services to customers of Region I. Embratel began providing intrastate long-distance services in July 1999, Intelig in January 2000, Telesp in March 2003, and Brasil Telecom in January 2004.
In 2006, we estimate that we provided approximately 81.9% of the total intrastate and interstate long-distance traffic within Region I. We measure our market share according to the information available from our own switches. Because we have the largest network in Region I, the vast majority of long-distance calls originated in Region I go through our switches even when the caller chooses Embratel or Intelig to provide the service. Calls originated from Véspers lines are not routed to our stations and therefore are estimated in the determination of our market share.
The regional fixed-line companies, such as Tmar, generally were not permitted to offer interregional or international long-distance services until December 31, 2003. However, because Anatel certified our early attainment, in 2001, of certain network expansion and universal service targets for 2003, we were allowed to start providing such services in July 2002. Embratel and Intelig are our main direct competitors in these traffic routes. In addition, since March 2003, Telesp also started to compete in this market. Brasil Telecom obtained a license to provide interregional and international long-distance services in January 2004. Nevertheless, we are still the main long-distance provider of interregional and international long-distance services to the long-distance customers of Region I.
In January 2006, Tmar launched the product named 31 Simplificado (Simplified 31), which provides the option of three packages of minutes that include intra-state, intra-regional and inter-regional calls. The client, by assuming the monthly commitment of 31, 62 or 93 minutes, simplifies the payment of long-distance calls, therefore eliminating the need to check distances and hours to know how much a long-distance call will cost. When the client does not use the package of minutes in a given month, the remaining minutes can be used in the following two months.
With regard to long-distance calls originated from mobile handsets, Anatel issued rules to require mobile operators to allow their subscribers to choose among the different long-distance carriers, such as Tmar. These new rules enhanced competition in this segment and have resulted in increased long-distance revenues for Tmar derived from both mobile-to-mobile and mobile-to-fixed-line calls in our region.
The competition from mobile service providers is increasing, but it is still limited by the fact that rates for mobile phone calls are higher than rates for calls originated on our fixed-line network. However, free mobile in-network minutes may impact our revenues from mobile long-distance calls if our mobile customers migrate to our competitors to remain within the network of the people to whom they plan to place long-distance calls.
Tmar is the main provider of long-distance service for calls originated from mobile telephones in Region I. Our main competitor in this market is Embratel, followed by Tim and Intelig in third place and Vivo in fourth.
Competition among the providers of fixed-mobile services is directly related to the competition in local services, since local calls represent the major part of revenues from calls between fixed and mobile telephones. Because the rates charged in the fixed-mobile service are higher than those charged in other types of calls, this service is more vulnerable to competition with calls originated from mobile telephone services.
The competition in the provision of services related to the use of the local network is limited. However, there can be no assurance that the current competitor, Vésper, which is controlled by Embratel, and any other
potential competitor that enters this market, such as Brasil Telecom and Telesp, will not threaten Tmars leadership position in the future.
In addition, the prices charged for the use of the local network tend to decrease, considering that the regulation establishes that the rates for the use of network must be driven by cost. These prices may also reduce because of the application of the X Factor. The X Factor is a reducing factor that has been applied to public rates over the last several years and that has, consequently, resulted in the decrease of these rates. The decrease in interconnection prices and the application of temporary rules until reaching the relationship with costs affects the market, promoting the use of interconnections in detriment to the construction of new networks.
The market for mobile services in Region I is extremely competitive. Oi competes primarily with four other groups that provide mobile telecommunications services in Region I. These groups consist of the following companies:
Of the competitors listed above, Claro has been Ois most aggressive competitor for the acquisition of mobile customers in Region I. Its strategy for gaining market share in this segment has included heavy subsidy of traffic and sale of handsets. Vivo and especially TIM have been slightly more conservative with respect to subsidies, with more focus on profitability. Nevertheless, Oi is still one of main providers of mobile services in Region I even though it was the last-but-one player to enter this market, as evidenced by Ois ability to capture 33.0% of all new mobile subscribers in Region I in 2006.
Competition in data transmission services is not subject to regulatory restrictions other than restrictions aimed at assuring that such services do not interfere with the provision of public-switched telephone services. We offer data services under the private regime through Tmar and Oi; hence, we are subject to much less stringent regulations when rendering data transmission services. This market is open to a great number of competitors, including the fixed-line companies and specialized services companies, which are competing in a high-growth market focused on large and medium-sized business customers.
Along with growth in volume and increasing demand for broadband capacity, we expect significant price reductions in data transmission services as competitors expand their networks. We also anticipate a shift in competition towards value-added services provided over IP platforms.
In Region I, we estimate that approximately 76% of all broadband services are provided in the form of ADSL. As the ADSL technology uses Tmars network, Tmar is currently the principal player in data transmission services within Region I. Of the broadband services provided through other means, we estimate that approximately 15% use cable technology in which Net and TVA are the main players and 5% use radio technology which are dominated by a few niche players.
Of the players in the broadband services in Region I, Telmex is increasing its presence through a partnership between its subsidiary, Embratel, and Net, the media company in which Telmex has recently invested, that establishes a cooperation for the provision of telephone, cable television and broadband internet services.
In 2006, we incurred R$310 million in marketing expenses, primarily to market our fixed-line, ADSL and mobile products under the brand names Telemar, Velox, Oi, Oi Internet and our long-distance Carrier Selection Code 31.
The main marketing objectives were to promote: (1) our fixed-line products, such as Global 31, which promotes our integrated service capacity to provide our customers with both interregional long-distance calls outgoing from Region I to Regions II and III and international calls, by allowing customers to choose us as their long-distance provider through our 31 Carrier Selection Code; (2) long-distance services from mobile phones through our fixed-line network; (3) Velox, our ADSL services (broadband services) for high-speed access to the internet; (4) our mobile telecommunications services, through specific campaigns focusing on products addressed to certain market segments, such as prepaid and postpaid retail and corporate customers; and (5) our integrated services that are bundled with other fixed-line and broadband products.
In 2006, we continued to offer integrated promotions by bundling the different products and services provided by us, such as mobile communications and ADSL services, and fixed-line products and public telephone services.
As to marketing channels, our principal aim is to have the proper product to the most appropriate channel, which may take place through the availability of different products in different channels, as well as through the use of different levels of commissions for a given product depending on the channel.
In the retail sector, our principal marketing channels are:
In the corporate segment, we sell our fixed-line products and services through:
We sell our mobile telecommunications services through a network of 4,371 points of sale, including third party retail outlets and our own stores, as well as through contact centers and the internet.
The year 2007 started with strong investments in the unification of the brands of our products and services under a single brand name, Oi. We became the first to offer fixed, mobile and long distance telephone, broadband, internet, data communication and entertainment under a single brand. We intend to expand the Oi brand recognition in the market place, reinforcing our products and services convergence.
We conduct independent research and development in areas of telecommunications services but do not independently develop new telecommunications hardware. We primarily depend on suppliers of telecommunications equipment for the development of new hardware.
As part of the privatization process of Telebrás, the private telecommunications operators contributed to Telebráss former Foundation for Research and Development of Telecommunications (Fundação Centro de Pesquisa e Desenvolvimento das Telecomunicações, or the Foundation), so that it could conduct research and development in this sector. Our latest agreement with the Foundation, dated March 2002, provides for the Foundations development of software and IT services. Tmar disbursed approximately R$5 million, R$7 million and R$7 million in 2003, 2004, 2005, and 2006, respectively, for software development related to billing systems, anti-fraud systems for public phones and management of network maintenance workforce.
Our 2006 capital expenditures reached R$2,327 million. Of this amount, 29.5% was allocated to the deployment of our mobile telecommunications services infrastructure, 24.0% for data transmission systems, 25.2% to voice transmission and 21.03% to other capital expenditures. All of our capital expenditures were funded through a combination of internal cash flow generation and bank and equipment financing.
The following table sets forth our capital expenditures for the three-year period ended December 31, 2006.
Our forecasted 2007 capital expenditure budget totals approximately R$2.4 billion. We plan to finance such expenditures through operating cash flows and long-term financings. We have budgeted 25% of our 2007 capital expenditure budget to the mobile telephone services business and 75% to the fixed-line business, which includes our regulatory targets.
Our principal properties consist of management offices located in the main capitals of the 16 states of Region I.
As of December 31, 2006, we owned 4,907 properties, in a total of 1.6 million square meters of built area, of which 96% were operational sites, in a total of 855 thousand square meters occupied by equipment.
At the end of 2006 we also rented 10,326 properties from third parties, of which 7,853 were fixed- telephone and 2,473 mobile-telephone related.
