We believe  Telefonica Brasil (VIV) is the telecom best positioned for success in Brazil thanks to its narrow economic moat, which is evidenced by its larger market share, particularly with its contract wireless base, higher revenue, better margins, and greater data usage. All of these strengths make the company more immune from the weak Brazilian economy; thus, we believe it can succeed even if Brazil’s economy remains stuck in the mud. Any recovery in Brazil’s economy would provide an additional boost.

In Brazil, there are four main telephone operators: Telefonica Brasil,  TIM Brasil(TSU), Claro (owned by  America Movil (AMOV)/(AMX)), and Oi (OIBR). We think Telefonica Brasil is the best positioned for current weak economic conditions as well as an economic recovery. Of the three pure-play Brazilian telephone companies, we credit only Telefonica Brasil with a moat. We also think America Movil has a narrow moat, but this is primarily due to its massive scale advantage in Mexico, where it boasts about 70% wireless market share. Telefonica Brasil’s moat is driven by its superior subscriber base, which we believe is indicative of a higher-quality network that provides it with a cost advantage.

Wireless Operation Sets Telefonica Brasil Apart

On the wireless side, Telefonica Brasil is the largest operator with 29% market share; however, the more important factor, in our view, is that it has 38.3% of its wireless customer base on contracts, almost double the average for the other three operators.Telefonica Brasil’s larger contract base has meant that its revenue has been less affected by the weak economy, since its customers have a precommitted amount of usage available. These customers have significantly higher average revenue per user, which means the firm has locked in about 70% of its wireless revenue before the month begins. Over the past five years, the firm has increased its focus on higher-value contract customers. In 2010, it had about twice as many contract customers as Oi, which had the fewest, but had only a 20% lead over second-place America Movil. Now, however, it has almost twice as many contract customers as America Movil and three times as many as Oi. We expect this trend to continue, with Telefonica Brasil’s contract base approaching the size of Oi’s entire base by 2019. Brazil has significantly cut mobile termination rates, or MTRs, in each of the past two years and has provided a glide path for continued large cuts in percentage terms for the next three years, though in terms of the Brazilian real, these cuts are becoming less meaningful. These lower MTRs have led customers to reduce the number of SIM cards they use, which led to the Brazilian wireless penetration rate declining in the second and third quarters of 2015.

We anticipate a continued reduction in prepaid SIM cards, which will increase the importance of contract customers even further. Overall, we anticipate minimal wireless subscriber growth, but a continued movement of subscribers from prepaid to contract. Despite Telefonica Brasil’s substantial lead in contract customers, we believe it will continue to expand its contract base. The larger contract base has also led to much higher data usage, with Telefonica Brasil generating data ARPU of BRL 11.90 per month. This is close to America Movil’s total ARPU and is the main differential in Telefonica Brasil’s total ARPU versus that of the other operators. As Telefonica has focused more on contract customers, its ARPU has held fairly steady, with customers paying a set amount every month. Operators that rely much more on prepaid contracts have seen ARPU decline as a result of MTR cuts and price reductions for voice usage. Texting revenue is also declining as customers move to other forms of communication, such as WhatsApp and Facebook; this is similar to moves we’ve seen in Europe. Thus, while the value of data and value-added services is growing rapidly, this hasn’t yet been sufficient to consistently raise total ARPU. As MTR cuts become less meaningful and data usage continues to increase, we expect ARPU will begin to increase for all operators, with Telefonica Brasil being the first to benefit, given its large contract customer base.

We expect data growth to be the key to Brazilian wireless telecoms’ continued success. With subscriber growth mostly coming to an end, revenue growth will depend on selling additional services. We anticipate that increasing data usage and value-added services, such as music streaming, entertainment, interactivity services, multimedia backup, and cloud-based services, will enable continued revenue growth. Again, Telefonica Brasil enjoys greater data revenue than its competitors. It has had a particularly strong 2015, despite the weak economy, and we anticipate that it will continue to increase its spread over its competitors. (America Movil does not break out its Brazilian data revenue.) Since 2009’s first quarter, America Movil’s ARPU has plummeted 40.9% and TIM Brasil’s has fallen 37.4%, while Telefonica Brasil’s is down only 11%. Oi was created from the merger of Tele Norte Leste and Brasil Telecom, so data before 2010’s third quarter isn’t comparable. Since that point, its ARPU has declined 27.1%. Telefonica Brasil’s ARPU has increased slightly in the past two years.

