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See more information at WWW.NOVASBE.PT Page 1/40

M

ASTERS IN

F

INANCE

E

QUITY

R

ESEARCH

 The Nova Research Team recommends buying Portugal Telecom after our valuation of the company at 4.20€ per share FY 2012, meaning an upside potential of 34%.

 Portuguese operations are suffering a lot from current macroeconomic conditions. The mobile sector revenues are dropping since 2009. Yet there is a light at the end of the tunnel, since the growing number of pay TV subscriptions enables for some resilience of the fixed telecom sector.

 Brazil’s economic boom keeps its pace towards the megalomaniac events in 2014 (FIFA World Cup) and 2016 (Summer Olympics). It thus represents an incredible growing opportunity in a still immature telecom market.

 Portugal Telecom liquid position enables the company to stay off the markets in this trouble period, at least until Sep 2013. The drawback is that spending the cash to repay debt during 2012 and 2013 will oblige to a sacrifice of the promised high dividend policy, an effect already acknowledged by its CEO, Zeinal Bava.

Company description

Portugal Telecom (PT) is the leader telecom services’ provider in Portugal, covering all fixed and mobile services for consumers, and enterprise solutions. PT is also present in Brazil, through Oi S.A, after selling Vivo to Telefonica – the main growth source. Its geographical diversification contemplates also several regions in Africa and Asia.

P

ORTUGAL

T

ELECOM

C

OMPANY

R

EPORT

T

ELECOMMUNICATIONS

4

TH

J

UNE

2012

S

TUDENT

:

G

ONÇALO

C

ORONHA

mst16000302@novasbe.pt

Transatlantic Growth

Brazil will be there… even if Eurozone collapses

Recommendation: BUY

Vs Previous Recommendation BUY

Price Target FY12: 4.20 €

Vs Previous Price Target 8.57. €

Price (as of 4-Jun-12) 3.13 €

Reuters: PTC LS, Bloomberg: PTC PL

52-week range (€) 3.00-7.67

Market Cap (€M) 2804.3

Outstanding Shares (M) 875.9

Source: Bloomberg

Source: Bloomberg

(Values in € millions) 2011 2012E 2013E

Revenues 6,158 5,545 5,416 EBITDA 2,199 2,199 2,137 EBIT 828 627 599 Net Profit 423 230 216 EPS 0.48 0.26 0.25 P/E 8.86 16.32 17.38 EV/Sales 2.00 2.23 2.28 Net Debt/Equity 1.77 1.78 1.59 Net Debt / EBITDA 3.01 2.86 2.76 Coverage Ratio 7.40 9.78 9.74

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PORTUGAL TELECOM – PTCPL COMPANY REPORT

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PAGE 2/40

Table of Contents

VALUATION

3

S

ENSITIVITY

A

NALYSIS

6

MACROECONOMIC ENVIRONMENT

8

G

REEK

E

XIT

/

E

URO

F

AILURE

10

COMPANY OVERVIEW

12

S

HAREHOLDER STRUCTURE

13

D

EBT

P

OSITION

13

SEGMENTS

14

P

ERSONAL

14

R

ESIDENTIAL

17

E

NTERPRISE

22

BRAZIL

OI S.A.

23

M

OBILE

25

R

ESIDENTIAL

26

C

OMPETITORS

ANALYSIS

29

ANGOLA

30

COMPARABLE FIRMS

31

SOURCE: BLOOMBERG AND ANALYST ESTIMATES (PT AND OI)

31

APPENDIXES

32

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Valuation

To value Portugal Telecom, we turn our attention mainly to Portugal and Brazil, without forgetting Angola. The valuation model used will be the SOTP (sum of the parts). In Portugal, PT presents three main segments – Residential, Personal and Enterprise. We will carefully look at these segments and the main trends on the market. In Brazil, Oi, SA reports in a more traditional way – Wireline (fixed telephony and internet) and Mobile – and recently started to report TV in separate as well, as the company started to gain significant revenues. Both valuations will be done using the Discounted Cash Flow method, followed by a sensitivity analysis. For our DCF valuation we considered three scenarios with different probabilities: the base scenario (50%) were we value PT and Oi according to the most likely development of their operations; the scenario of Greece (alone) leaving the EMU (40%); and the scenario under which the EMU fails and the Euro is replaced by national currencies (10%). For the other companies PT has participations on, and because they account for a minor part of the value of PT, we will only use a Multiples’ based approach1.

Portugal is currently a tough environment due to the macroeconomic environment, and PT (as well as overall telecom market) is being caught within this tailspin economy. The mobile sector revenues are falling mainly due to a decline in the ARPU2 – more aggressive competition in prices – and MTR3. The residential segment4 is showing more resilience, in great part thanks to the effect of the triple-play offers – market share in TV booster from 0% to 30% in only 4 years –, thus the overall ARPU for the segment has been stable. In Brazil, strategic partnership Oi S.A. represents the main growth driver for PT. The booming economy is being followed closely by the telecom sector. After the success of the partnership with Telefonica – Vivo –, PT has a different challenge now. Oi is the leader in fixed telephony (a shrinking segment) and broadband internet services, but the challenges are the growing market of pay-TV in which Oi is still a weak player and the mobile sector – the most mature telecom segment, leaded by Telefonica.

1 Scenarios 1, 2 and 3, respectively, for future reference 2 Average Revenue Per User

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PAGE 4/40 The calculation of the costs of capital5 for Portugal Telecom and Oi S.A were based on the CAPM model. We considered two different costs of capital: one for Portuguese operations and one for Brazilian operations. Table 1 summarizes all the information, presented in nominal terms.

