Stock of the Month: VIV

The World Cup in Brazil has benefited a few of our Inner Circle stocks, and while the excitement is starting to wind down, the month-long spotlight on one of the world’s most exuberant consumer markets is giving us a great buying opportunity right now.

Telefonica Brasil (VIV) was originally known as Vivo, which was the biggest Brazilian mobile communications carrier until it was absorbed into Spain-based corporate parent Telefonica in 2011. Since then, the company has consolidated its position in Brazil’s $68 billion telecommunications sector, capturing close to $16 billion in revenue a year from about 94 million fixed and mobile subscriber accounts.

To give you an idea of the scale involved here, the company has approximately 50% more mobile subscribers than Sprint does in the United States and three times as many accounts as every network in Canada combined. Factor in VIV’s ability to ride 3.6% annualized growth in this market – especially on the lucrative 4G end of the spectrum – and this becomes an attractive global telecom play even before Brazil sees one bit of return on its $11 billion World Cup investment.

Marketed as Vivo across wireless, fixed-line voice, Internet and TV markets, VIV has evolved its offering into a true quadruple connectivity play. Mobile accounts for about two thirds of revenue and is growing faster than the legacy fixed-line business is eroding, while add-on broadband, pay TV and wireless data segments are surging at a double-digit rate off a comparatively low base.

On the mobile side, the company reliably reports a 28%-29% share of the entire Brazilian user base worth about $10 billion in annual revenue, centered around its stronghold of Sao Paulo – the biggest city in the southern hemisphere and the home of about one in 10 Brazilians.

Average revenue per user (ARPU) is still low in global terms at under $10, but as the subscriber mix gravitates toward higher-end voice and data plans, there is a vast amount of room to upsell into a widening Brazilian middle class. By comparison, U.S. carriers routinely capture more than $60 a year per user and even in emerging markets like China and India an ARPU of $12-$13 is possible.

The challenge here for VIV and other carriers is the unusually heavy Brazilian tax burden, which even close advisors of President Dilma Rousseff now admit has been a sector-weakening mistake. Although the Rousseff regime has rolled back some rules – notably a tariff on smartphones and other data-intensive devices – this relief has come so recently that demand is only in the initial stages of recovering.

Potential lower taxes would mean more money for carriers to capture on their own behalf, so I see an opportunity here for VIV and its rivals to collectively edge their ARPU back to global standards. And in any event, the organic pace of smartphone adoption and new wireless-enabled machine-to-machine technologies should help keep VIV revenue increasing at a base of least 4% a year, while EPS may turn the corner as early as the current quarter.

While there may be cheaper global telecom stocks, few of those deeply discounted names offer as powerful a combination of growth and value. Now that VIV has restructured its legacy fixed-line operations to deliver TV and broadband, the overall earnings and revenue comparisons finally seem to have stopped eroding. Recent revenue expansion was on par with the S&P 500 as a whole and management is experimenting with extremely creative ways to accelerate that trend and translate it to the bottom line.

Expanding its Network

VIV made waves a few months ago by agreeing to rent space on its network to U.S.-based data carrier NII Holdings, which operates across the Western Hemisphere as Nextel. This sort of arrangement is well established in the United States – it’s the reason large data centers are sometimes known as “telecom hotels” – and signals the evolution of Brazil as a global player in the remotely hosted data cloud.

More importantly for us, the deal will push about $95 million a year onto VIV books through 2019, starting last Thursday, July 3. Since VIV has already built the network capacity it is renting, I suspect most of this new revenue stream will ultimately feed straight into VIV earnings, possibly boosting EPS by as much as 6% on an ongoing basis.

While a 6% fundamental lift makes VIV interesting at its current price of 14.3X trailing earnings, analysts have yet to incorporate this side of the story into their forecasts or performance targets. If anything, consensus on the earnings piece has gone down since the deal was announced in May, so we have an opportunity here to get in ahead of what could be an upside surprise when VIV reports on July 30.

That 6% lift is especially interesting for what it might mean for VIV’s dividend. In the past, the company has paid about a third of its earnings back to shareholders, so we could see VIV increase its already-significant payout by $0.02-$0.04 over the next year.

As with many Brazilian stocks, the yield here is often misreported – my math indicates that VIV has written checks worth $1.41 per ADR over the last year, which at a price of around $20.35 implies a strong income base of 7% here. Very few U.S.-traded telecom stocks can boast anything comparable, and as the company grows the numbers only get more compelling. Buy VIV up to $21 as we target a 20% return by the end of the year.