We have also been granted the use of 4,442 properties owned by third parties as comodato or cessão de uso (right of use) for which we are not required to make any lease payments. Most of these properties are used as operational sites.
We also lease non-occupied properties to third parties, which represented, at the end of 2006, 306 properties partially leased to third parties (suppliers and non-related parties) and 20 totally leased to third parties.
As of December 31, 2006, the net book value of our property, plant and equipment was R$11,733 million (compared to R$12,518 million in 2005). Buildings, land and leasehold improvements represented approximately 10.5% of the net book value of our property, plant and equipment, underground ducts, post and towers, cables and lines represented approximately 32.9% of the net book value, plant and equipment related to trunking and switching stations represented approximately 15.6%, transmission equipment represented 27.0%, construction in progress represented approximately 4.4%, and other fixed assets represented approximately 9.6%. All property and equipment which are essential in providing the services described in the 2006 Concession Agreement are considered reversible assets, which means that, should the 2006 Concession Agreement expire or terminate without being renewed, these assets will automatically revert to Anatel. There are no other encumbrances or environmental issues that may affect the utilization of our property and equipment. For more details, see Note 18 to the consolidated financial statements of TNL.
Our business is highly dependent on the concessions and licenses that Anatel has granted us. For a description of these concessions and licenses, see Our operations and Regulation of the Brazilian telecommunications industry.
We have either registered or filed intellectual property applications for our most important fixed-line, mobile phone, broadband and long-distance brand names with the Brazilian Intellectual Property Agency (Instituto Nacional de Propriedade Intelectual). We believe the brand names and trademarks that identify us and our businesses are important for us, and we have accordingly taken the appropriate steps to protect them.
In the first half of 2006, TNL engaged an international advisory company and after conducting a comprehensive survey decided to implement a project for the unification of its activities under the Oi brand. This project is aimed at reinforcing the concept of convergence of services, improving the practices shared among the companies controlled by TNL, as well as facilitating the perception of the groups financial soundness by the client. The implementation of the project to unify its activities under the Oi brand will take place in several phases. Certain phases related to internal and external visibility have already been initiated, including the announcement to the press on February 28, 2007.
Our main activity, which is to provide fixed-line telecommunications services is generally not affected by major seasonal variations, except for the first quarter of the year, when the economic activity is generally reduced in Brazil. Our mobile telecommunications services are affected by a seasonal increase in mobile handset sales during the second and fourth quarters of each year due to Mothers Day in Brazil and the year-end holiday season.
As required by the 2006 Concession Agreement, Tmar maintains the following insurance policies: (1) all risk property insurance covering all assets pertaining to the concession; (2) business interruption insurance covering lost revenues deriving from property damage; and (3) performance bond insurance to assure compliance with the obligations related to quality and the universal targets set forth in the agreement.
In addition to the above policies, we have civil liability insurances. Our assets that are of material value and/or exposed to high degrees of risks are also insured. For more details, see Note 32 to the consolidated financial statements of TNL.
Regulation of the Brazilian Telecommunications Industry
Our business, including the services we provide and the rates we charge, is subject to comprehensive regulation under the Brazilian General Telecommunications Law and various regulations derived therefrom. Tmar and Oi operate under concessions and licenses that allow them to provide specified services and set forth certain obligations that they must comply with. See Concessions and licenses.
Anatel is the regulatory agency for telecommunications, according to the General Telecommunications Law. Anatel is administratively independent. Any new regulations proposed by Anatel must be open for comments by the general public. Anatels final decisions may only be challenged in Brazilian courts.
On June 10, 2003, a presidential decree, or the Decree, was issued, outlining a number of new rules and guidelines with the purpose of consolidating several changes in the regulation of Brazils fixed-line telecommunications sector. The Decree sets forth general declarations of policy regarding, among other things: (1) universal access to telecommunications services; (2) stimulation of employment and development of the Brazilian telecommunications sector; (3) promotion of competition and adoption of rate readjustment policies that take into account Brazilian socioeconomic considerations; and (4) the financial equilibrium of existing concession agreements. The Decree also defined certain changes reflected in the concession agreements entered into by each public regime company as of January 1, 2006.
A number of bills affecting telecommunications policy have been submitted to the Brazilian Congress with an aim to make telecommunications services more accessible to Brazils low-income population. These bills have proposed to: (1) eliminate the monthly subscription fee (assinatura mensal) that compensates telecommunications companies for extending and maintaining fixed-line telecommunications services for their customers; and (2) impose inexpensive fixed-line telephone plans (telefone social) that telecommunications companies would be required to provide to certain eligible low-income residential users. If approved, these types of proposal are expected to affect the overall margin of telecommunications providers, including us. For a discussion of the risks associated to the impact of telecommunications regulations on our business, see Item 3. Key Information. Risks relating to our business Our business is highly regulated. Changes in regulations or our failure to meet obligations set forth in Tmars concession may adversely impact our business.
On June 2, 1998, the concessionaires signed with Anatel the Concession Agreements for Local and Long-distance Commuted Fixed-Line Service in the states of Rio de Janeiro, Minas Gerais, Bahia, Ceará, Pernambuco, Espírito Santo, Pará, Rio Grande do Norte, Amazonas, Maranhão, Alagoas, Piauí, Paraíba, Sergipe, Amapá and Roraima (Concession Agreements).
The Concession Agreements expired on December 31, 2005. On December 22, 2005, Tmar signed with Anatel the 2006 Concession Agreement for the National Local and Long-distance telephony services, which regulates the provision of services beginning January 1, 2006 and is valid for 20 years. Pursuant to the 2006 Concession Agreement, Tmar must pay, as consideration for the extension of the Concession Agreements, every two years, an amount equivalent to 2% of the net revenue for the prior year, during the extension period.
An integral part of the 2006 Concession Agreement is the General Plan of Goals for the Universalization of the STFC (fixed-line telecommunications services), published on June 28, 2003 in the Official Gazette of the Union as a decree as well as the Quality Plan and the new General Plan of Competition Goals, to be regulated by Anatel.
The major changes of the 2006 Concession Agreement relate to:
Until 2005 calls were measured and charged in terms of pulses, consisting of a single charge per call and another charge for each additional four-minute fraction of usage. The 2006 Concession Agreement establishes a per-minute billing system as an effort to establish a more objective and transparent billing criteria to the customer. The objective of Anatel with the migration to a minute-based system is not to reduce rates but to offer a more transparent rate structure for customers.
As to the new readjustment index, Anatel started using a specific rate readjustment index based on a basket of rates for telecommunications services, the IST Index. The IST Index provides a more balanced account of the evolution of prices charged to both retail and wholesale consumers than the former inflation rate applied to the telecommunications sector, the IGP-DI Index, which focuses more on the evolution of wholesale prices. In recent years, with the stability of the Brazilian currency, the evolution of the IGP-DI Index has been very close to that of consumer-oriented indices, which suggests that the variation between the IST Index and IGP-DI Index may not be substantial, so long as the Brazilian currency remains stable.
The 2006 Concession Agreement has established a new method of calculating the productivity discount factor, or the X-Factor, that limits the monetary readjustment to telecommunications rates as provided by the IST Index. Under the original Concession Agreements, Anatel would impose pre-determined productivity factors for each of the telecommunications concessionaires. With the 2006 Concession Agreement, the method for calculating the X-Factor has evolved from a system of arbitrary productivity targets established by Anatel to one that seeks to measure a concessionaires productivity against the actual results that are obtained by all other concessionaires of the telecommunications industry. This new method of calculating the X-Factor was used for 2006 and will be used for 2007. From 2008 on, the method of calculating the X-Factor will be based on the operational costs that are inherent to the telecommunications sector. For a description of the new method of calculating the X-Factor, see Regulation of the Brazilian telecommunications industry Fixed-line services.
The 2006 Concession Agreement implemented a special pre-paid, fixed-line plan, known as Individual Access for Special Class (Acesso Individual para Classe Especial, or AICE), which has a lower subscription price than that of our Basic Service Plan. The AICE plan is a cheaper fixed-line alternative to residential customers, limited to one line per household, precluding customers from obtaining additional fixed lines. Therefore, we do not believe the AICE plan will have a material adverse effect on an overall margin.
The terms for number portability set forth under the 2006 Concession Agreement will allow telecommunications customers to take their telephone numbers with them only when they are replacing their fixed-line or mobile telephone service provider with another fixed-line service or mobile provider. In addition, the number portability will be allowed only when customers switch telephone service providers operating within that customers city.
The right to provide telecommunications services is granted either through a concession or a authorization. Concessions are granted under a public regime, while authorizations are provided in a private regime. The right to render local services in Region I have been granted to Tmar by Anatel through a concession, while in Regions II and III this right was awarded through a authorization/license.