Table 1

Portugal

Brasil

WACC 7.26% 7.56%

Rf

1.69%

5.28%

Re

10.59%

13.15%

Rd

7.10%

4.83%

βEquity

0.996

1.049

βStoxx 50

1.191

βBovespa

1.182

D/E

1.66

1.02

Tax rate

26.5%

34%

The risk free used for Portugal was the German Bund 10y, while for Brazil we used the US T-Bond 10y (2.0%) adjusted for inflation6 – 2.8% in the US and 6.2% in Brazil. We considered the market values of equity – the market capitalization – and debt7. For the cost of equity8 we assumed that the systematic risk of the Eurozone breakup should be measured, and therefore we estimated that risk with the β of the Euro Stoxx 50 index on the MSCI World Index (as for Brazil we used the Bovespa index on the MSCI World index). The β of the equity for both companies was computed through comparable companies (appendix 1), and the market premium used was of 7.5%, since as “risk-free” assets such as the German Bund and the US T-Bonds are now save haven assets, investors may expect higher market premiums on stocks. The cost of debt9 calculation was

5   D E D t r D E E r

WACCe d1

6 1 1 ) 1 )( 1 ( ( )      US Br US f f r r   7   y BookDebt y y p InterestEx MktDebt E T                   1 ) 1 ( 1

1 , where y is the market yield and T is the average maturity of debt

8

emium Mkt

r

ref eIndex Pr

9

1 ) ( 1 ) 1 (     

d d

d y P RR P

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PAGE 5/40 based on the yields observed in the market. We assumed PT yields10 incorporate 2% probability of default and Oi S.A. yields11 incorporate 1% probability of default, and a recovery rate of 48% for the telecom industry overall12. The nominal growth rate used for the terminal value was 2%, implicitly assuming a long-term inflation of 2%.

The market capitalization (under each scenario) was then calculated subtracting the Net Debt of Portugal Telecom, as of the end of the financial year 2011. The outstanding number of shares is currently 875.9 million, as reported by Portugal Telecom. The expected value of each company was achieved through a weighted average of the three scenarios. Minorities were estimated based on the percentage of claims over total assets in the financial year of 2011, and then replicated in percentage of the Enterprise Value FY’12. One last important fact to mention is that our valuation of Oi S.A. implicitly gives us a price target for the Brazilian operator of R$ 16.2, a 39% potential up-side comparing the last observation.

Table 2 - Portugal Telecom Estimated Value

Fair Value to PTC (€M)

Company Method Stake Base (50%) Greek Exit (40%) Euro Break-Up (10%)

PT Portugal DCF 100% 3,726 2,732 414 2,997 Oi (Brazil) DCF 25.60% 7,120 7,120 7,045 7,113

Contax (Brazil) EV/EBITDA 6x 19.50% 223 223 223 223

Unitel (Angola) EV/EBITDA 6x 18.75% 811 811 811 811

MTC (Namibie) EV/EBITDA 6x 25.50% 122 122 122 122

CVT (Cape Verde) EV/EBITDA 6x 30.00% 70 70 70 70

CST (São Tomé and Príncipe) EV/EBITDA 6x 38.25% 7 7 7 7

CTM (Macao) EV/EBITDA 6x 28.00% 198 198 198 198

Timor Telecom (Timor) EV/EBITDA 6x 41.12% 67 67 67 67

Net Debt (FY '11) 7,351 7,351 7,351 7,351 Minorities (FY '12) 617 568 448 580

Total Fair Value 4,376 3,432 1,158 3,677

# Shares (M) 875.9 875.9 875.9 875.9 Price per Share (€) 5.00 3.92 1.32 4.20 Expected Fa i r

Value (€M)

Source: Analyst estimates

10 Bullet, coupon 4.5% annually, matures at 16/06/2025, y

mid=8.02% 11 Bullet, coupon 5.75% annually, matures at 02/10/2022, y

mid=5.41% 12

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PAGE 6/40

Table 3 - WACC / Growth Rate sensitivity

WACC (percentage points ∆)

4.99648 2% 1% 0% -1%

-1% 0.88 1.93 3.30 5.18

0% 1.80 3.15 5.00 7.67

1% 3.01 4.82 7.45 11.61

2% 4.65 7.24 11.34 18.77

Source: Analyst Estimates

G ro w th R a te (p e rc e n ta g e po in ts ∆)

Table 4 - Portuguese performance sensitivity

Triple-Play Market Share (∆ % )

4.9965 -5.0% -2.5% 0% 2.5% 5.0%

-5.0% 4.14 4.31 4.47 4.64 4.80

-2.5% 4.40 4.57 4.73 4.90 5.07

0% 4.67 4.83 5.00 5.16 5.33

2.5% 4.93 5.09 5.26 5.42 5.59

5.0% 5.19 5.36 5.52 5.69 5.85

Source: Analyst Estimates

Mo b il e Ma rke t Sh are (∆ % )

Table 5 - Brazilian performance sensitivity

Data, TV and F. Voice Market Share (∆ %)

4.9965 -5.0% -2.5% 0% 2.5% 5.0%

-5.0% 1.96 2.92 3.88 4.84 5.81

-2.5% 2.51 3.48 4.44 5.40 6.36

0% 3.07 4.03 5.00 5.96 6.92

2.5% 3.63 4.59 5.55 6.52 7.48

5.0% 4.19 5.15 6.11 7.07 8.04

Source: Analyst Estimates

Mo b il e Ma rke t Sh are (∆ % )

Sensitivity Analysis

Every valuation is estimated based on assumptions. And even when assumptions are very well justified one cannot be sure whether they will hold for the future, even more when valuing companies perpetually. Because of that we have analyzed the sensitivity of our base scenario price target for Portugal Telecom to several drivers. Our inputs change our terminal value estimations of Portuguese segments and Oi S.A. (WACC and nominal Growth Rate), our explicit forecasts (market shares, ARPU), and the total value of Oi S.A. for Portugal Telecom at the end of the year (forward exchange rate €/R$ 6M).

