<PAGE>
As filed with the Securities and Exchange Commission on March 16, 1999.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
Amendment No. 2
to
FORM 20-F/A
(Mark One)
[X] REGISTRATION STATEMENT PURSUANT TO SECTION 12(b)
OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
[_] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended:
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
for the transition period from to
Commission file number: 001-14499
EMBRATEL PARTICIPACOES S.A.
(Exact name of Registrant as specified in its charter)
Embratel Holding Company
(Translation of Registrant's name into English)
The Federative Republic of Brazil
(Jurisdiction of incorporation or organization)
SCN-Quadra CN2, Lote F, 2(degrees) Andar, Sala 204
Brasilia-DF, Brazil
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the
Act:
<TABLE>
<CAPTION>
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
<S> <C>
Preferred Shares, without par
value.......................... New York Stock Exchange*
</TABLE>
- --------
* Not for trading, but only in connection with the listing of American
Depositary Shares on the New York Stock Exchange
Securities registered or to be registered pursuant to Section 12(g) of the
Act: None
Securities for which there is a reporting obligation pursuant to Section 15(d)
of the Act: None
Indicate the number of outstanding shares of each of the issuer's classes of
capital or common stock as of the close of the last fiscal year covered by
this Registration Statement: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes No X
Indicate by check mark which financial statement item the registrant has
elected to follow.
Item 17 Item 18 X
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<C> <S> <C>
PRESENTATION OF INFORMATION................................... ii
GLOSSARY OF TERMS............................................. v
EXCHANGE RATES................................................ viii
PART I
ITEM 1. Description of Business....................................... 1
ITEM 2. Description of Property....................................... 25
ITEM 3. Legal Proceedings............................................. 25
ITEM 4. Control of Registrant......................................... 26
ITEM 5. Nature of Trading Market...................................... 26
ITEM 6. Exchange Controls and Other Limitations Affecting Security
Holders....................................................... 28
ITEM 7. Taxation...................................................... 30
ITEM 8. Selected Financial Data....................................... 34
ITEM 9. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 38
ITEM 9A. Quantitative and Qualitative Disclosures about Market Risk.... 60
ITEM 10. Directors and Officers of Registrant.......................... 61
ITEM 11. Compensation of Directors and Officers........................ 63
ITEM 12. Options to Purchase Securities from Registrant or
Subsidiaries.................................................. 63
ITEM 13. Interest of Management in Certain Transactions................ 63
PART II
ITEM 14. Description of Securities to be Registered.................... 64
PART III
ITEM 15. Defaults upon Senior Securities............................... 77
ITEM 16. Changes in Securities and Changes in Security for Registered
Securities.................................................... 77
PART IV
ITEM 17. Consolidated Financial Statements............................. 77
ITEM 18. Consolidated Financial Statements............................. 77
ITEM 19. Consolidated Financial Statements and Exhibits................ 77
</TABLE>
i
<PAGE>
PRESENTATION OF INFORMATION
Overview
Embratel Participacoes S.A. (the "Registrant"), a corporation organized
under the laws of the Federative Republic of Brazil ("Brazil"), was formed
upon the reorganization of Telecomunicacoes Brasileiras S.A.--Telebras
("Telebras"), a corporation organized under the laws of Brazil that, together
with its operating subsidiaries (the "Telebras System"), was the primary
supplier of public telecommunications services in Brazil. On May 22, 1998, the
shareholders of Telebras approved the restructuring of the Telebras System to
form, in addition to Telebras, twelve new telecommunications companies (the
"New Holding Companies") by means of a procedure under Brazilian corporate law
called cisao or "split-up". The New Holding Companies were allocated
substantially all of the assets and liabilities of Telebras, including the
shares held by Telebras of the operating subsidiaries of the Telebras System.
The New Holding Companies, together with their respective subsidiaries,
comprise (a) three regional fixed-line operators, (b) eight regional cellular
operators and (c) one domestic and international long-distance operator. The
restructuring of the Telebras System into the New Holding Companies and their
respective subsidiaries is referred to in this Registration Statement on Form
20-F (the "Registration Statement") as the "Breakup" of Telebras. See
"Description of Business--Background" and "--The Company."
The Registrant is one of the New Holding Companies formed upon the Breakup
of Telebras. In the Breakup, all of the share capital of Empresa Brasileira de
Telecomunicacoes ("Embratel") held by Telebras (representing 98.7% of the
total share capital of Embratel) was transferred to the Registrant. Embratel
is the primary provider of domestic and international long-distance telephone
services in Brazil, as well as other telecommunications services such as data
communication, text, sound and image transmission, and internet services.