According to the applicable laws, public regime companies are subject to certain obligations as to quality, continuity and universality of service, network expansion and modernization. Public regime companies are also subject to Anatels supervision as to the rates that they may charge customers. Private regime companies, though not generally subject to the requirements concerning universal access and network modernization, are subject to certain network expansion and quality of service obligations set forth in their authorizations.
Public regime companies, such as Tmar, also often offer certain services under the private regime, of which the most significant are the data transmission services. Oi offers mobile services under the private regime, according to an authorization acquired by it on February 13, 2001. See Our history and development Our significant subsidiaries TNL PCS S.A.
In addition to Tmar, the companies that operate in the public regime in Brazil include two other regional fixed-line service providers (Telefônica and Brasil Telecom), one national long-distance carrier (Embratel) and other secondary local operators. These four primary public regime companies (Tmar, Telefônica, Brasil Telecom and Embratel) are the main providers of fixed-line telecommunications services in Brazil, including local and intraregional services and interregional and international long-distance service. All other telecommunications service providers, including other companies authorized to provide fixed-line services in Region I, operate under a private regime.
There are a number of circumstances according to which a public regime company may have its concession terminated as listed below:
With a view to introducing competition in fixed-line telephone services in Brazil, in 1999 the federal government created four private-regime licenses to compete with the incumbent fixed-line concessionaires. Three of these licenses were to be issued to providers of local and intraregional long-distance services to operate in the three fixed-line regions. Embratel currently holds two of these licenses, which allows it to provide local services in Regions I and III, and GVT holds the other license to provide the same services in
Region II. The fourth competing license, currently held by Intelig, was to be issued to a licensee that would provide intraregional, interregional and international long-distance services throughout Brazil. Since 2002, the number of licenses that the federal government can issue is unlimited. Fixed line companies operating under a private regime have substantially less obligations, such as universal targets, than public regime fixed-line operators. Although Tmar was granted a license to provide fixed-line services under the private regime framework in Regions II and III, Tmars fixed-line telecommunications services in Region I are provided under public regime rules as explained below.
Each of the public regime companies operated under a concession that expired at the end of 2005. They all extended their concessions for an additional 20-year period. These new concessions were granted under the new conditions set forth in the new General Plan on Quality Goals, the new General Plan on Universal Goals and the terms set forth in the 2006 Concession Agreement. These concessions may also be revoked prior to expiration. Every second year during the 20-year renewal period, public regime companies will be required to pay biannual renewal fees equal to 2% of annual net operating revenues from telecommunications services of the immediately preceding year. The main features of the public regime fixed-line service are described below.
Public regime companies are subject to certain restrictions on alliances, joint ventures, mergers and acquisitions with other concessionaires of fixed-line telephony.
The General Plan on Universal Service Goals sets forth our main network expansion and modernization obligations such as providing public telephones in towns with more than 100 inhabitants and installing residential fixed-lines within seven days of a request, in towns with more than 300 inhabitants.
An additional network expansion requirement imposed on us by the 2006 Concession Agreement is the rendering of services in public telecommunication offices that serve as business centers for low-income populations (PST) . The centers must offer: (1) a minimum of four public computers with internet access; (2) a minimum of four public telephones; (3) a fax machine; and (4) service seven days a week from 8:00 a.m. to 8:00 p.m., according to the General Plan on Universal Goals.
Each telecommunications services provider, either under a public or a private regime, must comply with the provisions of the General Plan on Quality Goals and also with the terms of its respective concessions and authorizations. All costs related to the compliance with the quality goals established by the General Plan on Quality Goals must be exclusively borne by the telephone service provider. The General Plan on Quality Goals establishes minimum quality standards with regard to:
The quality standards of the services is measured according to the definitions and quality indicators established by Anatel. Every month fixed-line companies subject to a public regime are obliged to report their compliance with quality goals to Anatel. Additionally, public regime, fixed-line companies are obligated to provide Anatel with an in-depth report and analysis on each quality goal that is not complied with. Anatel may also collect such data from companies at any time without prior notice.
Public regime fixed-line companies that fail to meet quality goals fixed by Anatel may be subject to warnings, fines, intervention by Anatel, temporary suspensions of service or cancellation of concessions and authorizations. See Fines and penalties.
Anatel measures Tmars performance individually in each of the states where we operate. As a result, our performance in any particular state may not meet one or more quality performance targets even if our overall performance is satisfactory. Therefore, we could be subject to fines or penalties as a result of our failure to meet the quality performance targets in one or more specific states.
Failure to meet the network expansion and modernization obligations set forth in our list of obligations may result in fines and penalties of up to R$50 million, as well as potential termination of our concession. Failure to meet the quality of service obligations established in our list of obligations may result in fines and penalties of up to R$40 million.
Under the fixed-line concession regime, concessionaires must offer a Basic Service Plan comprised of the following basic services: installation, monthly subscription, and switched local minutes. The rates charged for the Basic Service Plan are comprised of a basket of two separate fees applied to each of those basic services. The rates charged under long-distance concessions are comprised of a basket of 20 fees varying in accordance with three basic criteria: (1) physical distance separating callers; (2) time of the day, and (3) day of the week on which the call is placed.
A price-cap mechanism is used to readjust the basket of rates charged in connection with local fixed-line and long-distance concessions. This price cap is adjusted on an annual basis pursuant to a formula set forth in the 2006 Concession Agreement. The formula provides for two adjustments to the price cap. First, the price cap is revised upward to reflect increases in inflation, as measured by the IST Index. Second, Anatel applies the X-Factor, which reduces the impact of the rate readjustment provided by the IST Index.
According to the new calculation method for the X-Factor set forth under our 2006 Concession Agreement, Anatel will calculate the sectors average productivity rate and compare it against our individual productivity result. The productivity factor which will be discounted from the IST Index will be equal to 50% of the higher of: (1) the average productivity rate for the telecommunications industry, and (2) our individual productivity result. If a company has a negative productivity rate, Anatel will not allow such company to have its rates readjusted above the IST Index.
Rates for individual services within the basket of basic services may be increased to the extent that the weighted average increase for the entire basket of basic services does not exceed the IST Index. We may increase the rate for any individual service above the weighted average increase of the basket by up to 5% for both local fixed-line and long distance services, so long as the prices of the other services are reduced proportionately to ensure that the weighted average rate increase does not exceed the revised basket of rates charged.
We may also offer alternative plans in addition to the Basic Service Plan. Alternative plans must be submitted for Anatels approval. The price caps of these plans are adjusted annually based on the IST Index.
For information on our current rates and service plans, see Rates.
General rules regarding interconnection are described in the General Rules on Interconnection (Regulamento Geral de Interconexão) promulgated by Anatel. All operating companies providing public-interest services are required, if technically possible, to make their networks available for interconnection, on a non-discriminatory basis, whenever such a request is made by another telecommunications provider.
There are two methods of calculating interconnection rates that operators pay for the use of each others networks. Anatel sets the interconnection rates charged for the use of another operators fixed-local or long-distance network. In July 2004, the interconnection rates to be charged for the use of another operators mobile network became freely negotiable by telecommunications companies as from February 2005. Some operators, including Tmar and Oi, have still not been able to agree on new mobile interconnection rates. As a result, operators have asked Anatel to arbitrate these rates.
For 2006, the termination rates that telecommunications companies may charge each other to terminate a call on their networks last mile have been limited to 50% of the rate charged to consumers for that same call. Based on the prices currently charged for local calls in Region I, the referred limitation in termination rates will result in a reduction of 27% in the termination rates that we charge other companies for the use of our networks last mile when terminating calls originated on their network. For 2007, this limitation in termination rates will be equal to 40% of the rate charged to customers for the calls they make that terminate on the last mile of our network. This further limitation will result in an additional 20% reduction in the termination rates that we charge other companies for the use of our networks last mile. From 2008 on, the method used to determine termination rates will take into account the actual operational costs of telecommunications companies.
The regulations for personal mobile telecommunications services allow companies to provide mobile telecommunications services under personal mobile services licenses. The personal mobile services licenses allow new entrants in the Brazilian telecommunications market to compete with existing telecommunications service providers. The personal mobile services regulations divide the Brazilian territory into three separate regions that correspond to the three regions of the public regime fixed-line telephone service. A total of five companies operating respectively in Bands A, B, C, D and E may offer mobile services in each region.
The personal mobile services license sets forth certain obligations and targets that must be met by a personal mobile telephone services licensee. Under these obligations, a personal mobile telephone services licensee is required to cover:
A locality is considered covered when an at least 80% of total urban area is covered. The failure to meet these targets may result in the penalties established in the regulations and, in extreme circumstances, in termination of the personal mobile telephone services license by Anatel.
