Tech margins are the most affected, but capex needs weigh on Telco's FCF

With macro factors becoming frequent in TMT discussions, we are launching a series of reports investigating the fundamental impacts on the sector. Our conclusions: 1) Tech margins are the most affected by inflation swings, with ~85% of sector Opex impacted by inflation (vs. low-to-high 60's of Telco's). However, their contracts with clients are mostly adjusted by inflation, which makes the sector broadly protected against increases; 2) Another key theme on Tech is the difference between the main inflation indexes in Brazil: IPCA/IGPM (affecting revenue growth) and INPC (influencing personnel cost). Index mismatches might cause additional margin volatility on the companies; 3) ISPs are more exposed to inflation swings compared to Big Telcos, due to (a) more expenses indexed to inflation and (b) higher capex/ sales ratio; both taking higher tolls on FCF; 4) Valuation multiples (EV/EBITDA) may cause an artificial distortion when looking at large telcos.

Internet Service Providers (ISPs) - Investment cycle boosts already high exposure to inflation

We believe that ISPs have the highest challenge on an inflationary scenario. The sector's average impact in FCF yield is -250bps with a 2p.p.'s increase in inflation. We believe that companies should not have an easy pass-through dynamic, considering segment competitive landscape with thousands of players.

Large Telcos - Lower impacts but challenging pass-through

Our studies suggest that Large Telcos are the least impacted by inflation swings, (FCF yield impacts of -65bps w/ a 2p.p.'s inflation increase). However, the companies have often struggled to pass-through inflation in Brazil, due to the competitive landscape (although we're seeing an improvement in 2023 due to the mobile consolidation).

Tech - Contracts are a "natural hedge" against inflation impacts

We see the Tech segment as the best positioned in a higher inflation scenario. Even though a material chunk of companies' opex is indexed by inflation, the overall impacts in FCF yield are the most limited in TMT (-50bps average impact in FCF and -8% earnings impact with a 2p.p.'s increase in inflation). The outperformance is partially explained by their high bargaining power, coming from the essentiality of their products and high switching costs.