The Registrant's principal assets are the shares of its operating subsidiary
Embratel. The Registrant relies almost exclusively on dividends from Embratel
to meet its needs for cash, including for the payment of dividends to its
shareholders. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources."
As used herein, the "Company" refers to the Registrant and its consolidated
subsidiary Embratel.
Presentation of Financial Information
Financial Statements and Minority Interests
The audited consolidated balance sheets included herein as of December 31,
1996 and 1997 and the related consolidated statements of income, cash flows
and changes in shareholders' equity for each of the years ended December 31,
1995, 1996 and 1997 (including the notes thereto, the "Consolidated Financial
Statements") and the unaudited consolidated condensed balance sheet included
herein as of September 30, 1998 and the related unaudited consolidated
condensed statements of operations and cash flows for the nine months ended
September 30, 1997 and 1998 (including the notes thereto, the "Unaudited
Consolidated Condensed Financial Statements") are the consolidated financial
statements of the Registrant. The portion of equity and income attributable to
shareholders other than the Registrant is reflected as "minority interests" in
the Consolidated Financial Statements and the Unaudited Consolidated Condensed
Financial Statements. At December 31, 1997 and September 30, 1998, such
minority shareholders owned 1.7% and 1.25%, respectively, of the share capital
of Embratel. Approximately 60% of the minority interests in Embratel are held
by institutional shareholders, including pension funds, mutual funds and
telecommunications companies. These shareholders obtained their interests in
Embratel in auctions held in April 1988, December 1991, and February 1997,
whereby Companhia Vale do Rio Doce S.A., Banco do Brasil S.A. and Centrais
Eletricas Brasileiras S.A., then state-owned companies that formerly held
interests in Embratel, sold their interests to the public. The remainder of
the minority interests is held by Camara de Liquidacao e Custodia, a clearing
house of the Rio de Janeiro Stock Exchange.
ii
<PAGE>
Formation of Registrant
The formation of the Registrant through the spin-off from Telebras has been
accounted for as a reorganization of entities under common control in a manner
similar to a pooling of interests. The assets and liabilities of the
Registrant that were spun off from Telebras were transferred at their indexed
historical cost. See Notes 2 and 28 to the Consolidated Financial Statements.
At the May 22, 1998 Telebras shareholders' meeting, the shareholders
approved a specific structure for the shareholders' equity of each New Holding
Company, which included an allocation of a portion of the retained earnings of
Telebras. In this manner, the balances of capital, reserves and retained
earnings, together with the corresponding assets and liabilities, for the
formation of the Registrant were established. Telebras retained within its own
shareholders' equity sufficient retained earnings from which to pay certain
dividends and other amounts. Telebras allocated to each New Holding Company
the balance of its retained earnings in proportion to the total net assets
allocated to each such Company. This value of allocated retained earnings does
not represent the historical retained earnings of the New Holding Companies
and, in the case of the Registrant, resulted in a decrease of R$210,432,000 in
relation to the Company's historical retained earnings. See Note 28 to the
Consolidated Financial Statements. Allocated retained earnings and future
retained earnings will be the basis from which future dividends will be
payable.
Effects of Inflation
The Consolidated Financial Statements and the Unaudited Consolidated
Condensed Financial Statements contained herein were prepared in accordance
with generally accepted accounting principles in Brazil ("Brazilian GAAP") and
are presented in Brazilian reais. Pursuant to Brazilian GAAP, the Consolidated
Financial Statements and, unless otherwise specified, the other financial
information for periods ending on or before December 31, 1997 presented herein
recognize certain effects of changes in the purchasing power of Brazilian
currency due to inflation and have been indexed and expressed in constant
reais of December 31, 1997 purchasing power. Such restatement has been
effected in accordance with Brazilian GAAP using the integral restatement
method (correcao integral) required under Brazilian GAAP through December 31,
1997. Inflationary gains or losses on monetary assets and liabilities have
been allocated to their corresponding income or expense caption in the income
statement. Inflationary gains or losses without a corresponding income or
expense caption have been allocated to other net operating income (expense).