In June 2002, we received authorization from Anatel to begin providing mobile telecommunications services through our mobile service subsidiary Oi. Our license to provide mobile telecommunications services is valid for 15 years and may be renewed for another 15 years. If the authorization is renewed, Oi will, as consideration for such renewal, be required to pay, upon renewal and on every second anniversary of the renewal, an amount equal to 2% of the prior years net revenue.
Companies holding personal mobile telephone services licenses are allowed to set at their discretion the prices to be charged for their mobile telephone services, provided that such prices are linked to existing service plans authorized by Anatel. Price caps are readjusted annually, based on the IST Index.
In 2006, while TNLs fixed-line network decreased from 14.9 million to 14.8 million lines in service, TNL expanded its mobile customer base to 13.1 million clients and its broadband customer base to 1.1 million ADSL clients, up from 10.3 million and 0.8 million, respectively. In December 2006, Oi reached an estimated market share of 27.4% in Region I in terms of number of active subscribers. For 2006, TNLs gross revenues increased 2.3% in comparison to 2005. The growth of TNLs mobile and data transmission categories is important in order to sustain the increase of TNLs revenues, as TNL expects no growth in its fixed-line network. Mobile lines in Region I already far exceed the number of fixed-lines. Costs of services, selling and general and administrative expenses increased 4.8% in 2006 (see Note 5, 6 and 7 to TNLs consolidated financial statements).
TNLs results of operations are significantly affected by the following factors:
Throughout Brazil, including in Region I, there is limited growth potential for traditional fixed-line voice services. Since privatization of the fixed-line network in 1998, significant capital expenditures have been made to expand the last-mile of the fixed-line network. According to Anatel, Brazil had 20.0 million fixed-line telephones in service in July 1998 and by the end of 2006, there were 38.8 million. However, a high proportion of the new fixed-lines in service are in low-income areas, which have a relatively low return on invested capital. Brazils fixed-line penetration level is now similar to that of other countries with similar per capita income, and, as has happened in such other countries, the fixed-line network has stabilized. In contrast, according to Anatel, the number of mobile subscribers in Brazil increased from 7.4 million in 1998 to 99.9 million in 2006. During this period, the Brazilian mobile segment has grown at an average rate of 38.4% per year, due to strong competition, advertising and prepaid plans, together with the ability of consumers to purchase handsets via interest-free installment plans (the cost of which is borne by mobile operators). During 2006, Ois customer base increased by 27.2% and its gross revenues grew by 23.6%.
As a result of this, the growth of mobile services in Region I and the reduction in inflation rates in Brazil (which influence TNLs fixed-line rate adjustments), TNL has seen a decrease in the growth of the gross revenue of its fixed-line telecommunications services from 26% in 2001 to 5% in 2005. In 2006, there was a slight decrease (0.8%) in the gross revenue from fixed-line services, from R$20.9 million to R$20.7 million.
As a result of these trends, TNL expects the number of fixed-lines and revenues from local fixed-line telecommunications services to remain stable. Alternatively, in its mobile business, TNL expects an increase in its customer base, traffic and additional services, but due to increasing market saturation, at lower rates than observed in the past. TNL also expects an increase in revenues from broadband and data transmission services, which still have a very low level of penetration in Brazil. Despite the low growth potential, TNL will continue
to invest in both its fixed-line and mobile networks in order to be able to offer bundled fixed-line, mobile and data transmission services. In addition, by owning both mobile and fixed-line telecommunications services networks in Region I and bundling these products, TNL minimizes interconnection costs for outgoing calls and maximizes interconnection revenues from incoming calls.
Competition in the telecommunications sector is increasing. This is being driven in large part by the pricing structure of fixed-line to mobile calls, since in Brazil mobile users only pay for outgoing calls. In addition, the current pricing structure allows for approximately 81% of net revenues generated by calls placed from fixed-lines to mobile phones to be allocated to mobile operators (interconnection charges), representing an important source of revenues for such operators. Growth of the mobile market is mainly a result of the expansion of prepaid plans, which increased the volume of incoming calls from the fixed-line network to the mobile network.
During 2006, the number of mobile lines in service in Brazil increased 15.9%, while the number of fixed-lines in service remained fairly stable. Mobile services are available to approximately 89.4% of the Brazilian population and 83% of households. According to estimates made by IBGE, approximately 77% of the Brazilian population lives in areas served by at least three mobile operators. Prepaid subscribers account for approximately 80% of our subscriber base.
The degree of competition in the mobile segment is high, with three or four large providers competing in each state. At December 2006, Oi had an approximate 27.4% market share in Region I in terms of number of active subscribers, compared to 26.3% market share at December 2005. Increasing Ois market share of the mobile market in Region I is strategically important to keep mobile network usage fees within TNL, which otherwise would be paid by TNL to its competitors. Because the estimated penetration of mobile usage in Region I was only 46.8% as of December 2006, TNL still expects to see growth in this segment over the next several years.
The degree of competition in the local fixed-line segment remains low, due to the required network investments in the last-mile and the focus of competitors on the corporate segment. Corporate subscribers represented approximately 18% of TNLs fixed-line subscribers as of December 2006. With the acquisition of Vésper in 2003, Embratel has widened its range of clients in local telephony. In addition, Anatel is attempting to stimulate competition in local services through the implementation of rules requiring line sharing and full unbundling; however, we do not expect these efforts to have a significant impact on competition.
In the long-distance market the degree of competition is strong, but due to traffic reduction, mainly in fixed-line originated calls, revenues slightly decreased from R$3,795 to R$3,703 million (2.4%). We continue to focus our marketing efforts on customer loyalty programs and alternative plans, also in the long-distance market.
Broadband penetration in Brazil remains low, with only 5 million users as of December 2006. TNL provides broadband services through ADSL technology, which already exists in more than 222 major cities in Region I. TNL estimates that ADSL technology had approximately a 77% market share in the broadband market in Brazil in terms of number of customers, with the other 23% split among cable, radio and satellite. In its region, TNL mainly competes with Net (a cable TV operator affiliated with Telmex).
In addition, companies authorized to provide limited specialized services have begun to compete with TNL in the provision of data transmission services for corporate customers. While this competition is negatively affecting the rates charged for these services, TNL has been able to increase its revenues through the acquisition of more clients, due to its ability to provide bundled solutions at lower costs. TNL is also developing sales channels with bundled services to small and middle market businesses.
TNL believes that bundling products is a key strategy to help to retain its existing clients and to increase its market share. For example, TNL has been able to stimulate the recharge of prepaid mobile minutes through its fixed-line bills, grant postpaid mobile subscriptions to new ADSL subscribers, combine household and
business telephony needs and offer prepaid cards that combine mobile, fixed-line and public telephony. For a detailed discussion of competition, see Item 4. Information on the Company Competition.
Brazilian currency has devalued frequently over the past four decades. Throughout this period, the Brazilian government has implemented various economic plans and used various exchange rate policies, including sudden devaluations, periodic mini-devaluations (such as daily adjustments), exchange controls, dual exchange rate markets and a floating exchange rate system. These exchange rate fluctuations and some of the Brazilian governments measures, taken in an attempt to curb inflation, have affected the cost of our loans and financing. The exchange rate fluctuations also affect the costs of our wireless handsets and fixed-line equipment, because part of that equipment is acquired abroad under contracts denominated in foreign currencies.
At December 31, 2006, 41.6% of our indebtedness was in foreign currency. Therefore, we typically hold derivative instruments to swap the foreign exchange rate variation to rates on interbank certificates of deposit (certificado de depósito interbancário, or CDI) variation. At December 31, 2006 we had coverage of 94% for the exchange rate variation risk. The purpose of these hedging transactions is to match the currency of our revenues with that of our debt.
The average annual interest rate of debt in local currency, including debentures, decreased from 15.9% per annum in 2005 to 13.2% per annum in 2006. The average annual interest rate of debt in U.S. dollars increased, from 6.1% per annum in 2005 to 7.0% per annum in 2006. However, because of the appreciation of the real against the U.S. dollar during 2006, we accrued significant losses on our balance sheet (as required under Brazilian GAAP) reflecting the costs of our swap operations.
While there is generally a favorable environment for the recovery of the Brazilian economy in 2007, it still remains vulnerable to shocks, given the high levels of Brazils domestic and public debt. TNL is making efforts to decrease its total indebtedness. Total indebtedness decreased 2.9% and 18.0% in 2006 and 2005, respectively.