From table 3 we can observe that both WACC and the growth rate have a tremendous impact on Portugal Telecom valuation. For instance, in the (unlikely) scenario of the WACCs for PT and for Oi being lower in one percentage point and the growth rate being 1% higher (meaning 1% real growth rate13) the price target of PT would be €11.61. Though, we believe that it is more likely to the opposite scenario to occur in the future (higher WACC and lower ‘g’) due to the potential worsening of the current crisis, so investors can have an indication of how price per share may change in the case it actually happens.

From tables 4 and 5 it is intuitive to understand the unbalanced weight Brazilian operations have comparing to Portuguese ones. From the extreme variations considered in market shares of the fixed and mobile sectors (the same for both countries, and both segments) the variation in the base scenario price target of Portugal Telecom is much

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Table 6 - Brazilian performance / Exchange rate sensitivity Forward Exchange Rate (% variation)

4.9965 10.0% 5.0% 0% -5.0% -10.0%

-10.0% 3.41 3.72 4.06 4.44 4.86

-5.0% 3.83 4.16 4.53 4.93 5.38

0% 4.26 4.61 5.00 5.42 5.90

5.0% 4.68 5.05 5.46 5.92 6.42

10.0% 5.11 5.50 5.93 6.41 6.94

Source: Analyst Estimates

AR

PU

(%

va

ri

a

ti

o

n

)

higher when the changes of estimates occur in Brazil than in Portugal. While the maximum variation of the price target (within the range we found reasonable), when PT’s market share reaches 2016 above or below the expected by 5%, is of 17%14, if the same variations occur to Oi’s market positioning in Brazil, the maximum variation, ceteris paribus, would be of around 61%.

Finally we conducted the last sensitivity analysis to measure the joint impact of Oi’s average expected ARPU’s changes and the nominal exchange rate observed at 31 Dec 2012. The exchange rate estimation is very important when valuing companies with a great percentage of its assets abroad (which is the case of Portugal Telecom with Oi).

Our base scenario assumes a nominal exchange rate at Dec 2012 of EUR / BRL 2.6415. But since uncertainty is nowadays the key word to describe European and World macroeconomic evolution, it is essential to estimate the value of PT under different assumptions of the exchange rate EUR / BRL. Thus, we assumed a range for the percentage variation of 10%, in accordance with the maximum depreciation of the Euro assumed in the case Greece leaves the Euro until the end of the year (Scenario 2). This means the Euro could appreciate or depreciate 10% relatively to the Brazilian Real. In the worst case, the EUR / BRL exchange rate would be 2.90, thus discounting Oi’s value at a higher exchange rate, and in the best case scenario the nominal exchange rate would be fixed at 2.39. As we can see from table 6, the variation is significant ( [4.26;5.90] ), though even in the nastiest case price per share would be much higher than now (3.12€). As for Oi’s ARPU impact (at the same range of variation), it is slightly higher, ceteris paribus, with the price varying in the range [4.06; 5.93], thus having no impact alone on our buy recommendation –still it can change significantly the shareholder’s return.

14 Over base scenario price target

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Macroeconomic environment

Europe

Recent economic crisis in Europe is affecting almost all countries, mainly the southern ones. Greece has already received financial help twice and part of its debt was pardoned by private creditors. In turn, Portugal is proving to be a “good student”, and the government seems to be doing its part with respect to the austerity measures set by the “troika” in order to return to the markets in 2013. But the poor economic conditions have spread to other European countries, such as Spain, Italy, Belgium, and even France. Eurozone (EMU) leaders seem to be failing in restructuring EU and ECB (European Central Bank) in order to more properly attack the crisis.

Recent Greek and French elections were meaningful. Sarkozy successor, François Hollande, wants to change the Eurozone path, focusing more on growth and relieving austerity. By its turn, Greek voters are dysfunctional: they seem to want to stay within the EMU, but want no austerity, and elected the extreme left leaders. The failure of the talks to form a government between to three most voted parties created renewed pressure on the markets, and a scenario of Greek bankruptcy and even Euro total breakup may now become a reality. As we can see by figure 1, “markets” are already discounting a higher probability of the worst scenarios for Greece and the Euro since the elections day.

Portugal

The situation in Portugal depends on the evolution in Europe, but it is worth to look at some macroeconomic indicators. First the real GDP declined 1.5% in 2011, and it is expected to fall even more in 2012, about 3.0%16, due to plummeting consumption, public spending and investment. Under these circumstances, increasing exports represent the best hope for the Portuguese economy. Inflation has been above European average in 2011 (3.6%) and for 2012 a similar value is expected (3.1%), followed by a return to historical values of 1.4% to 1.5% until 201717. The unemployment rate is increasing, reaching more than 12% in 2011 and possibly 14.4% in 2012, and then slowly decreasing to the expected 11% at

16 Source: IMF forecasts 17 Source: IMF forecasts Figure 1

Figure 2

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PAGE 9/40 201618. If the austerity program is successful, then return to the financial markets should be met with a decrease in the yield of Portuguese debt, though Eurozone leaders have the major role on southern countries recovery.

The main threat for Portugal Telecom, though, is whether Portugal will enter in bankruptcy or not in the upcoming years. If so, Portugal Telecom’s ability to issue money in the markets will be severely affected, and its operations will suffer mainly by lack of investments.

The overall telecom market in Portugal has faced severe troubles in the past years, and the complications are not expected to relief in the foreseeing future. Total revenues for the telecom industry decreased from 2009 to 2011 more than 4.5%19. The most affected segments were the mobile (€3.5 Bn in 2009 to €2.9 Bn in 2011) and fixed telephonies (€0.86Bn in 2009 to €0.78 Bn). Allowing for some resilience in the business of telecoms is the increasing TV plans’ subscriptions – revenues increased from €0.77 Bn in 2009 to €0.92 Bn in 2011. These statistics are the result of the decreasing middle class purchasing power in Portugal, which is being the most affected by the austerity plans.