We anticipate that this rate of growth will increase by 2017, at which point the other telecoms’ ARPU will probably begin to increase slightly as well. We think Telefonica Brasil can increase its ARPU regardless of the economy, thanks to its large contract customer base. However, prepaid customers are more likely to need a recovery in the economy, as reduced voice usage is likely to offset data growth. TIM Brasil has the largest prepaid wireless base, and its minutes of use have declined as the economy has weakened, pushing down the firm’s revenue.

Convergence Also Benefits Telefonica Brasil

Brazil is behind Europe in the transition to a converged offering of traditional fixed-line telephone products (including fixed-line telephony, broadband, and pay television) and joining these services with wireless telephony. However, this phenomenon is entering the country. We think the movement to quad play is particularly positive for Telefonica Brasil and particularly negative for TIM Brasil.Alongside its status as the largest wireless operator in the country, Telefonica Brasil owns the incumbent fixed-line operator in Sao Paulo state. In this region, the firm has begun to sell a quad-play service. However, this was limited to just that region until the end of May, when Telefonica Brasil acquired GVT, which was an alternative carrier that had built an extensive fibre network through much of the country outside Sao Paulo state. This network offers significantly faster broadband speeds than Oi, the incumbent fixed-line operator outside Sao Paulo state. In addition to taking broadband share from Oi, this enables Telefonica Brasil to offer a quad-play service across most of Brazil.

We think America Movil is also positioned well for quad-play offerings. The company owns Net Servicos, the largest cable television operator in the country, which provides it with a fibre network in some of the wealthiest regions in the country, allowing faster broadband speeds and rights to television content. We believe TIM Brasil is poorly positioned for convergence due to its minimal fixed-line infrastructure. While it is trying to build out this portion of its network, it will remain an underwhelming business, even if it hits its goal of 500,000 customers by 2019. While Oi is the incumbent fixed-line operator in most of Brazil, its network is quite slow. The company is enhancing its broadband speeds, but generally it is well behind the networks built by GVT and Net Servicos, which is leading to a decline in its broadband base.

A decrease in churn is a primary objective for firms moving to converged service offerings. The lower a company’s churn, the less it needs to spend on advertising and marketing, which increases a customer’s long-term value. While churn is reduced by convergence, it is also affected by the quality and coverage of the network, along with the pricing and plans on offer. Generally, operators with the best network compete on more than price; this provides them with the lowest churn, which is another sign of a moat.

Brazil’s Economy and Politics Under Pressure

Brazil’s weak economy and political situation complicate the changes occurring in the communications market. Brazil benefited from China’s growth by exporting commodities, particularly iron ore. Thus, the slowing in China’s economy has particularly pressured Brazil’s economy, and as commodity prices have collapsed, so too have Brazil’s exports. This has pushed its balance of payments into a deficit and sent the Brazilian real swooning. Alongside the fall in the country’s economy, Brazil’s political system is in shambles as a result of the escalating scandal at Petrobras. President Dilma Rousseff now has the lowest presidential ratings of any standing president in the country’s history. Meanwhile, members of Congress are so worried about trying to protect themselves that the government has ground to a halt, just as further change is needed.

In addition, Congress is considering impeachment proceedings against Rousseff, which will probably cause further political gridlock. We believe the political issues are exacerbating the economic problems in Brazil, which is probably delaying any economic recovery; in our view, this makes it all the more critical to focus on companies that can perform despite the economy. Before the financial crisis, GDP led the Brazilian real/U.S. dollar exchange rate. Since then, however, the exchange rate has acted more as a guide to future GDP. Both the future curve for Brazil’s exchange rate and the International Monetary Fund’s estimates for Brazil’s GDP project that 2015 will be the bottom of the cycle. While both are likely to remain negative in 2016, the percentage decline should be reduced. The iron ore price has also led exports. Despite the negative headlines, we think Brazil will eventually recover, as it has in the past. Charles de Gaulle once said, “Brazil is the country of the future…and always will be.” While we agree to some extent, the country has demonstrated that it can overcome adversity.

