Oi’s Post-Merger Outlook Souring on Debt Deal Gone Wrong

When Oi SA announced its merger with Portugal Telecom SGPS SA last year, Chief Executive Officer Zeinal Bava said the new company could better take advantage of growth opportunities in Brazil. Analysts from Citigroup Inc. to Macquarie Group Ltd. say it will probably miss its chance.

Losses stemming from Portugal Telecom’s holdings of 897 million euros ($1.2 billion) of commercial paper from a firm that defaulted will drive up leverage for the combined company. That makes it harder for Oi to compete in an auction this year of 4G licenses that Credit Suisse Group AG analyst Andrew Campbell called a “once in a lifetime” opportunity. Brazil had also been counting on Oi to help drive consolidation among carriers, said a government official, who asked not to be identified because talks with companies are private.

Bava said on an October conference call after the $14 billion merger was announced that he would boost cash flow, improve corporate oversight and trim Oi’s debt load. Now, after the default by Portugal Telecom’s debtor, the deal is increasing the leverage of the Rio de Janeiro-based company, costing it an investment-grade rating and drawing criticism from Brazilian development bank BNDES, which said it lacked good corporate governance.

‘Selling Point’

“The selling point for that merger was improved governance down the line and this improved financial situation for the company,” said Cristiano Guerra, head of Latin America and U.S. research at shareholder advisory firm Institutional Shareholder Services Inc. in Rockville, Maryland. Instead, the company “got a ratings downgrade, and this issue in Portugal has impacted their leverage,” he said.

Oi declined to comment. Portugal Telecom didn’t respond to an e-mail request for comment. BNDES declined to comment beyond a July 8 statement on the default the combined company is absorbing. The press office for Brazil’s presidency said comment should come from the Communication Ministry, which didn’t immediately respond to an e-mail and phone call.

Brazil’s government supported having Oi lead a breakup of Tim Participacoes SA, the second-largest wireless company in Brazil, according to the government official. The plan came from a decision by Brazil’s antitrust regulator in December that phone carrier Telefonica SA must reduce its stake in Tim’s owner, Telecom Italia SpA, and divest half of its own Vivo unit -- unless it can persuade Telecom Italia to sell Tim.

Oi’s financial situation “may prevent Oi from participating in a hypothetical in-market consolidation in Brazil,” a team of Citigroup analysts led by Lucio Aldworth wrote in a July 16 note.

Growth Opportunity

Oi is also less likely to be able to bid in the 4G auction for government spectrum licenses to improve wireless data coverage -- telecommunications companies’ best opportunity for growth, said Kevin Smithen, a New York-based Macquarie analyst.

“The quality of the network for a data-centered market will become much more important than it is today,” Smithen said in a telephone interview. “Oi and Portugal Telecom, because of their balance sheets, they just don’t have the liquidity to compete.” Oi had 35 billion reais ($15.8 billion) in total debt in the first quarter of 2014, the most among Brazilian peers, according to data compiled by Bloomberg.

Rioforte Investments SA, a subsidiary of Espirito Santo International, last week failed to repay the short-term debt it owed to Portugal Telecom, leading to a renegotiation of the merger terms with Oi. Portugal Telecom would have had as much as 39.6 percent of the new company, known as CorpCo, and will now get a 25.6 percent stake, according to a regulatory filing.

Oi said it didn’t previously know about the debt, and Portugal Telecom hasn’t said why Oi wouldn’t have been informed despite the impact it would have on liquidity after a merger. Espirito Santo owns 10 percent of Portugal Telecom.

Junk Rating

After last week’s default and new merger terms, Standard & Poor’s and Fitch Ratings cut Oi to junk. S&P expects leverage of the combined company to be at a ratio of more than 4 times earnings, Luisa Vilhena, primary credit analyst for Oi at S&P in Sao Paulo, said in a telephone interview. Analysts at Citigroup and Credit Suisse also forecast a ratio of about 4.

“The default on the commercial papers by Rioforte was the main driver for the downgrade,” Vilhena said. “When we look at the company after the default and see almost 3 billion reais on the balance sheet that’s no longer in cash -- money that was supposed to reduce leverage -- that has pressured the company’s ratios even more.”

Oi’s Bava, who is also CEO of Portugal Telecom’s PT Portugal unit, said on a call in October, shortly after the merger was announced, that the deal would bring higher liquidity and “accelerate our ability to crystallize the significant growth opportunities that we see in Brazil.”

He projected that after the merger, Oi would have net debt of 41 billion reais, or 3.3 times earnings before interest, tax, depreciation and amortization.

Oi shares climbed 2.5 percent to 1.62 reais at 4:32 p.m. in Sao Paulo. The stock had sunk 56 percent this year through yesterday.

CEO Turnaround

Consolidation, such as a breakup of Tim, is one of two ways Oi can succeed, said Credit Suisse’s Campbell. The other is through a management turnaround driven by Bava, who is the first CEO at Oi with long-term experience in telecommunications, he said.

“They didn’t really have leadership that came from a lengthy telco background,” Campbell said in an interview in Sao Paulo. “He’s bringing an expertise that the company didn’t have previously. The idea is to do more with less.”

Telefonica and America Movil SAB, which respectively own Vivo and Claro in Brazil, have “the deepest pockets,” Smithen said, allowing them to invest freely in the spectrum auction. “Tim and Oi are going to have to make decisions whether they will invest a market that over time will favor Claro and Vivo,” he said.

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