Telecommunications service rates are subject to comprehensive regulation by Anatel. The New Concession Agreement, effective in January 2006, provides that rates will be adjusted based on the IST Index. The IST Index is calculated based on a weighted average of a number of Brazilian price indexes and its composition will be reviewed every two years. Rate adjustments can be effected after any period of at least 12 months and on the initiative of Anatel or the concessionaire.
There are also regulations requiring operators to prepare current financial data in order to implement cost-based and long-term incremental cost analyses. These analyses combined with productivity discussions could lead to limitations on future rate adjustments. In addition, in connection with the terms of the New Concession Agreement Form, Anatel implemented a variety of other rate related issues, such as the productivity factor. For a detailed discussion of the new terms that may affect TNLs concession see Item 4. Information on the Company Regulation of the Brazilian telecommunications industry New telecommunications regulations.
Brazilian political and economic environment, effects of inflation and foreign exchange rate fluctuation
TNL has been, and will continue to be, affected by the economic, political and social conditions in Brazil. Most notably TNLs operations have been impacted by the fluctuation of the real and by variation in interest rates influenced by the Brazilian government in its efforts to control inflation. See Item 3. Key Information Exchange rates and Item 3. Key Information Risk factors Risks relating to Brazil. The
following table shows GDP growth, inflation rate, U.S. dollar exchange rate variation and interest rate for each of the three years ended December 31, 2004 to 2006:
TNLs significant accounting policies are described in Note 3 to the consolidated financial statements of TNL included in this annual report. In preparing the consolidated financial statements, TNL relied on estimates and assumptions derived from historical experience and various other factors that it deemed reasonable and relevant. Critical accounting policies are those that are important to the portrayal of TNLs financial position and results and require managements, subjective and complex judgments, estimates and assumptions. The application of these critical accounting policies often requires judgments made by management regarding the effects of matters that are inherently uncertain, with respect to TNLs results of operations and the carrying value of TNLs assets and liabilities. TNLs results of operations and financial position may differ from those set forth in the consolidated financial statements if its actual experience differs from managements assumptions and estimates. In order to provide an understanding of TNLs critical accounting policies, including some of the variables and assumptions underlying the estimates, and the sensitivity of those assumptions and estimates to different parameters and conditions, set forth below is a discussion of TNLs critical accounting policies relating to:
TNLs revenue recognition policy is significant because TNLs revenue is a key component of its results of operations. Managements determination of price, collectability and the rights to receive certain revenues for the use of TNLs network are based on judgments regarding the nature of the fee charged for services rendered, the price for certain products delivered and the collectability of those revenues. Should changes in conditions or discussions cause management to determine that these criteria are not met for certain transactions, the amount of accounts receivable could be adversely affected. In addition, TNL relies upon revenue recognition measurement guidelines in accordance with rules issued by Anatel.
Revenues from the usage of TNLs network by other telecommunications service providers are recorded based on a formal document of declared traffic and services rendered, the Traffic Exchange Declaration (Documento de Declaração de Tráfego e Prestação de Serviço), issued by an outsourced clearing house.
Accounts receivable from telecommunications services are valued by applying the rates on the date the service is rendered. These receivables also include credits for services rendered but not yet billed, up to the balance sheet date. The value of services rendered but not yet billed is determined by the valuation of the metered services at year-end or by estimates that take into account the performance of the previous month. The related taxes are determined similarly and accounted for on an accrual basis.
Late-payment interest is accounted for upon the issue of the first bill following the payment of the overdue bill.
The revenues related to the sale of public telephone cards, mobile handsets and accessories are accounted for upon the transfer of title. However, mobile prepaid cards revenues are deferred and recognized as income, based on customer usage.
The provision for doubtful accounts is stated at an amount that TNL considers sufficient to cover any probable losses on realization of accounts receivable from its customers and is included in selling expenses. TNLs accounting policy for establishing the provision is consistent with its billing and collection process.
This provision is established in order to recognize probable losses on accounts receivable, taking into account the actions TNL takes to limit providing services to clients with past-due accounts and to collect delinquent accounts, beginning when the account is either 60 days past due for the fixed-line segment or 15 days past due for the mobile segment, and increasing progressively thereafter, as follows:
TNL includes government entities, corporate clients and other telecommunications service providers in the calculation basis of the provision. TNL has also entered into agreements with certain clients to collect past-due accounts, including agreements allowing clients to settle their delinquent accounts in installments. The amounts that TNL actually fails to collect in respect of these accounts may differ from the amount of the provision established.
TNL depreciates property, plant and equipment using the straight-line method at rates it judges compatible with the useful lives of the underlying assets, primarily five to 10 years for network and equipment, 25 years for buildings, underground ducting, posts, and towers, five years for hardware and software and
10 years for furniture, fixtures and others. Depreciation rates are adjusted, and may vary between the fixed-line and mobile segments, to take into account changes in estimated useful lives based on technical obsolescence and assessment by outside experts. Impairment tests are applied whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. TNL has not recorded any impairment during the years 2005 and 2006. In 2004, TNL recorded impairment on AIX assets in the amount of R$54 million. Maintenance and repair costs are capitalized when, according to managements judgment, such maintenance or repair increased installed capacity or useful life. TNL has not capitalized any material maintenance and repair costs during the three-year period ended December 31, 2006.
The preparation of TNLs financial statements requires TNL to make estimates and assumptions regarding contingencies that affect the valuation of assets and liabilities at the date of the financial statements and revenues and expenses during the reported period. These contingencies include the legal proceedings discussed in Note 26 of the consolidated financial statements.
Unless otherwise required by changes in accounting standards and practices, TNL will continue to record liabilities in connection with these contingencies in the same manner as it does currently, based on its assessment of the risk of loss at each preparation date of the financial statements. TNL classifies its risk of loss in legal proceedings as remote, possible or probable. Provisions recorded in TNLs financial statements in connection with these proceedings reflect reasonably estimated losses as determined by management based on legal advice and in accordance with Brazilian GAAP and U.S. GAAP. As discussed in Note 3(n) to the consolidated financial statements of TNL, TNL records as a liability its estimate of the costs of resolution of such claims, when it considers their losses probable. It is possible that TNLs assumptions and, therefore, estimates of loss in respect of any given contingency will change in the future based on changes in the related situation. This may therefore result in changes in future provisioning for legal claims. TNL records liabilities in connection with pending litigation based on estimates of the amounts of probable losses. Currently, all lawsuits involving TNL and the subsidiaries have been controlled in a data warehouse, where the information related to each lawsuit is available, such as: value involved, risk, loss expectation, progress status, external legal counsel responsible, etc. See Item 8. Financial information Legal proceedings.
Brazilian employment and labor legislation is extensive and complex, giving rise to many claims from current and former employees and outsourced personnel. These relate primarily to hazardous work condition premiums, equalization of salary scales and overtime, claims from outsourced personnel and other matters. TNLs management estimates the potential losses on outstanding labor claims based on labor court decisions as they are issued in each labor lawsuit filed against it. In this respect, all labor lawsuits are initially classified as a possible contingency that TNL may have to face as soon as it is filed against us and no provision is made for it. Once TNL has a lower court decision for a labor lawsuit, it will change this classification to probable or remote depending on the outcome of such lower court decision. A provision will then be made if the lower court decision has been entirely or partially unfavorable to TNL. TNLs risk of defeat in a labor lawsuit will be changed again if a higher court reverses the lower courts decision entirely or in part. In such case, the respective provisioning also shall be revised accordingly.
The complexity of the Brazilian corporate tax system often results in disputes on a number of different taxes. TNL is currently involved in tax proceedings regarding, and has filed claims to avoid payment of, certain taxes that it believes are unconstitutional. These tax contingencies, which relate primarily to value-added tax, service tax and taxes on revenue, are described in detail in Note 26 to its consolidated financial statements. TNL records provisions for probable losses in connection with these claims based on the opinion of external legal counsel and based on an analysis of potential results, assuming a combination of litigation and settlement strategies. TNL does not believe that the proceedings, which it considers as probable losses, if decided against it, will have a material adverse effect on its financial position. It is possible, however,
that future results of operations could be materially affected by changes in TNLs assumptions and the effectiveness of its strategies with respect to these proceedings.
TNL is currently involved in many claims regarding issues related to assessments by Anatel, indemnification requested by former resellers of prepaid calling cards, many individual claims requesting indemnity in small claims courts and subcontractors, among others. TNL records provisions for probable losses based on the opinion of its external legal counsel as to their assessment concerning the outcome of the litigation and their estimates of the involved amounts.