Another factor that may severely affect Portugal Telecom is the bankruptcy levels in Portugal. The segment with higher EBITDA (as well as revenues) in Portugal is the enterprise sector – products and services to corporates and companies. The skyrocketing of the number of bankruptcies in Portugal, as one can see from figure 6 is threatening PT, and that is already reflected in 2010 and 2011 operating performance. It is expected that economic activity contracts even more until 2014, so PT should lose even more clients due to this effect.

Brazil

Brazil is a completely opposite market, with high growth opportunities. According to IMF estimations, real GDP growth (2.7% in 2011) is expected to be 3% in 2012 and 4% onwards. Inflation (6.6% in 2011) should stagnate between 4.5% and 5.2% yearly until 2016, and unemployment rates should remain between the historical 6% and 7%.

18 Source: IMF forecasts

19 Source: Anacom Parecer do Conselho Consultivo

Figure 4

Figure 5

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PAGE 10/40 One trigger to boost Oi revenues is the whether the middle class in Brazil will continue to consolidate its importance or not. For the past twelve years, being one of the fastest growing economies in the world helped the middle class to increase from 61M to more than 100M at the beginning of 2012 (CAGR of 11.6%), comparing to an increase of the total population of 4% annualized, throughout the same period20. Middle class increased from 37% to 54% of the total population. Also from the Brazilian Government the purchasing power of the middle class has been stable for the past three years, meaning Oi will benefit largely from the increasing middle class, but not from an increasing purchasing power to acquire more costly products.

Two important facts happenings that should sustain Brazilian growth are the FIFA World Cup in 2014 and the Olympic Games in the summer of 2016 at Rio de Janeiro. These two events will boost both investment in technology and infrastructure in Brazil for the next years.

Greek Exit / Euro Failure

21

In order to accommodate the probabilities of Greek default (in 2012) (ever more a real possibility), and even of a Euro break-up (during 2013 in case Greece leaves EMU), we look at two main economic indicators – GDP growth and nominal exchange rates – and how they may be affected. For PT we believe the effects on GDP will affect, approximately, directly the operating revenues of Portuguese operations (the same for Oi in Brazil), since telecom companies are delivering services for corporations – their operations will suffer from GDP decline – and final consumers – which average purchasing power will as well suffer proportionally. The effect on nominal exchange rates will affect Portuguese operations that when denominated for the new currency will devaluate in approximately the same proportion as the currency depreciation.

In the first scenario – only Greece exiting the Eurozone – we expect Portuguese real GDP to fall more 1% to 2% (annually), comparing to the current base scenario until 2016. The lower GDP growth (even more negative up to 2014) is explained by an immediately increasing in the yields, probably postponing Portuguese return to the markets – expected in September 2013. This increase in yields will make

20 Source: Brazilian Government Statistics 21 Assumptions Appendix 4

Figure 7

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PAGE 11/40 the institutions responsible for the foreign help to increase the pressure on Portuguese government to be ever stricter on the austerity measures, decreasing domestic demand and thus GDP. The Euro will probably depreciate around 10% comparing to USD (from the current 1.25 exchange rate) for around 1.10 to 1.25. This depreciation will reflect the (1) outflows of capital from Eurozone, (2) the likely end of the Euro as safe-haven currency once and for all and (3) liquidity injection in Eurozone from the ECB that will increase inflation.

On the second scenario – total Euro failure – we assume Portuguese real GDP may decline around 8% in 2013 – about 8% more than the current estimates. Our predictions are based in other currency regimes failures (though somehow different than EMU). Argentina’s GDP dropped around 11% in the first year, Mexico fell 7% in 1994, and Russia’s GDP declined 5.4% in 1998. After that we expect the real GDP decline comparing to current estimates to slowly decaying, to 4% in 2016. As for the exchange rate every country will redenominate its new currency accordingly to the Euro, and then when free-float starts there will be an immediately depreciation of every new currencies, though at very different levels. It is important to separate two effects: (1) the new Deutsche “Mark” depreciation to USD and (2) the new Portuguese “Escudo” depreciation against the “Mark. We estimate t0068e depreciation of the “Mark” to be around 20% of the current value (1.25) – 10% over the 10% fall of Euro after Greek Exit –, thus achieving parity with USD. This will be the effect of the capital outflows (even from Germany, after a catastrophic attempt to create a new and strong currency (€)), and will not go further due to deflation at the core European countries (due to lower domestic and European demand). But the most important factor is the depreciation of “Escudo” to “Mark”, that we estimate to be at around 50% – to a total of 70% to USD. Then the nominal exchange rate should recover to a long-term goal of 35% depreciation – a value in line with the depreciation Portugal would need (ceteris paribus) to become more competitive. This is in line with depreciations occurred in Russia, Argentina and Mexico (figure 9). Foreign capital will leave the country as soon as possible, and this will happen mainly due to impossibility of returning to the market soon (at least at low costs) thus forcing Bank of Portugal to issue a lot of money to increase liquidity in Portuguese financial system. This will create very high inflation, thus depreciating a lot the new currency.

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Company Overview

Portugal Telecom (PT SGPS) is a global telecommunications operator, and its presence is spread in 10 countries, including Portugal. Its main businesses are the mobile and fixed lines, multimedia and data, and corporate solutions.

In Portugal, Portugal Telecom has consistently been the market leader in the mobile business, through TMN, despite the loss of some market share to its main competitor, Vodafone, in recent years. 4G may be one of the main triggers of this sector, though there is still some uncertainty about its path in the upcoming years. The fixed line business is more divided. Portugal Telecom is still the leader in the fixed telephony services and Internet, though being the second player in the TV sector, after ZON Multimedia - despite incredible market share gains in the past years (with MEO). The technologic (Fiber-To-The-Home) and advertising battle will be crucial in determining the market shares and leadership between these two companies.

