CHICAGO--(BUSINESS WIRE)--The proposed merger between Oi S.A. (Oi) and Portugal Telecom SGPS SA (PT) is moving ahead with approvals from antitrust regulators in both Brazil and Portugal, as well as from PT's creditors which recently approved the consent solicitation, according to Fitch Ratings. Amid concerns from some dissenting minority shareholders of Oi on the transaction structure, the general shareholders meeting for both companies will be held on March 27, 2014 to determine key issues for the merger to proceed. This report highlights Fitch's answers to the most frequently asked investor questions on the proposed merger and provides Fitch's position on the issues.
Question: Will the merger proceed despite differing views from minority shareholders?
The extraordinary general shareholders' meeting will be held on March 27, 2014 for shareholders to approve Oi's capital raising plan, and the valuation of PT's operating assets to be contributed to subscribe to Oi's such capital raising. These two conditions are key prerequisite for the proposed merger to proceed.
Independent advisory firm, Institutional Shareholder Services (ISS) has voiced their concerns that the proposed merger does not fairly represent the best interest of Oi's minority shareholders and favours the controlling shareholders. While acknowledging potential positives from the merger, the minority owners have been expressing their concerns that the terms of the merger, including the valuation of PT's assets, will result in a significant dilution of their shares. Meanwhile, another independent advisory firm, Glass Lewis & Co., has analysed that the deal could be positive for minority shareholders in light of the potential improvement of the governance structure.
To address this concern, Comissao de Valores Mobiliarios (CVM), Securities and Exchange Commission of Brazil, initially ruled that Oi's controlling shareholders, Telemar Participacoes S.A (Telemar), would not be allowed to vote with respect to the approval of the valuation of PT's assets at the upcoming shareholders' meeting. However, Oi has appealed the decision, and on March 26, 2014, a day before the meeting, CVM ruled in favour of Oi confirming that only PT and its controlled company, Bratel Brasil S.A., representing 7% of the ordinary shares, will be prohibited from exercising their voting rights. Given Telemar's 56% ownership of Oi ordinary shares, Fitch believes that the shareholders will be able to come to an agreement and vote in favour of the planned merger.
Question: What are the key remaining steps and the expected timeline of the merger?
Based on the assumption that the shareholders approve Oi's capital raising plan, including the PT asset contribution, the next step will be the pricing of Oi's capital increase on April 16, 2014.
Oi plans to raise about BRL14 billion of capital from a combination of BRL5.7 billion (EUR1.75 billion) from PT's asset contribution and the rest from cash raised from investors. Under the agreement with PT, PT's obligation to contribute its operating asset is subject to Oi successfully raising at least BRL7 billion cash proceeds, of which BRL2 billion will come from the investment fund of Banco BTG Pactual S.A. and the existing shareholders of Telemar. Based on the various market reports, Oi seems to have secured commitments from 14 local banks that will buy up to BRL6 billion of Oi's new shares, in case of an insufficient demand. The company plans to close the transaction by April 23, 2014.
Within 60 days from the closing of the capital increase, there will be a merger of shares in which all of Oi's shares, not owned by Telemar, will be exchanged for Telemar common shares and Oi will become the wholly owned subsidiary of Telemar. The transaction will be followed by a merger of PT shares into Telemar, with the latter as the surviving entity; PT's existing bondholders will receive an unconditional guarantee from Oi. Should the process proceed as planned, the merger will be complete within the first half of 2014.
Question: What are the synergies from the merger?
Given the different operational geographies, Fitch does not foresee any meaningful operational integration that could lead to an immediate improvement of the competitive positions of Oi and PT in their respective markets. However, Fitch believes that the merged entity's credit profile should benefit from increased scale with an over 100 million subscriber base and geographic diversification of cash flows, as well as some merger synergies in terms of cost savings and sharing of best practices over the medium to long term. In addition, modest deleveraging will accompany the rights issue although its impact will be limited to a debt reduction of BRL2.0bn - BRL3.0bn.
In addition, the merger will substantially improve the new company's corporate governance structure by eliminating Oi's current complex shareholding structure and restructuring it with one class of shares of one listed entity, Telemar (Corpco), with same voting rights and dividends.
The company has disclosed that it expects to achieve BRL5.5 billion of synergy on a net-present-value basis, of which the majority should come from the improved efficiency of its operations. In addition, the company expects to gain some fiscal benefits, mainly tax credits, from the merger, although these benefits could prove to be one-off items and eventually be exhausted.
Question: What is Fitch's view on the merged entity? When will the Watch be resolved?
Fitch has placed Oi and PT's ratings, both rated at 'BBB-', on Rating Watch Negative reflecting a view that following the merger the financial profile of combined entity is less likely to support a 'BBB-' rating. Fitch estimates pro-forma leverage of the post-merger entity will be above the current downgrade guideline of 3.5x at Oi. PT's downgrade guideline for net debt / EBITDA plus associate dividends is likewise currently set at 3.5x.
For Oi, profitability erosion was evident in 2013 due to the competitive pressure in the Brazil telecom market with its recurring EBITDA margin falling to 27.9% from 31.5% in 2012. In addition, any meaningful deleveraging in the short term is unlikely based on Fitch's expectation of negative free cash flow (FCF) generation in 2014 due to high capex, other investment cash outflows, and falling margins. The company has taken on a series of asset disposals to raise cash since late 2012 but the impact on its net debt has been small.
For PT, its performance in Portugal remains under pressure on the back of difficult macro challenges with its domestic EBITDA falling by 9% in 2013 compared to 2012. In addition, the absence of dividend receipts in 2013 from its Angolan associate, Unitel, has negatively impacted its cash flows.
Given the operational challenges faced in both markets, any major improvement in the financial profiles of the pro forma merged entity may prove challenging after the merger despite the management's intention to delever. Due to the forecasted negative FCF, the net leverage ratio of the merged entity is likely to be above 3.5x in the short to medium term. Therefore, Fitch retains its conservative view that the merger synergy may not be strong enough to curb the weakening operating trends, in which case the ratings of the merged entity may be pressured at the current 'BBB-' rating level of both Oi and PT.
The Rating Watch on both companies' ratings will be resolved following the close of the merger in the coming months. Fitch will closely monitor and assess the impact from the merger when more details on the management's new business and financial strategies are available. Also, Fitch believes that the individual ratings of Oi and PT will continue to remain under pressure in the case the merger falls through given the aforementioned operating challenges.
The newly merged entity will be headquartered in Brazil, with an over 100 million subscriber base from its operational geographies in Brazil, Portugal, Africa and Asia. Pro forma revenue and EBITDA are estimated to be about BRL37 billion and BRL12 billion, respectively, of which about 70% are expected be generated by its Brazilian operation. The company's pro forma net debt, including the impact from the proposed capital raising of Oi, is estimated to be BRL46 billion.
Additional information is available on www.fitchratings.com.
Applicable Criteria and Related Research:
--'Fitch Places Oi on Rating Watch Negative' (Feb. 26, 2014).