TNL has not recorded a provision for every labor, tax or civil exposure, but only for those of which an unfavorable outcome, based on external legal advice, is considered probable. TNL has estimated the total value of unrecorded exposures to claims considered as possible and remote losses to be R$8,778 million and R$1,984 million, respectively, as of December 31, 2006. TNL believes that its estimates are based on reasonable assumptions and assessments of external legal counsel.
At the moment, TNL does not have material contingent assets, where an inflow of economic benefit is probable. Contingent assets would only be recorded upon a final judicial decision regarding disputes over various matters such as tax credits.
On December 31, 2006, we had loans and financing (including debentures) subject to floating interest rates, which totaled 67.6% of our total debt, based on the Brazilian long-term interest rate, or TJLP, the CDI rates and IGP-M in the case of real-denominated debts, and based on LIBOR, in the case of U.S. dollar- and Yen-denominated debts, and based on a foreign currency basket in the case of the foreign currency portion of the BNDES Facilities.
As of December 31, 2006, we had derivative agreements pursuant to which we swapped 17% of our total debt subject to floating interest rates, in particular, under contracts bearing interest of U.S. dollar LIBOR plus 0.5% to 5.0% per annum, which totaled 42.8% of our total debt, to fixed rates, reducing our exposure to changes in U.S. dollar LIBOR to 4.6% of our total debt and our exposure to floating interest rates in total to 56.3% of our total debt.
Results from cross-currency interest rate swap operations are determined and recorded on a monthly basis by comparing contractual exchange rates to month-end exchange rates, when applicable, regardless of the terms of settlement in the applicable derivatives contract.
Under U.S. GAAP the results of derivative transactions are recognized at fair value, in accordance with Statement of Financial Accounting Standards, or FAS No. 133 Accounting for Derivative Instruments and Hedging Activities, and calculated at year-end, which could potentially alter net income (loss) significantly. Our foreign currency loans and financings, including swap agreements, totaled US$1,382 million and US$2,752 million at December 31, 2006 and 2005, respectively.
In the past, TNL has used derivative contracts (swaps, options and forwards) to swap its foreign currency risks. Currently, all the derivative contracts are cross-currency interest rate swaps under which an obligation denominated in foreign currency is exchanged for a real-denominated obligation bearing interest at the CDI rate. The gain (loss) on swap transactions recorded under Brazilian GAAP reducing or increasing foreign currency indebtedness will be effective if we maintain these agreements until their maturity, regardless of the fair value at year-end, as we currently intend to do.
As of January 1, 2001, we began applying FAS No. 133 for reconciliation purposes of Brazilian GAAP to U.S. GAAP. Because of the fact that our transactions do not qualify for hedge accounting under this standard, derivatives are recorded at fair value. Therefore, TNL eliminates the gains and losses of derivative contracts
not yet financially realized in its U.S. GAAP financial statements. Fair values are based on pricing models that take into account current market and contractual prices for the underlying financial instruments or commodities, as well as time value and yield curve or volatility factors underlying the positions. If we maintain these instruments to maturity, as we currently intend to do, the unrealized gains and losses will substantially offset interest expenses, due to foreign exchange rate variations. For example, our financial results for the years ended December 31, 2006 and 2005 were impacted by an appreciation of 9.5%, and 13.4%, respectively, of the U.S. dollar exchange rate, due to long-term indebtedness in foreign currency.
While the exchange rate variations affect our indebtedness and our financial results, gains and losses of these derivative contracts are recognized in income under interest expense. However, for Brazilian GAAP purposes, gains and losses due to fair value measurement are not recognized, generating a loss of R$3 million in 2006, a loss of R$122 million in 2005 and a loss of R$111 million in 2004 in the respective U.S. GAAP income statements.
Under Brazilian GAAP, accounting standards do not specifically address business combinations and the purchase method is applied based on book values. The goodwill or negative goodwill on the acquisition of a company is recorded by calculating the difference between the acquisition cost and its underlying book value. If the goodwill or negative goodwill is based on future profitability expectations, the goodwill amortization is recognized in the consolidated statements of income over a period consistent with the period over which the gains or losses are expected to be incurred. If the goodwill or negative goodwill is based on the fair value of property, plant and equipment, the amortization is recognized in the consolidated statements of income over a period consistent with the assets remaining economic lives.
Under U.S. GAAP, TNL adopted the procedures determined by FAS No. 141 Business Combinations to recognize acquisitions of interests in other companies. The method of accounting used in business combination transactions is the purchase method, which requires that acquirers reasonably determine the fair-value of the identifiable assets and liabilities of acquired companies, individually, in order to determine the goodwill paid in the purchase, which has to be recognized as an intangible asset. The difference between the book value and the fair value has to be classified on the balance sheet as property, plant and equipment and assigned to a specific reporting unit.
Under U.S. GAAP, goodwill represents the excess of the acquisition cost of a business over the fair value of the identifiable tangible and intangible net assets acquired. The cost of acquired entities at the date of the acquisition is allocated to identifiable assets and the excess of the total purchase price over the amounts assigned to identifiable assets is recorded as goodwill. Effective January 1, 2002, TNL adopted FAS No. 142 Goodwill and Other Intangible Assets. This standard changed the accounting for goodwill and other indefinite-lived intangible assets from an amortization method to an impairment-only approach.
The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level, at least annually and whenever indicators of impairment exist. Reporting units may be operating segments or one level below an operating segment, referred to as a component. Businesses for which discrete financial information is available are generally considered to be components of an operating segment. Components that are economically similar and managed by the same segment management group are aggregated and considered a reporting unit under FAS No. 142. Step one compares the fair value of the reporting unit (calculated using a discounted cash flow method) to its carrying value. If the carrying value exceeds the fair value, there is a potential impairment and step two must be performed. Step two compares the carrying value of the reporting units goodwill to its implied fair value (i.e., fair value of reporting unit less the fair value of the units assets and liabilities, including identifiable intangible assets). If the carrying value of the goodwill exceeds its implied fair value, the excess must be recorded as impairment.
Income taxes in Brazil are calculated and paid on a legal entity basis. There are no consolidated tax returns. Accordingly, TNL only recognizes deferred tax assets, related to tax loss carryforwards and temporary differences, if it is likely that they will be realized on a legal entity basis.
Under Brazilian GAAP, the amount recorded is the net amount, which must be supported by a business plan and approved by TNLs Board of Directors and Fiscal Council. As required by CVM Instruction No. 273/98 and CVM Instruction No. 371/02, TNL discloses in its Brazilian GAAP financial statements the amounts expected to be recovered for the next ten years.
In Brazil, the tax law is sometimes significantly altered by provisional measures (medidas provisórias) announced by presidential decree. The provisional measures can affect tax rates as well as other areas that could impact deferred taxes. These measures remain in force for 30 days and expire automatically if they are not extended for an additional period. When calculating the effect of tax changes or other changes on deferred income taxes in Brazil, the provisional measures are substantively considered as enacted law. For the calculation of deferred taxes, Brazilian GAAP requires the use of the tax rate that is expected to be in effect when the temporary differences or tax loss carryforwards will be realized.
Under U.S. GAAP, only enacted tax rates may be used to calculate deferred taxes. Tax rates for future periods, which have been established by provisional measures, are not considered to have been enacted and are ignored. The current, combined tax rate of 34% was enacted in 2003.
For U.S. GAAP purposes, the total deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred taxes will not be realized. The valuation allowance is substantially comprised of tax loss carryforwards generated in the mobile business, which was established in mid-2002. The mobile business has required high levels of investment and is not expected to generate relevant taxable income in the next few years. For U.S. GAAP purposes, we have recorded an additional valuation allowance in comparison to Brazilian GAAP, for the subsidiary Oi (mobile segment) due to the history of this entitys losses.
The following discussion of TNLs consolidated financial position and results of operations for the three-year period ended December 31, 2006 should be read in conjunction with its consolidated financial statements, which are included at the end of this annual report.
The consolidated financial statements have been prepared in accordance with Brazilian GAAP, which differs in certain significant respects from U.S. GAAP. See Note 35 to the consolidated financial statements for a summary of the differences between Brazilian GAAP and U.S. GAAP, Note 37 for a net income (loss) reconciliation of the differences between Brazilian GAAP and U.S. GAAP for the years ended December 31, 2004, 2005 and 2006, Note 38 for a shareholders equity reconciliation as of December 31, 2005 and 2006, Notes 39 and 40 for presentations of statements of operations and changes in shareholders equity and Note 41 and 42 for an additional disclosure about cash flow and pension plans prepared in accordance with U.S. GAAP.
Statements of operations for 2004, 2005 and 2006
The following table sets forth the components of TNLs statements of operations, as well as the percentage change compared to the prior year, for the three-year period ended December 31, 2006.