We don’t believe the country can consistently live up to its potential, but we do think it can return to decent growth. Thanks to Brazil’s hosting of the World Cup in 2014, most of its preparation for the 2016 Olympics is complete, which should bring in significant extra revenue that year. In addition, the Central Bank of Brazil has reasserted its independence and has once again significantly increased interest rates. While the high rates are adding pressure to the slowing economy, they also play an important role in bringing down inflation. Brazil has returned to being the country with the highest real interest rates in the world. The government had pressured the central bank to lower interest rates before the presidential election, which helped Rousseff win re-election, but the bank appears to have realized its mistake and has cranked rates higher, despite pleas from the government not to. This is the strategy that allowed the country to bring inflation back under control in 2002, when the stock market collapsed and the economy weakened ahead of the election of former president Luiz Inacio Lula da Silva. While the government doesn’t currently seem capable of accomplishing anything of value, it is important to remember some of the reforms that have taken place since Lula’s election, including a reduction in government pensions and education reform. We view improving education levels as particularly important for the country to experience a more sustainable GDP growth rate.

Educational reform previously faced challenges: Parents would remove their children from school and send them out to earn money for the family. To address this issue, the government passed a plan to provide cash to the very poor to encourage them to keep their children in school. However, additional reform is still needed, particularly with pensions, and corruption has actually increased. One positive of the Petrobras scandal is that some very prominent politicians have been indicted and should be removed from office. We view this as crucial for cleaning up the political establishment, many members of which see elected office as a chance to bring wealth to their family and friends, rather than to support the country, which significantly impedes the smooth functioning of the economy.

Brazil’s Weakness Is Hurting Telecom Sector

This weakness in the economy has also hurt the telephone companies. With close to 80% of the country on prepaid wireless plans, subscribers have become more aware of the amount of time they spend on their phones. TIM Brasil’s minutes of use have declined, ARPU has weakened as Brazil’s economy has rolled over. As TIM Brasil has the largest prepaid wireless base, we would expect it to take the biggest hit to its MOU and ARPU. That said, data use is rising dramatically. More than 50% of wireless customers are now on smartphones, and with most people not having access to a fixed-line connection, wireless phones are their main access to the Internet. As customers transition to smartphones and 3G and 4G networks, their data use is jumping significantly. In the past 12 months, smartphone penetration has increased about 50% and now exceeds half of the handsets in use; this increase in data usage is beginning to offset the declines in voice pricing and MOUs. We expect that increased data usage will push up ARPU and revenue over time, as we anticipate that contract customers who aren’t paying for every bit of data access will tend to use more data. As Telefonica Brasil has by far the largest contract customer base, we think it is best positioned for dealing with the economy’s short-term struggles. We also think it is well positioned for any eventual recovery due to its converged offers.

Betting on Quick Consolidation in Brazilian Telecom Is Risky

We think the weak economy and political problems have reduced the chance of consolidation in Brazil. During the past year, many rumors have surfaced regarding imminent consolidation in the country. In our view, however, the biggest issue is that current Brazilian law doesn’t allow for consolidation from four to three operators; given this, the law needs to be changed before any consolidation can occur. The Brazilian regulator is against consolidation, so changing the law may not be enough. However, even changing the law will require political capital, negotiation, and compromise. With the current political mess in Brazil and the need for other reforms to improve the economy, we don’t think anyone has the political capital or desire to spend on changing this law.

Comments from TIM Brasil and Oi regarding board discussions on the subject have been partial drivers of the rumors. Most recently, LetterOne Group, the investment vehicle of Russian billionaire Mikhail Fridman, offered Oi as much as $4 billion if it would merge with TIM Brasil and allow him exclusive rights to negotiate. While Oi agreed to an exclusivity agreement with LetterOne for seven months, nothing will come of it without a change in the law. We think this is a bizarre strategy for Fridman, as he controls VimpelCom (VIP), which owns Wind, the third-largest telecom operator in Italy. A merger between Oi and Tim Brasil could provide  Telecom Italia (TI) with much-needed cash to reduce its debt and provide it with greater flexibility in competing in its home market against Wind.

While we believe consolidation would benefit all the operators, we think it is still some time away from happening. No deal can occur without Telecom Italia’s approval, and management has been reluctant to give up its main division of revenue growth. That said, Vivendi (VIVHY) recently bought a 20% stake in the firm and is asking for four board seats. Additionally, Xavier Niel (who controls Iliad) has acquired options to convert to 15% of Telecom Italia. These changes in the company’s ownership have led management to reduce its vocal opposition to a deal. We think Brazil’s recent economic issues and revenue declines at TIM Brasil have also influenced its thinking. Despite the increasing interest in a deal, we think it will be a slow process. That said, we think there is a good chance of some kind of merger in the longer term, though there are problems with any combination. We don’t think the regulator will allow any of the firms to combine outright, so a creative solution is needed. One issue is that Oi is the only operator that doesn’t have a controlling shareholder from outside Brazil.