See Note 2a to the Consolidated Financial Statements. The Unaudited
Consolidated Condensed Financial Statements as of and for the nine months
ended September 30, 1997 were prepared on a fully indexed basis to recognize
the effects of changes in the purchasing power of the Brazilian currency
during the periods presented and are stated in constant currency as of
December 31, 1997.
Until December 31, 1995, the relevant inflation index selected by the
Comissao de Valores Mobiliarios (the Brazilian Securities Commission or "CVM")
and the one used for the constant currency method under Brazilian GAAP was the
Unidade Fiscal de Referencia (the "UFIR"). Since January 1, 1996, the CVM has
no longer required that the constant currency method of accounting be used in
the preparation of the consolidated financial statements of publicly traded
Brazilian companies. Restatement in constant currency is now optional under
CVM rules and any general price index may be used. The Brazilian Institute of
Accountants has recommended that the Indice Geral de Precos--Mercado (the
General Prices Index-Market or the "IGP-M") be used for this purpose. The
Company's management believes that the IGP-M is the most appropriate measure
of the general price inflation in Brazil and has elected the IGP-M for
purposes of preparing its consolidated financial statements in accordance with
the constant currency method effective January 1, 1996. See Note 2a to the
Consolidated Financial Statements and Unaudited Consolidated Condensed
Financial Statements.
In July 1997, the three-year cumulative inflation rate for Brazil fell below
100%. However, for accounting purposes, the constant currency method continued
to be applied through December 31, 1997. Although the Brazilian Institute of
Accountants has not yet issued instructions to discontinue restating financial
information to constant currency, the Company's management has concluded that
the effects of inflation at the rate of 1.6% for the nine months ended
September 30, 1998 are not material. Accordingly, the restated balances of
nonmonetary assets and liabilities of the Company as of December 31, 1997
became the new basis for accounting, and the
iii
<PAGE>
consolidated statement of income for the nine months ended September 30, 1998
has not been restated for inflation, except for the effect of depreciation
expense being calculated using balances for fixed assets restated to December
31, 1997.
Currency Translations
All references herein to (i) the "real", "reais" or "R$" are to Brazilian
reais (plural) and to the Brazilian real (singular), the official currency of
Brazil and (ii) "U.S. dollars", "dollars" or "US$" are to United States
dollars. As of July 1, 1994, the denomination of the Brazilian currency unit
was changed to the real from the cruzeiro real (each real being equal to 2,750
cruzeiros reais at such time). All amounts in cruzeiros reais have been
restated in reais in this Registration Statement. Certain amounts herein may
not sum due to rounding.
This Registration Statement contains translations of certain real amounts
into U.S. dollars solely for the convenience of the reader. These translations
should not be construed as representations that the real amounts actually
represent such U.S. dollar amounts or could be or could have been converted
into U.S. dollars at the rate indicated. Unless otherwise indicated, such U.S.
dollar amounts have been translated from reais at the commercial buying rate
for the purchase of U.S. dollars (the "Commercial Market Rate") published by
Banco Central do Brasil (the "Central Bank of Brazil") for September 30, 1998,
which was R$1.1856 to US$1.00. The noon buying rate in New York City for cable
transfers in reais as certified by the Federal Reserve Bank of New York has
not been consistently reported for Brazilian currency during the periods for
which data are presented in this Registration Statement. See "Exchange Rates"
for information regarding rates of exchange.
Market Information
Upon the Breakup of Telebras, holders of common and preferred Telebras
shares ("Telebras Common Shares" and "Telebras Preferred Shares" and,
together, "Telebras Shares") were deemed under Brazilian law to own, in
addition to such Telebras Shares, one common or preferred share, as
applicable, of each New Holding Company for each such Telebras Share held by
them. Following the Breakup and until September 21, 1998, the Telebras Common
Shares and the common shares of the New Holding Companies traded only as a
unit on the Bolsa de Valores de Sao Paulo (the "Sao Paulo Stock Exchange"),
the Bolsa de Valores do Rio de Janeiro (the "Rio de Janeiro Stock Exchange")
and the seven other Brazilian stock exchanges (together with the Sao Paulo
Stock Exchange and the Rio de Janeiro Stock Exchange, the "Brazilian Stock
Exchanges"). Similarly, the Telebras Preferred Shares and the preferred shares
of the New Holding Companies traded only as a unit on the Brazilian Stock
Exchanges during this period. Telebras American Depositary Shares ("Telebras
ADSs"), each originally representing 1,000 Telebras Preferred Shares,
continued to trade on the New York Stock Exchange, Inc. (the "NYSE"), except
that following the Breakup and until November 16, 1998, each Telebras ADS
represented 1,000 Telebras preferred shares and 1,000 preferred shares of each
of the New Holding Companies. On September 21, 1998, the common shares and
preferred shares of each New Holding Company were distributed in Brazil and
commenced trading separately on the Brazilian Stock Exchanges. On November 16,
1998, American Depositary Shares representing preferred shares of each New
Holding Company, including those of the Registrant, were issued and commenced
trading separately on the NYSE. The ADSs of the Registrant commenced trading
prior to the effectiveness of this Registration Statement pursuant to Rule
12a-5 of the Rules and Regulations under the Securities Exchange Act of 1934,
as amended (the "Exchange Act"). See "Nature of Trading Market" and
"Description of Securities to be Registered--Description of American
Depositary Receipts in respect of Preferred Shares."