Comparison of Revenues, Costs and Expenses in 2005 and 2006
The following table sets forth the components of TNLs operating revenues, as well as the percentage changes, for the years indicated.
The following table sets forth the revenues for TNLs local services, as well as the percentage changes, for the years indicated.
Monthly subscription fees. Monthly subscription fees remained stable. The growth of customer adhesion to alternative plans based on minutes increased the monthly subscription fee revenue, however, this effect was offset by a 0.5% rate reduction of in July 2006 and a 3.1% decrease in fixed-lines in service.
Metered services. In 2006, pulse-based revenues decreased 8.0%, primarily due to the decrease in volume cause by the migration of originating calls from fixed-line segment to mobile segment, as well as the migration of dial-up internet access to ADSL access. Clients using ADSL pay a monthly fee instead of paying pulses while using dial-up internet access. The number of ADSL clients increased as a consequence of TNLs investment in this product, which already accounts for 7.8% of TNLs fixed-lines in service. In addition, the growth of adhesion to minute-based alternative plans caused a decrease in revenue from the pulse line to the monthly subscription fees line.
VC1 services. Revenues in this category consist of charges for local calls from fixed-line to mobile telephones, which are billed at the lowest rate (VC1) and accounted for as local services. A substantial part (88%) of TNLs fixed-line to mobile traffic consists of VC1 calls. In 2006, revenues from VC1 calls remained stable primarily due to the fact that there was no rate readjustment that year.
Collect calls. In 2006, revenues from collect calls decreased mainly due to a 54.0% decrease in rates. In May 2006, an Anatel Resolution required us to apply the rate used for local calls to the collect calls. This rate is lower than the rate used previously used for collect calls (which was the rate also used in long-distance calls).
Installation fees. In 2006, revenues from installation fees increased primarily because in 2005, TNL employed several lower fee or no fee promotions to install new lines or reinstall cancelled lines in order to stimulate the growth of fixed lines in service.
Other revenues. Revenues from other local services consist primarily of charges for special services such as fixed-line prepaid calling cards and installation of additional telephones on the existing line, as well as equipment rental.
The following table sets forth the revenues for TNLs long-distance services, as well as the percentage changes, for the years indicated.
Intrastate long-distance (intraregional). Revenues from intrastate long-distance decreased in 2006, mainly due to the combined effect of a 2.9% tariff decrease and a decrease in traffic.
Interregional. In 2006, these revenues increased mainly due to an increase in traffic volume, partially offset by the 2.9% tariff decrease.
Interstate long-distance (intraregional). These revenues decreased in 2006, mainly due to the combined effect of a 2.9% tariff decrease and a decrease in traffic.
VC2 and VC3 services. Revenues in this category consist of charges for long distance calls from fixed-line to mobile telephones. Revenues from VC2 and VC3 increased mainly due to the combined effect of an increase in traffic and an 8.0% rate increase.
The following table sets forth the revenues for TNLs other fixed-line services, as well as the percentage changes, for the years indicated.
Prepaid calling cards for public telephones. Revenues from the use of prepaid calling cards for public telephones remained stable in 2006. The 0.4% rate decrease that occurred in July 2006 was offset by the 1.2% increase in the number of credits sold.
Additional services. Additional services consist primarily of services such as directory assistance, caller ID, calls on hold, voicemail and call forwarding.
Advanced voice. Advanced voice services consist of 0300, 0500, 0800 and 0900 services providing businesses with a number with agreed upon fees, which may be charged to the caller or to the client. In 2006, the revenue of both services remained stable.
The following table sets forth the remuneration for use of the fixed-line network, as well as the percentage changes, for the years indicated.
Revenues relating to the use of fixed-line network include revenues received from other mobile and fixed-line telecommunications operators for completing local and long-distance calls through TNLs network.
In 2006, remuneration for use of the fixed-line network decreased 30.9% primarily due to a 25.5% decrease in the interconnection rate for the use of the local network, established by the renewal of the concession agreement in January 2006.
The following table sets forth the revenues for TNLs mobile telephone services, provided through Oi, as well as the percentage changes, for the years indicated.
Mobile telecommunications services in Brazil are offered on a calling-party-pays basis, under which subscribers only pay for calls that they originate, in addition to roaming charges.
Rates vary according to the service plan subscribed to, the call origin, destination and length. Each call is billed for at least 30 seconds and thereafter, for every additional 6 seconds. Under Ois postpaid plans, customers pay subscription fees in addition to usage charges.
Oi had 10.3 million users as of December 31, 2005 and 13.1 million as of December 31, 2006. Of the 13.1 million users, approximately 82% are users of prepaid plans and 18% of postpaid plans, which is the same breakdown of users as in 2005. The monthly average revenue per user was R$20.04 in 2006 compared to R$20.69 in 2005.
Originating calls. Revenues of originating calls increased primarily due to the increase in the average number of users.
Sale of handsets and accessories. The revenues from the sale of handsets and accessories totaled R$319 million in 2006, of which R$89 million was generated from sales of prepaid handsets and R$165 million was generated from sales of postpaid handsets. The additional R$65 million in revenue is related to sales of Subscriber Identity Module cards, or SIM cards, which are chips containing information relating to the users account, enabling the user to change handsets without losing information. In 2006, Oi sold 296 thousand prepaid handsets and 1,550 thousand postpaid handsets. Subsidies for prepaid and postpaid handsets were 84.9% and 87.8% of the respective sale prices. The revenue attributable to mobile handsets and accessories sales decreased 58.5%, due to Ois new strategy to reduce acquisition costs (through subsidy, commission and logistics) in the pre-paid segment, focusing mainly on SIM card sales. The average price TNL charged in 2006 for a prepaid handset was R$294.95 compared to R$158.29 in 2005 and for a postpaid handset, R$72.57 compared to R$79.11 in 2005.
Monthly subscription fees. Postpaid users pay a monthly subscription fee, which includes a certain number of minutes, and are billed according to actual use on a monthly basis, varying according to the service plan to which they subscribe. Monthly subscription fee revenues increased due to adjustments of the average rate of the standard postpaid plans by 6% (for all plans) and 15% (only for old plans) in April and September 2006, respectively, and due to the growth in the average number of users, with an average subscription fee of R$44.36 in 2006 and R$36.34 in 2005.
National and international roaming. TNL receives revenues from roaming agreements with other local and international mobile operators using GSM technology. When a subscriber of another mobile operator originates a call using TNLs network, the other mobile operator pays TNL for the call using the applicable rate. Moreover, when TNLs subscribers are outside TNLs coverage area and receive or place calls, TNL charges them a roaming rate. These revenues remained stable in 2006.
In 2006, R$69 million of TNLs roaming revenues are attributable to international GSM mobile operators, with which TNL has roaming agreements and the clients of which used their mobile telephones in Brazil. The remaining R$51 million was obtained from roaming charges from TNLs clients for use of mobile services outside TNLs authorized Region I.
Additional services. Revenues from additional services increased primarily due to the annual rate increase. Revenues from pre-paid Short Message Services amounted to R$182 million, representing 65.9% of additional services revenue. The remaining amount refers to General Packet Radio Service and Wireless Application Protocol.
The following table sets forth the remuneration for the use of TNLs mobile telephone services, provided through Oi, as well as the percentage changes, for the years indicated.
This item includes revenues received from both fixed-line and mobile telecommunications operators for the use of TNLs mobile network for completing calls.
Use of fixed-line to mobile network. These revenues totaled 224 million in 2006, excluding R$732 million received from Tmar eliminated upon consolidation. These revenues increased in 2006 as a result of the growth in the average number of users.
Use of mobile-to-mobile network. These revenues, primarily from other mobile operators in the main cities in Region I, increased mainly due to new billing system called full billing, under which the remuneration for the use of the network is calculated according to total incoming traffic. In July 2006, this new system replaced the partial bill and keep system, under which the remuneration is done by the net traffic of incoming and outgoing calls among the mobile operators. In addition, client base growth also contributed to the increase of this revenue.
The following table sets forth revenue for TNLs data transmission services, as well as the percentage changes, for the years indicated.
Asymmetric Digital Subscriber Line (ADSL). TNL sells ADSL high-speed internet access under the brand name Oi Velox. This is a strategic product, enabling us to inhibit both entrants offering high-speed access through the cable television network and other fixed-line competitors from obtaining remuneration for the use of their network in TNLs region or increasing their market share, included in bundled packages of services offering financial benefits to users that subscribe.
ADSL revenues increased in 2006 as a result of TNLs continued focus on increasing Oi Veloxs penetration of the internet market. The number of Velox subscriptions increased 37.5%, from 0.8 million in 2005 to 1.1 million in 2006. In 2006, TNL expanded its coverage and penetration into new client markets, stimulated by an increase in computer sales and by offering bundled solutions. Veloxs customer base represented 7.8% of TNLs total fixed-lines in service as compared to 5.4% in December 2005.