Besides Portugal, the most important market for PT is Brazil, through the strategic partnership with Oi SA. Brazilian telecom market is proving to be very attractive, with major growth opportunities (both in fixed and mobile businesses). The challenge for PT is huge, after “exchanging” its participation of Brazilian mobile market leader Vivo for the leader in the fixed telephony business, Oi. Oi’s main competitors are Vivo, Claro and Tim.

Portugal Telecom is still present in Africa and Asia, through participations in companies on Angola, Cape Verde, China (Macau), Kenya, Mozambique, Namíbia, S. Tomé and Príncipe and Timor.

Figure 10

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PAGE 13/40

Shareholder structure

After the end of the strategic partnership with Telefonica in Brazil, the participations that PT and Telefonica had in each others were sold, and since then BES became the largest shareholder of Portugal Telecom, followed closely by RS Holding (an asset management firm who made a capital contribution in kind – 50.01% of Ongoing’s capital). The “re-entering” of PT in the Brazilian market also undertook great changes on its shareholder’s structure, with Oi, S.A. now being the third shareholder of PT. Caixa Geral de Depósitos Group (CGDG) is also worth mentioning, with 6.25% of PT’s capital, because in the end, it can be the means through which the Portuguese Government can try to influence PT’s business, after losing its “golden shares” in 2011. To complete the analysis of the most relevant long-term shareholders in PT, we will remark Norges Bank (Norwegian), Capital Research and Management (US) and UBS (Swiss), with over 4% of the capital each one, diversifying geographically PT’s main shareholders. The current shareholders’ structure may hold back some investments of PT, since some important shareholders such as CGDG and BES are in tough liquidity situations (as most southern banks), therefore looking for keeping an aggressive dividend policy instead of new investments.

Debt Position

The amount of gross debt of Portugal Telecom accounts for €12,408 billion, in which 72.6% is long-term debt and 27.4% is short-term debt. Within the €9 billion of long-term debt, approximately €4.4 billion are long-term corporate bonds, and €3.3 billion are in the form of bank loans. The short-term debt (about €3.4 billion) is composed mainly by bonds (€1.5 billion) and most of the remaining is divided between bank loans, commercial paper, suppliers or liabilities related with equity swaps.

This debt structure is particularly important to face this crisis, since the €3.8 billion PT still has i n cash after the selling of Vivo is sufficient to repay the principal of its short-term debt, and therefore PT does not need to seek refinancing in the markets at least until 2013. This is even more important because it is the time when Portugal is expected to be able to issue sovereign debt in the markets again, and if this is the case, then the markets will once again look at PT in a more favorable way.

Figure 12

PT' Shareholers' Structure

Entity % of Capital

Grupo Espírito Santo 11.34%

RS Holding, SGPS, S.A. 10.05%

Capital Research and Manag. 9.97%

Oi, S.A. 7.20%

Grupo CGD 6.25%

YBS AG 5.05%

Norges Bank 5.00%

Others 4.97%

Source: PT Annual Report

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PAGE 14/40 As a final note and despite what was said, Moody’s downgraded Portugal Telecom’s rating to Ba2 (from Ba1) in April, keeping the negative outlook. Among the main reasons presented by Moody’s (poor debt financial ratios in 2011, negative trends “driven by regulation, competition and macroeconomic crisis”, and challenge of Oi), the main driver for this downgrade was the Ba3 rating for the Portuguese Republic. We disagree with this position of the Credit Rating agency, since most of the short-term debt is going to be repaid in 2012, and therefore the financial ratios will improve to the normal values (Debt/EBITDA from 2.6x in 2011 to 1.7x expected in 2012, and Oi results in the first quarter of 2012 proved a significant improvement in the operating performance). The ratings of PT by S&P’s and Fitch are BB+ and BBB, respectively, both with negative outlooks.

Segments

22

As stated before, from the 30th June 2011 onwards, reported segments from the operations in Portugal changed from a division by technology (Mobile and Wireline) to a separation by clients (Personal, Residential and Enterprise) within a single segment – Portuguese Communications. (figure 15 with (relative) EBITDA of segments).

Personal

This segment relies mostly on all TMN clients but companies. There are four more companies operating in this business (Vodafone, Optimus, ZON (uses Vodafone network) and CTT). The recent trends show that TMN is being able to maintain its market share in the mobile sector, as stated above. In this market, the competition is mainly based on prices, with the three main operators offering very similar services, and any differences may come from the timing of implementation more than from long-term differentiation.

Penetration rates in Portugal have been constantly above European Union (25) average, and the difference has been increasing up to 2011 (figure 16). We expect that the growth rate to decline in the following years, and the penetration rate to stabilize around 170%, as Portugal is in 2011 the EU country with higher penetration rate in the mobile sector right after Italy and Finland.

22 Operating Data Appendix 2 Figure 14

Figure 15

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Tribal Plans and the Mobile Termination Rates

We believe the main reason why TMN has been losing clients to Vodafone is related with the younger clients – the tribal plans23 and the network effect. When Optimus first launched its tribal plan in 2008 (with Tag), TMN did not respond immediately, since it was seen as a desperate move from Optimus, but Vodafone replied with both Extreme and Extravaganza plans. With the first move advantage, Vodafone was able to steal clients from TMN (since it also has a solid client base, and young clients are more willing to change its network). TMN retorted (with Moche) right after. After the implementation of these plans, Vodafone was the great winner, adding more clients, and Optimus the one with the smallest increase of clients24.