References herein to the "Preferred Shares" and "Common Shares" are to the
preferred shares and common shares, respectively, of the Registrant.
References to the American Depositary Shares or "ADSs" are to American
Depositary Shares, each representing 1,000 Preferred Shares, of the
Registrant. The ADSs are evidenced by American Depositary Receipts ("ADRs").
iv
<PAGE>
GLOSSARY OF TERMS
The following explanations are not intended as technical definitions, but to
assist the general reader to understand certain terms as used in this
Registration Statement.
Access charge: Amount paid per minute charged by network operators for the
use of their network by other network operators. Also known as an
"interconnection charge" or "network usage charge".
Access gates: The points of interface between the network equipment (either
dedicated or switched) and the transmission media that connect network
equipment to the end user. The quantity of service is directly related to the
quantity of network access gates.
AMPS (Advanced Mobile Phone Service): An analog cellular telephone service
standard utilizing the 850 MHz band, in use in North America, parts of South
America, Australia and various other areas.
Analog: A mode of transmission or switching which is not digital, e.g., the
representation of voice, video or other modulated electrical audio signals
which are not in digital form.
Analog network: A network using analog technology with circuit switching,
capable of connecting one user with all the users, but with limited
transmission capacity.
ATM (Asynchronous Transfer Mode): A broadband switching technology that
permits the use of one network for different kinds of information (e.g.,
voice, data and video).
Automatic international roaming: A service which permits a subscriber to use
his or her cellular phone on a foreign cellular operator's network. The
subscriber may receive calls made to the subscriber's regular cellular number
(such calls are "automatically" passed to the foreign operator's network).
Band A Operator: A former Telebras cellular operating subsidiary that has
been granted a concession to provide cellular telecommunications services in a
particular area within a radio spectrum frequency range referred to by Anatel
as "Band A".
Band B Operator: A cellular operator that has been granted a concession to
provide cellular telecommunications services in a particular area within a
radio spectrum frequency range referred to by Anatel as "Band B".
Base station: In cellular mobile telecommunications, a radio
transmitter/receiver that maintains communications with the cellular
telephones within a given cell. Each base station in turn is interconnected
with other base stations and with the public switched telephone network.
Broadband services: Services characterized by a transmission speed of 2
Mbit/s or more. According to international standards, these services are
divided into two categories: (i) Interactive services, including
videotelephone/videoconferencing (both point-to-point and multipoint);
videomonitoring; interconnection of local networks; file transfer; CAD;
highspeed fax; e-mail for moving images or mixed documents; broadband
videotext; video on demand; retrieval of sound programs or fixed and moving
images; and (ii) Broadcast services, such as sound programs, television
programs (including high-definition TV and pay TV) and selective document
acquisition.
CATV (Cable television): Cable or fiber-based distribution of TV programs.
CDMA (Code Division Multiple Access): A standard of digital cellular
technology.
Cell: The geographic area covered by a single base station in a cellular
mobile phone system.
v
<PAGE>
Cell splitting: The process of dividing cells into smaller coverage areas by
reducing the power output and the antenna height of the base station
transmitter. Cell splitting increases capacity in a particular area by
allowing for the further reuse of frequencies by a mobile communications
system.
Cellular service: A mobile telephone service provided by means of a network
of interconnected low-powered base stations, each of which covers one small
geographic cell within the total cellular system service area.
Channel: One of a number of discrete frequency ranges utilized by a base
station.