Transmission EILD. Revenues in this category (Industrial Exploration of Dedicated Lines) consist of payments for leasing dedicated data-transmission lines to telecommunications services providers, primarily mobile operators, which use these services to link their radio base stations to their switching centers. In 2006, transmission revenues increased mainly due to an increase in the average prices towards the end of 2005 and due to an increase in the average number of leased lines.
Dedicated Line Service SLD. Revenues from Dedicated Line Service (Serviços de Linhas Dedicadas) consist of payments for the rental of dedicated digital data transmission lines, which are used primarily by corporate clients. In 2006, these revenues remained stable.
Internet Protocol services. IP services consist of dedicated and dial-up internet access for internet service providers, as well as Virtual Private Network services that enable companies to set up networks such as intranets and extranets. In 2006, revenues from IP services decreased due to a decrease in dial-up service rate in January 2006.
Switching packs and frame relay. In 2006, revenues from switching packs and frame relay services increased due to an increase in monthly subscriptions of frame-relay services.
Other services. Revenues from other data transmission services increased mainly due to an increase in equipment rentals and an increase in the subscription revenue from our internet provider clients (Oi internet), which was launched in 2005 and reached 2.4 million clients at the end of 2006, supported by the growth of computer sales in Brazil. In addition, there was an increase in the revenue received pursuant to agreements with internet service providers, as such internet service providers experienced an increase in the number of their ADSL clients in 2006.
ICMS and other indirect taxes. Gross revenues are subject to a value-added tax (ICMS), and two federal contributions, the PIS and the Cofins. See Item 4. Information on the Company Taxes on telecommunications services. In 2006, consolidated taxes increased slightly in line with gross revenues.
Discounts and returns. Since TNLs sales contracts do not provide for returns, these amounts essentially refer to discounts offered to clients in specific conditions. The increase in 2006 is mainly due to an increase in discounts to corporate clients, primarily in the mobile segment due to strong competition in this industry.
Costs of services
The following table sets forth the components of TNLs costs of services, as well as the percentage change compared to the prior year. TNL also included the main costs of each separate segment; however, the sum of the components of all segments does not correspond to the consolidated cost component primarily as a
result of intercompany eliminations (provided) and because immaterial cost components of some segments are included in other costs.
Depreciation decreased in 2006 due to the increasing amount of fixed-line equipment that is fully depreciated. This effect was partially offset by an increase in the mobile segments depreciation, which still invests more than its depreciation level. In 2006, Ois capital expenditures was R$680 million.
Interconnection costs increased 16.6% in 2006, primarily due to the introduction of the new interconnection remuneration system among the mobile operators, the full billing system. As noted in the item related to revenues from Use of mobile-to-mobile network, under this new system the interconnection remuneration is paid for all incoming and outgoing traffic, instead of for the net traffic among operators. The main effect of this change was the increase in both revenue and cost of interconnection.
In 2006, the fixed-line costs of network maintenance increased mainly due to the third party contract renegotiations and the growth of Oi Veloxs client base. The mobile costs of network maintenance also increased mainly due to the growth of its subscription base.
The volume of handsets sold in 2005 totaled 4,233 thousand of which 2,699 thousand were prepaid and 1,534 thousand were postpaid. In 2006, this volume decreased to 1,846 thousand, of which 296 thousand were prepaid and 1,550 thousand were postpaid. The volume of handsets sold decreased due to TNLs new strategy to reduce acquisition costs (through subsidy, commission and logistics) in the pre-paid segment, focusing mainly on SIM card sales.
As noted above, in 2005, the average costs of prepaid and postpaid handsets sold were R$216 and R$221, respectively, with a total cost of R$835 million. In 2006 these average costs were R$216 and R$300 for prepaid and postpaid handsets sold, respectively, with a total cost of R$578 million.
According to Brazilian GAAP, TNL defers the postpaid handset subsidy over a 12-month period, because the client agreement provides for reimbursement of R$300 in the event of cancellation or migration to the prepaid system before the completion of the contractual period. Accordingly, TNL considers the subsidies part of the customer acquisition cost, and defers and amortizes them up to the limit of R$300 during the minimum 12-month contractual period. TNL does not defer the subsidy of prepaid customers, since there is no early cancellation fee under these plans, guaranteeing the payback of customer acquisition costs. Under US GAAP, the postpaid subsidy is not deferred, being recorded as cost of services when the handset is sold. See Note 3(h) to TNLs consolidated financial statements.
These costs primarily include circuit rental, mobile platform, energy posts, satellite, right of way, dedicated lines of other service providers, and sites for tower installation for the mobile segment. In 2006,
consolidated rental and insurance costs increased primarily in the mobile segment, mainly due to adjustments in the right-of-way contract related to EILD (Industrial Exploration of Dedicated Lines) costs, tower rental with non-associated companies and infra-structure operating rental.
Tmar and Oi have intercompany rental agreements, whereby Tmar provides EILD services to Oi and Oi provides services by Wireless Local Loop technology. These costs are treated as intercompany eliminations.
In 2006, costs of materials decreased, primarily in the fixed-line segment, mainly due to the reduction in the costs of materials and fuel used in the network, partially offset by an increase of materials related to the product Oi Velox.
Electricity costs increased mainly because of the average rate increases of 21.0% and 10.4% applied by TNLs electricity providers in late 2005 and 2006, respectively.
Personnel costs are allocated between costs of services rendered, selling expenses and general and administrative expenses, based on a payroll process that only allows personnel to be hired if there is headcount and budget associated to each cost department. If an employee is transferred between departments, the reallocation of the cost to the new department must be authorized in order to maintain the integrity of the process.
Personnel costs decreased in 2006, mainly due to headcount reductions. TNL had a total of 8,055 and 7,098 employees in 2005 and 2006, respectively.
Other costs of services consist primarily of other services rendered by third parties and a fee imposed by Anatel on telecommunications operators (Fistel), which is a fee for the monthly activation and annual inspection of switching stations and mobile terminals. In addition, since 2006, according to the fixed-line new concession contract, Tmar is required to pay, biannually, 2% of its gross revenue as concession fee. For accounting purposes, this expense is recorded annually.
In 2006, other costs of services increased both in the mobile segment, due to an increase in the Fistel fee as a result of the expansion Ois client base and network and in the fixed-line segment due to the concession fee discussed above.
According to Brazilian GAAP, the Fistel fee for activation of prepaid and postpaid subscribers (R$26.83 per subscriber) is being deferred and amortized over 24 months, which is TNLs estimated average retention period. During 2006, Oi deferred R$73 million of these fees on the balance sheet as prepaid expenses and amortized R$92 million. Costs of these fees totaled R$80 million and R$92 million in 2005 and 2006, respectively. For US GAAP purposes, these costs are recorded in the moment of the activation. (See Note 3(h) to TNLs consolidated financial statements).
In connection with the Fistel fee for maintenance, charged based on prior years number of radio base stations, Oi expensed R$94 million and R$142 million in 2005 and 2006, respectively. Tmar expensed R$23 million and R$21 million with Fistel maintenance fees in 2005 and 2006, respectively.
The following table sets forth the components of TNLs selling expenses, as well as the percentage change compared to the prior year and the main expenses of each separate segment. However, the sum of the components of all segments does not correspond to the consolidated selling expense component primarily as a
result of intercompany eliminations (provided) and because TNL included immaterial selling expense components of some segments in other costs.
Sales commissions are paid to TNLs internal personnel, sales agents and dealers, mainly for the acquisition of corporate clients. In 2006, these expenses decreased because of the decrease in the termination rate, over which the commission for the traffic generated by the internet providers is paid. This effect was partially offset by the increase of sales commissions in the mobile segment, due to the growth in volume of the subscribers activation.
The consolidated provision for doubtful accounts decreased in 2006, representing 2.1% and 2.0% of 2005 and 2006 gross operating revenues, respectively. TNL has continued to take a number of actions in order to improve collection processes, in particular for corporate and wholesale clients.
Postage and billing expenses decreased slightly in 2006, impacted primarily by a change from registered to simple postage, which is less onerous, and also due to a decrease in postage volume.
Marketing expenses increased in 2006 primarily due to cultural sponsorships. Marketing expenses represented 1.7% and 1.8% of 2005 and 2006 net operating revenues, respectively.
Third parties services consist primarily of expenses such as consultancy, electricity, clearing services and others.
Personnel costs increased in 2006 due to certain modifications made to posts and salaries in the last quarter of 2005.