Another important fact related with the network effect and tribal plans is the declining of the Mobile Termination Rates25 (MTR) in Portugal (figure 18), as well as in other countries (OECD tried to pressure recently international regulators to abolish MTR to an easier comparison of mobile costs between countries). Figure 19 shows the different MTR across European countries. As MTR decline, the network effect (and so the effect of tribal plans) is diluted, since the cost for the operator of ending a call in other networks decreases, and so that price tends to be reflected on the price paid by the user.

For TMN, as for Vodafone, the decrease in MTR is very prejudicial, since it is the market leader. The effect of reducing MTR permits for more competition from operators with lower market share since they benefit mainly from a reduction in costs, while operators with higher market share suffer more from revenues decline. The explanation is simple: most TMN users make calls to other TMN users, while Optimus users are more likely to make calls to other networks, such as TMN. Therefore, the smaller the MTR, the smaller the amount Optimus has to pay to TMN, thus reflecting on the margins of the operators.

23Plans with free data transfer between users, with a monthly fee. “Extravaganza” and “Extreme” (Vodafone), “Moche”

(TMN) and “Tag” (Optimus)

24 Annual Reports 2008 25

“Fees mobile phone companies charge other carriers to terminate calls on their networks”, on Commerce Commission

Figure 17

Figure 18

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Mobile Broadband

The Fourth Generation (4G)

The fourth generation of mobile devices is already a reality in Portugal. The auction for the LTE26 technology occurred in December 2011, with the three main mobile operators in Portugal sharing almost all the spectrum frequencies with a total investment of € 372 M27 – TMN alone invested €113 M28. This auction revealed a strong investment and that all the operators believe this new technology will be crucial for the future of the market. As one can see in graph x data services are gaining more importance every year in the mobile telecom industry, as a source of revenues. Users rely more and more on data services as opposed to minutes of calls, which represent already less than 70% of total revenues. Total active users of mobile internet and data transfer (through 3G and 3.5G technologies) increased from 2007 to 2011 from 3,074 to 13,029, while broadband internet revenues in the same period skyrocketed from €130 M to €360 M29.

4G’s main advantage is the higher speed of internet through mobile broadband. 4G LTE allows for speeds up to 100Mb/s, four times faster than current speeds in Portugal, and can be accessed in mobile phones, tablets or laptops using USB devices. High speed internet allows also for a new market, which PT is already exploring through MEO Mobile: online renting of movies, series or even TV everywhere. In the future, this could be an important source of clients and revenues. The rapid increase in sales of smartphones or tablets is crucial for the influence and acceptance of 4G as main value creation driver in the future of mobile telecommunications. Figure 21 shows that Portugal already had a smartphone penetration of close to 25% in Dec 2011, slightly above global average, but still with margin for increasing. With 3G technology, TMN was already market leader for the past five quarters in mobile broadband, though losing some clients to Optimus and Vodafone recently (figure 22 market shares mobile net). The prices for these services are still high (€50 – the price for 80 TV channels plus full access to fixed internet – for 100Mb) therefore we believe the prices may go down in the near future due to increase in competition and proliferation of the services.

26 Long Term Evolution 27 Source: Vodafone

28 Source: Annual Report 2011 29 Source: Anacom

Figure 20

Figure 21

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PAGE 17/40 Estimates for worldwide penetration of tablets in five years rely between 18% and 25%30, thus reaching the same acceptance (in five years) as Smartphones did. This is particularly important since tablets are already apt to use 4G, contrary to a significant number of smartphones. Among the infinity (and the number is ever growing) of mobile applications in the market, there are already a few (Mobile TV, internet games) that require 4G internet speeds for high resolutions, triggering consumption. However, the current macroeconomic environment, and unemployment rate in Portugal, might slowdown the proliferation of these luxury goods and services.

However, this technology is still not completely implemented across the country. Only on the 26th of April did Anacom completely turned off Analogic TV signal allowing for the operators to start installing antennas across the country in order to access 4G in more regions31. Turning off the Analogic TV was necessary to release frequencies that can now be used for new technologies, as has been done across Europe32. Also, Anacom will force the Operators to invest in all the locations that are not covered by 3G and are not part of the initial plan of investment on the fourth generation. These two facts will force PT to increase its investment in CapEx for 2012 and possibly 2013, aside from the investment already made to purchase the spectrum frequency license. Analysts forecasts are presented below.

Table 6 2011 E2012 E2013 E2014 E2015 E2016

EBITDA (€ M) 347 316 317 298 299 316

Market Share (%) 43.0 42.9 42.8 42.7 42.5 42.4

ARPU (€) 9.7 9.0 9.0 8.5 8.5 9.0

CapEx (€ M)

158

250

200

200

200

200

Residential

The residential segment relates to all the services rendered to the householders by PT Comunicações – fixed services. These services are paid TV by subscription, internet (fixed broadband) and voice. Its main competitor in all three business sub-segments is ZON Multimedia.

30

Tablet Demand and Disruption - Mobile Users Come of Age, Morgan Stanley Research

31 Source: Anacom

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Voice

The fixed telephony service in Portugal has been declining in value due to the decrease in prices in mobile phone services. Nevertheless, the number of accesses and the penetration rate (graph 4.3.1) have been increasing since 2008 – due to increase in triple-play offers by MEO and ZON, where the phone calls for Portugal are free –, after a slight decline during the previous years. However, overall trend in EU is to a decrease of usage of fixed telephony, so we believe this recent trend in Portugal will not be maintained. Most important of all, business evolution shows that fixed telephony revenues dropped almost 50% between 2004 and 2010 (graph 4.5.1).

Portugal Telecom has also been losing some positioning in this market, mainly for ZON Multimedia, who presented fast growth for the recent years – PT had 63% market share on Dec 2010, and 57% on Dec 201133 – though this is not dramatic, since fixed telephone will certainly not be the driver of future growth.