While the firm’s disastrous merger with Portugal Telecom diluted the stakes of the Brazilian government, primarily through its development bank, and local pension funds, we think the government would prefer to see Oi as one of the surviving operators. However, Oi is so leveraged that it is struggling to survive and has no capacity to take on more debt for an acquisition. Its stock has also been crushed, making a stock swap impossible, even with 18.4% of its shares held in treasury. Only with a capital infusion, which would massively dilute existing shareholders and would probably have to include the government, would Oi be able to acquire somebody else. Its debt is so large that even $4 billion from LetterOne may not be sufficient. On the other side, TIM Brasil has a strong balance sheet itself, but its parent is highly leveraged. TIM Brasil’s weak fixed-line position would also benefit from merging with another operator.

Ultimately, we anticipate consolidation in Brazil and expect it will come in the form of Oi and TIM Brasil joining forces, with some of their wireless subscribers being sold to Telefonica Brasil and America Movil. However, we think it will take time and government involvement, which politically isn’t going to happen anytime soon. Telecom Italia will be the most affected by the slower process of consolidation that we project. We think some of the company’s shareholders anticipate a speedy disposal of TIM Brasil, which will free up cash to pay down debt, restructure, and possibly consolidate the broadband market in Italy; we believe this has driven interest in Telecom Italia’s stock and pushed it well above our fair value estimate. In our view, however, this quick scenario is unlikely. Telecom Italia’s lack of flexibility and inability to reduce its debt, despite this having been a priority for the past couple of years, will end in frustration. We then expect a sell-down in the stock, resulting in its price decreasing toward our fair value estimate.

The longer industry consolidation takes, the more TIM Brasil’s weak fixed-line positioning will be recognized and the more it will hurt the valuation that the company could receive in a takeout scenario, which in turn would reduce the amount of cash Telecom Italia would have for restructuring. We think Telefonica Brasil and America Movil will both benefit from consolidation, owing to reduced competition and the ability to attract more subscribers, which will provide greater scale and allow fixed costs to be spread over a larger subscriber base. In our view, however, timing is not as important for them, given their better positioning with both strong fixed-line and wireless operations. We anticipate that both will wait patiently, and we doubt that Telefonica Brasil will be a catalyst in bringing about consolidation. If America Movil continues to be squeezed in Mexico, it could become more aggressive in pushing for consolidation in Brazil; otherwise, we think it is likely to be patient.

Telefonica Brasil Is Our Preferred Way to Play Brazil

While we don’t expect either consolidation or an improved economy anytime soon, we think it will be difficult to identify the bottom of the economic cycle for Brazil. We think long-term investors should begin to look at Telefonica Brasil. We think it has the strongest moat in Brazil with the best overall positioning, particularly in the growing wireless contract and 4G space, as well as in broadband (with the acquisition of GVT). The firm has a solid balance sheet, with debt at just 0.4 times EBITDA, which will enable it to participate in consolidation whenever it happens.Telefonica Brasil has generally also had the highest EBITDA margins in the country. While its margins have declined in the past couple of years, we anticipate improvement thanks to the cost-cutting available from the acquisition of GVT.

Additionally, the stock trades at a wide discount to our fair value estimate. To reach the current stock price, our model needs to assume either zero revenue growth or zero EBITDA-margin growth after 2015. We don’t think either of these scenarios is likely. Even if the wireless side remains flat, with data revenue only offsetting continued MTR cuts and voice pricing declines, the fixed-line side will continue to grow thanks to the acquisition of GVT. While GVT’s revenue growth rate has slowed from the mid-20s to the high single digits, we are very confident that its revenue will continue to increase. Likewise, we are confident that cost-cutting opportunities from its acquisition will enable Telefonica Brasil to increase its EBITDA margins. At the time of the acquisition agreement, Telefonica Brasil’s management said it anticipated EUR 4.7 billion in synergies. Even if these synergies have decreased as a result of additional marketing and retention spending needed to offset the weak economy, we are confident that the firm can increase its margins. Additionally, the firm has maintained its ARPU even as the other operators declined during the past two years (when MTRs were cut the most in Brazilian real terms). We are confident that, given its large contract-subscriber base and increasing revenue growth, its ARPU growth will increase and its wireless business will also provide revenue growth, regardless of the economy.