Digital: A mode of representing a physical variable such as speech using
digits 0 and 1 only. The digits are transmitted in binary form as a series of
pulses. Digital networks allow for higher capacity and higher flexibility
through the use of computer-related technology for the transmission and
manipulation of telephone calls. Digital systems offer lower noise
interference and can incorporate encryption as a protection from external
interference.
Digital penetration: The substitution of equipment capable of transmitting
digital signals for equipment limited to analog transmission.
Exchange: See Switch.
Frame relay: A data transmission service using fast protocols based on
direct use of transmission lines.
Internet: A collection of interconnected networks spanning the entire world,
including university, corporate, government and research networks from around
the globe. These networks all use the IP (Internet Protocol) communications
protocol.
ISDN (Integrated Services Digital Network): A system in which several
services (e.g., speech and data) may be simultaneously transmitted end-to-end
in digital form.
Leased high-speed data communication: The digital exchange of information at
speeds exceeding 64Kbps transmitted through mediums that are leased to users
for their exclusive use.
Local loop: The system used to connect the subscriber to the nearest switch.
It generally consists of a pair of copper wires, but may also employ fiber-
optic circuits, microwave links or other technologies.
Manual international roaming: A service that permits a subscriber to use his
or her cellular phone on a foreign cellular operator's network. The subscriber
may only receive calls made to a temporary number issued to the subscriber by
the foreign operator for use while roaming.
Microcells: A small cell covered by a low-power base station. Microcells can
cover small areas such as a single building.
Network: An interconnected collection of elements. In a telephone network,
these consist of switches connected to each other and to customer equipment.
The transmission equipment may be based on fiber optic or metallic cable or
point-to-point radio connections.
Network usage charge: Amount paid per minute charged by network operators
for the use of their network by other network operators. Also known as an
"access charge" or "interconnection charge".
Optical fiber: A transmission medium which permits extremely high
capacities. It consists of a thin strand of glass that provides a pathway
along which waves of light can travel for telecommunications purposes.
vi
<PAGE>
Packet-switched data communication services: Data services based on
parceling or breaking the data stream into packets and switching the
individual packets. Information transmitted is segmented into cells of a
standardized length, which are then transmitted independently of one another,
allowing maximization of available capacity and usage of a single transmission
path for multiple communications. The cells are then reassembled upon reaching
their destination.
PBX (Private Branch Exchange): Telephone switchboard for private use, but
linked to the national telephone network.
Penetration: The measurement of the take-up of services. As of any date, the
penetration is calculated by dividing the number of subscribers by the
population to which the service is available and multiplying the quotient by
100.
Private leased circuits: Voice, data or image transmission mediums leased to
users for their exclusive use.
PSTN (Public Switched Telephone Network): The public telephone network that
delivers basic telephone service and, in certain circumstances, more advanced
services.
Repeaters: A device that amplifies an input signal for retransmission.
Roaming: A function that enables cellular subscribers to use their cellular
phone on networks of operators other than the one with which they signed their
initial contract.
Satellite services: Satellites are used, among other things, for links with
countries that cannot be reached by cable or to provide an alternative to
cable and to form closed user networks.
SDH (Synchronous Digital Hierarchy): A hierarchical set of digital transport
structures, standardized for the transport of suitably adapted payloads over
physical transmission networks.
Sectorization: The process of dividing cells into sectors by using
directional antennae at the base station. Sectorization reduces co-channel
interference which permits smaller cells and increases network capacity.
Switch: These are used to set up and route telephone calls either to the
number called or to the next switch along the path. They may also record
information for billing and control purposes.
TDMA (Time Division Multiple Access): A standard of digital cellular
technology.
Universal service: The obligation to supply basic service to all users
throughout the national territory at reasonable prices.
Value Added Services: Value Added Services provide additional functionality
to the basic transmission services offered by a telecommunications network.