Comparing the minutes (graph x) used of fixed phones vs mobile phones, we see that consumers have been constantly exchanging the use of fixed phones by mobile phones, and it is our expectation this trend to continue.

TV

TV subscriptions have become increasingly important in the residential business, probably being the main value creation driver in this segment. In recent years, MEO has been the main bet of PT in this sector. ZON (after the spin-off from PT in 2006) has been market leader with a great market share, though decreasing. After PT launched MEO (in 2007) ZON has been losing clients to PT at an incredible pace (graph with market shares já com estimativas). The increase in TV subscribers is closed linked with the increase in triple-play (MEO) subscribers, as we will refer below. It is also important to mention that the number of subscribers of cable TV in Portugal and the penetration rate have been constant for the recent years, showing slight improvements34, and we do not expect that to change in the future.

33 Source: Anacom

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Internet

This market is characterized by two main players: PT is the market leader (as in the Voice sector) with almost 50% market share (mainly through SAPO ADSL and the increasing MEO clients), while ZON has been stealing some clients, with a market share at Dec 2011 of 33% (figure 10). We believe that this is a market with great potential in Portugal. Though the number of clients has been increasing steadily on recent years, there is still great margin to improve, since penetration rates at internet fixed access are still by far below most of European Countries (figure 23). Even more important is to refer that Portugal is one the third country (of OECD) on the list of higher average internet speed contracted, which means that technology must be important for Portuguese consumers, and with FTTH PT can offer the best offers in speed.

Triple Play

The market for the three components of the Residential segment have been analyzed separately, but the real market for householders is no longer the separate purchase of these services, but instead what is called the “triple-play”35. The evidence of this market evolution is undercover above. In the segments PT has a leading position (Internet and Voice) it is losing market share to Zon, and in the segment Zon is the clear leader (TV) it is losing market share to PT, so that the market shares of each company on the three segments are converging. Zon has 46% market share in the triple-play market, while PT has only 34%, as at Dec 201136. Also, we can understand from the different trends of the market shares that the main driver of this segment is the TV offer. Consumers chose their “triple -play” service provider most of the times based on the TV offer and its quality perception, since Internet and Voice are more undifferentiated goods up to now. Although, our view is that paradigm may slightly change towards internet in the future, since costumers will become more eager for faster and faster internet connection, and whoever wins the battle between FTTH37 (PT) and Eurodocsis (Zon)38 – FTTH allows for wider broadband once inside the house, thus not losing speed or quality if used for multiple devices, while fiber-to-the-street delivered by

35

TV, Internet and Voice together for a fixed monthly fee.

36 Annual Reports 2011 of Zon Multimedia and PTC 37 Fiber-to-the-home

38 Zon only delivers Optical Fiber to the street cabinets, while PT (as well as Clix) already delivers FTTH, already covering

1.6M homes.

Figure 23

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PAGE 20/40 Zon loses it. Up-to-now FTTH clients (figure 24) are not that much comparing to the investment PT has made through 2008 to 2011 – roughly € 90M / year39. As one can see in the same graph, only in 2010 and 2011 FTTH started to be popular over Portuguese internet users, allowing them higher speeds, but still far to compensate PT investment.

FTTH

PT has made a huge investment in FTTH, which ended in Dec 2011, already covering 1.6M houses, and PT has no intention of expanding this service. However, up-to-date FTTH has not been responsible for the increasing market share of PT, but rather the aggressive marketing strategy. We also believe that FTTH will not be determinant in the near future, since it allows for broadband features way higher than the actual consumer needs, therefore consumers will not be willing to pay high prices. Also, PT is way ahead of its European peers regarding the investment already completed vs the investment other companies are still beginning to undertake. Figure 24 shows the penetration of FTTH across different countries40. The question remains whether investing sooner than its peers means a competitive advantage or a waste of money, but we believe that for the positioning of MEO in the “triple-play” segment it was important that PT dominates the FTTH line, since it will become the differentiated factor in the following years. The question remains if PT will have to “open” the line to other operators – it has not been yet discussed by Anacom nor other European regulators – but even in that case, the investment will be certainly fully compensated, as it occurred in the past with other technologies.

“Stable market”

This segment has been the most resilient throughout the crisis, simply because in this sector clients pay a fixed amount every month, no matter how much they use the services (most of calls fixed-fixed are already free as in the mobile phone sector), while with mobile phones consumers may opt to spend only an average of 10€ a month instead of 20€ before the crisis. This can be shown by figure 26, with the evolution of Residential and Personal revenues. Therefore we believe this

39Source: Annual Reports 2008/ ‘09/ ‘10/ ‘11 40 ISP Review

Figure 25

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PAGE 21/40 segment would continue to be very resilient for the next two to three years, while the crisis slowly gets over in Portugal.

We expect the Capex to be high for the year of 2012 and 2013 due to the Data Center that is being constructed in Covilhã, but then to return to normal – before 2008 – levels, since the investment in FTTH already stopped. Analyst forecasts are presented below

Table 7 2011 E2012 E2013 E2014 E2015 E2016

EBITDA (€ M) 307 324 324 327 326 327

Market Share (%)

Voice 57 56 55 54 53 52

Internet 49 50 50 50 50 50

TV 36 38 39 41 43 44

ARPU (€) 30.8 30.3 29.7 28.9 28.1 27.0

CapEx (€ M) 525 510 400 400 400 400

Convergence Fixed / Mobile

Beyond the

“triple

-

play”?

