EMBRATEL

Emerging Markets Finance

Lorena Navarro Jaime ArriagadaLuis De ZabalaFernando Diaz

February 26, 1999

Agenda for Today

• Outline and Background of the Case

• Takeaways / Learning Points

• Suggested Solutions

• What happened after?

Case Outline

• Introduction

• Brazil and its Privatization Process

• Telebras and Embratel

• Investment Opportunities and Risks

• Valuation

Brazil

• History of Instability

• 20 years of military rule

• Unstable political environment

• Capital controls, high tariffs, high interest rates

• Cardoso Era

• Plan Real as Minister of Finance

• President of Brazil in 1994

• Privatization Plan

• Where are we ?

Telebras and Embratel

The Telebras Transformation

TELEBRAS YESTERDAY TELEBRAS TODAY

• 1 Government controlled holding company:

> 27 local fixed-line subs> 26 local wireless subs> 1 long distance sub

•12 Privately controlled holding companies:

> 3 Regional fixed-line Cos> 8 Regional Wireless Cos.> 1 long distance operator

Telebras and Embratel

• EMBRATEL OVERVIEW

•Embratel Provides:> Domestic Long-Distance (DLD) Inter-region + Intra-region> International Long-Distance (ILD)> Data transmission> Others (Internet, etc)

•Total Assets of R$ 7.9 billions

•Total Revenues of R$ 2.2 billions

Investment (I)

Opportunities • New access charges to the fixed line network

• Based on a flat rate that will have positive effects on earnings

• High growth in Long Distance Market• Domestic long distance represents bulk of the revenues.• Small international LD market if compared Brazil with other countries.

• Good opportunities for cost cutting and cost control• Synergies brought by the buyer

Investment (II)

Risks• Competitive environment coming ahead

• Concession of a “mirror company” in 1999• Industry completely open in 2002• Fixed line companies as competitors in intraregional market•Cellular companies are potential competitors

• Big one-time charges against earnings: • Write-off of assets to adjust to the new competition.• Accounting policy changes: depreciation, pension obligations and tax management .

Takeaways (I)

High Priority Medium Priority Low Priority

Discounted Cash Flows

Nominal vs. Real vs. Dollars

Time horizon

Terminal Value (constant growth, comparables)

Drivers benchmarks (projections)

Investment schedule

Taxes (Investment credits)

Legal constraints

Takeaways (II)

High Priority Medium Priority Low Priority

Discount Rate

Alternative Methods to incorporate country risk

Beta (CAPM) - Comparables (leverage-unleverage)

Market Risk Premium

Time horizon of key drivers (eg. Sovereign Debt)

Optimal Capital Structure (historical, industry average)

Comparables

Country Risk

Current or Trailing

Price horizon

Value Ratio (P/E, Value/Ebidta, Rev/Subs.,other)

Suggested Solution - DCF Model

• Build a full valuation model “The Puzzle”

• Macroeconomics Assumptions

• Market Growth Rates

• CAPEX and Depreciation

DCF Model (II)

• Ke = Rf + *(Rm-Rf)… and ?

• Which Beta?

DCF Model (III)

• The WACC under IICCRC is substantially higher

than under Sovereign Debt Spread model.

IICCRC SDS - Model

DCF Sensitivities

• Company risk should be incorporated through the FCF

• Country risk should be included in the Cost of Equity (Ke)

* Value of 52% in Embratel’s equity

Comparable Company Analysis

• Key issues:

– What multiple?

– Which Companies?

– How to incorporate country risk?

Latin American Telecoms importanceYTD 1998

21%

37%

23%

23%

14%

18%

32%Argentina*

Brazil

Chile

Mexico

Peru

Average

Venezuela

Market Cap. as % of local index

* Argentina’s correlation is the average of Telecom Argentina and Telefonica de ArgentinaSource: Salomon Smith Barney

72%

67%

68%

57%

52%

71%

86%

ADR Vol. as % of local index

Argentina*

Brazil

Chile

Mexico

Peru

Average

Venezuela

Correlation Local Market vs. ADRs YTD 1998

0.84

0.96

0.92

0.65

0.82

0.98

0.77Argentina*

Brazil

Chile

Mexico

Peru

Average

Venezuela

Each Telecom company has become increasingly a proxy for their home market

* Argentina’s correlation is the average of Telecom Argentina and Telefonica de ArgentinaSource: Salomon Smith Barney

Estimated Telebras’ Multiple using IICCR1998

38.7

36.1

92.6

45.2

63.2

41.6Argentina*

Brazil

Chile

Mexico

USA

Venezuela

Institutional Investor Country Credit Rating

Source: Salomon Smith Barney

4.1

3.3

8.9

5.2

6.9

5.3

EV/EBITDA 98E

Average

3.5

3.7

4.5

4.2

4.9

4.2

BRAZIL Estimated EV/EBITDA 98E

Estimated EMBRATEL Multiple using IICCR1998

4.1

8.7

15.2

8.0

0.0 5.0 10.0 15.0 20.0

Sprint

MCI WorldCom

AT&T

Telebras

Company

Source: Salomon Smith Barney

4.1

8.7

15.2

8.0

0.0 5.0 10.0 15.0 20.0

adjusted by country risk = 3.3x

EV/EBITDA 98E

Valuation Summary

0.7 1.2 1.7 2.2 2.7

IICCRDiscount rate

SovereignDebt spreaddiscount rate

Comps

Billion US$ (52% stake)

Value paid $2.26

What happened ?

• July 1998: MCI Worldcom won auction with a bid of $ 2.3 bn.

• This amount represented a premium of 47% of minimum price set by the government.

• Sprint offered the best price in sealed envelope, R$2.499 bn. vs. R$2.477 bn offered by MCI.

• The auction went to open outcry; MCI acquire Embratel in less than a minute for R$2.650.

What happened ?

Brazil Brady Bond Spread over 30yr. US Treasury

0

200

400

600

800

1000

1200

1400

1600

1800

basi

s po

ints