Recently Vodafone (a company traditional only focused on the mobile sector) has entered in the fixed business, with triple play offers. This bet of Vodafone could be one of two signals: either Vodafone started to perceive this as an attractive market or it is a strategic way of guaranteeing a broader service delivery. It is possible that in the upcoming years we may assist to an even stronger convergence between fixed and mobile businesses. Not only do we see (across Europe) the proliferation of the same companies delivering these two services in the respective countries41, as there are already services offered to cover all sectors. For instance, MEO is already providing a service in which the consumer can watch TV everywhere: on a traditional TV, tablet or mobile phone42. We believe that sooner or later this convergence will be a reality and every company should be able to deliver not only the “triple-play” as well as mobile services with it. It is still too soon to make a guess on what will be the driver of this “whole” telecommunication service – mobile or TV? – as it is somehow clear that TV is the first choice on the “triple-play” sector. However, if a company wants to become a player in this new business (if it ever becomes a reality), then it must provide every single service included, and PT is well positioned with TMN and MEO. In that sense we see as

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PAGE 22/40 likely a possible M&A between some operators. A clear example may be Zon and Sonaecom, with Zon taking advantage of the position of Optimus in the mobile business, or even Vodafone acquiring Zon, with the same purpose – taking advantage of the positioning of Zon on the fixed sector. In any of these M&A deals may create synergies in the case of a fixed-mobile convergence, and PT would face a sole strong competitor across all segments, which does not happen now.

Enterprise

This segment it probably the one where it is more visible the convergence between fixed and mobile services, and integrated offers. PT offers solutions for both SMEs and great corporations, with great investments in infrastructures and in telecom-IT convergence43, increasing the penetration of IT/IS44 and BPO45 services. The new data center PT expects to be completed by the end of the year will target “Cloud Computing”46 innovation, with a strategic partnership with Microsoft and Cisco47. This segment includes data, voice, fixed and mobile services and Information and Communications Solutions – more focused on great enterprises – for small, medium and big enterprises.

Portugal Telecom is by far the most credible and best positioned operator in Portugal for this client segment, being able to provide and entire service for the enterprises, from top to bottom, with solutions covering the most traditional telecom services (voice and data transfer) to IT and implementation consulting services to its clients. PT Inovação, PT Negócios48 and PT Prime49 (subsidiaries from PT Group) are key institutions for retaining clients.

Although we believe PT has been competent and innovative delivering solutions to its clients, the segment has been facing some difficulties, with revenues decreasing 9% in 2011. This decrease in revenues is mainly due to decrease in the number of clients (SME), since a significant percentage filed for bankruptcy in 2011, as stated before. In the first 4 months of 2012, 1,650 companies have filed

43 New Data Center in Covilhã, to be completed in 2013 44 Information and Technology/Information Systems 45 Business Processing Outsourcing

46

Allows firms to adapt to new business models more quickly and frequently – flexible capacity and access to IT services are the main services PT is offering companies with this new service

47 Source: Annual Report 2011 48 Solutions for SME

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PAGE 23/40 for bankruptcy in Portugal, 45%50 more than in the same period in 2011, and the number already had increased 60% from 2010 to 2011. Also, bigger corporations tend to have a tighter cost control, therefore reducing in the perks conceded to their employers (mobile phones, smartphones and free tariffs) or the amount spent on communications, data transfer or IT/IS innovation.

We believe these trends will continue in the next years, at least as long as Portugal is in recession, and therefore revenues of Enterprise tend to decline up to 2015, and then slowly recovering as Portuguese economy does so. Analyst forecasts are presented below.

Table 8 2011 E2012 E2013 E2014 E2015 E2016

EBITDA (€ M) 412 355 363 372 363 382

Brazil

Oi S.A.

51

Brazil investment may not be represent the major source of EBITDA currently, but has for sure the greatest growth potential. It is important to first take a look at the telecommunications’ market in Brazil.

Previous Note

Oi, SA = Telemar SA + Brasil Telecom + Telemar norte leste, Partipações

During 2011 and beginning of 2012 Oi holding companies executed a process to simplify the corporate structure. Oi (the brand name) was hold by three different public companies: Tele Norte Leste Participações S.A (TNL), Telemar Norte Leste S.A. (Telemar) and Brasil Telecom S.A. (BrT)52. In order to simplify, the shareholders of the Oi Companies approved at February 27, 2012 the (1) new corporate name for BrT – Oi S.A –, (2) the merger of TNL into Oi S.A., (3) partial split-off of Telemar with the acquisition of the split off portion by Coari and (4) the merger of Coari into Oi S.A. The old and new corporate structures are schematized below. Portugal Telecom continues having its stake ate Oi through a direct participation and a participation in TmarPart.

50 Source: INE

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Shareholders’ Structure

The main (controller) shareholder of Oi is Telemar Participações, with 56.44% of the shares, but with PT having more than 20% participation in Telemar. It is a complicated structure, But in the end Telemar and Portugal Telecom (15.55% directly and 10.05% indirectly participation) being the major shareholders of Oi. All other shareholders have 3.4% or less of the shares, and they don’t seem to be able to join in order to have decision power over Oi.

The Telecom Market

Contrary to Portugal, the country is divided in three regions, in which companies need different licenses to operate in. Region I consists on all the Atlantic coast north of São Paulo; Region II consists in the west districts and south of São Paulo districts; and Region III is the São Paulo state (figure 28). It is important to mention that Oi does not operate in all states or in all regions yet, and that may be a setback in PT’s strategy in Brazil, since Oi does not always have access to the most attractive markets – it does not provide internet service in São Paulo, for instance (besides that, it offers TV, Internet, Voice (Wireline) and Mobile services in all the three regions.

Oi Operations in Brazil

Oi provides wireline (now called residential as PT did for Portuguese operations) and mobile (personal mobility) services in Brazil. On the mobile sector Oi is now present on the three regions after the takeover of BrT in 2009. Within the residential segment, Oi is present in every state with fixed telephony (though poor

Imagem

Table 5 - Brazilian performance sensitivity
Table 9  2011  E2012  E2013  E2014  E2015  E2016  EBITDA (R$ M)  8,609  10,648  11,000  11,313  11,631  11,891

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