vii
<PAGE>
EXCHANGE RATES
There are two legal foreign exchange markets in Brazil--the commercial rate
exchange market (the "Commercial Market") and the floating rate exchange
market (the "Floating Market"). The Commercial Market is reserved primarily
for foreign trade transactions and transactions that generally require prior
approval from Brazilian monetary authorities, such as the purchase and sale of
registered investments by foreign persons and related remittances of funds
abroad. Purchases and sales of foreign exchange in the Commercial Market may
be carried out only through a financial institution in Brazil authorized to
buy and sell currency in that market. As used herein, the "Commercial Market
Rate" for any day is the commercial selling rate for Brazilian currency into
U.S. dollars, as reported by the Central Bank of Brazil. As used herein, the
"Floating Market Rate" is the prevailing selling rate for Brazilian currency
into U.S. dollars which applies to transactions to which the Commercial Market
Rate does not apply, as reported by the Central Bank of Brazil. Prior to the
implementation of the Real Plan, the Commercial Market Rate and the Floating
Market Rate differed significantly at times. Since the introduction of the
real, the two rates have not differed significantly, and effective as of
February 1, 1999 the Central Bank of Brazil has unified the two legal exchange
rates, although maintaining the regulation for each of the Commercial and
Floating Markets. There can be no assurance that there will not be further
changes in the applicable regulations which may result in significant
differences between the two rates in the future. Both the Commercial Market
Rate and the Floating Market Rate are freely negotiated but may be strongly
influenced by the Central Bank of Brazil.
On July 1, 1994 the real replaced the cruzeiro real as the unit of Brazilian
currency, with each real being equal to 2,750 cruzeiro reais. The issuance of
reais was initially subject to quantitative limits backed by a corresponding
amount of U.S. dollars in resources, but the Federal Government subsequently
expanded those quantitative limits and allowed the real to float, with parity
between the real and the U.S. dollar (R$1.00 to US$1.00) as a ceiling. On
March 6, 1995, the Central Bank of Brazil announced that it would intervene in
the market and buy or sell U.S. dollars, and established a trading band (faixa
de flutuacao) for the Commercial Market Rate (which is defined through
auction) within which the exchange rate between the real and the U.S. dollar
could fluctuate. The Central Bank of Brazil initially set the band with a
floor of R$0.86 per US$1.00 and a ceiling of R$0.90 per US$1.00 and provided
that, from and after May 2, 1995, the band would fluctuate between R$0.86 and
R$0.98 per US$1.00. Shortly thereafter, the Central Bank of Brazil issued a
new directive providing that the band would be between R$0.88 and R$0.93 per
US$1.00. On June 22, 1995, the Central Bank of Brazil issued another directive
providing that the band would be between R$0.91 and R$0.99 per US$1.00 and
subsequently reset the band on January 30, 1996 to between R$0.97 and R$1.06
per US$1.00. Upon resetting the band on January 30, 1996, the Central Bank of
Brazil adjusted the exchange rate within such band on a number of occasions,
generally in increments of R$0.001, by means of buying and selling U.S.
dollars in electronic auctions. On February 18, 1997, the band was reset by
the Central Bank of Brazil to float between R$1.05 and R$1.14 per US$1.00. On
January 13, 1999, the band was reset by the Central Bank of Brazil to float
between R$1.20 and R$1.32. Shortly thereafter, on January 18, 1999, the band
was suspended by the Central Bank of Brazil and the real was permitted to
float and since that time has been extremely volatile. On March 9, 1999, the
Commercial Market Rate was R$1.9056 per U.S. dollar. There can be no assurance
that the real will maintain this exchange rate in future periods.
viii
<PAGE>
The following table sets forth the Commercial Market Rate expressed in reais
per U.S. dollar for the periods and dates indicated. Prior to July 14, 1994,
The Federal Reserve Bank of New York did not publish a noon buying rate for
customs purposes in the City of New York for cable transfers in the Brazilian
real and its predecessor currencies (the "Noon Buying Rate").
<TABLE>
<CAPTION>
Commercial Market Rate:
Nominal reais Per US$1.00(1)
-----------------------------------
Year Ended December 31, Low High Average(2) Period-End
- ----------------------- ------ ------ ---------- ----------
<S> <C> <C> <C> <C>
1994...................................... 0.1204 0.9815 0.6754 0.8490
1995...................................... 0.8340 0.9726 0.9227 0.9726
1996...................................... 0.9726 1.0394 1.0080 1.0394
1997...................................... 1.0395 1.1164 1.0555 1.1164(3)
1998...................................... 1.1165 1.2087 1.1644 1.2087(3)
1999 (through March 9).................... 1.2078 2.1647 1.9845 1.9056
</TABLE>
- --------
Source: Central Bank of Brazil
(1) Amounts expressed in nominal reais have been translated from the
predecessor Brazilian currencies in effect during the relevant period at
the rates of exchange at the times the successor currencies became the
lawful currency of Brazil.
(2) Represents the average of the month-end exchange rates during the relevant
period.
(3) The Noon Buying Rate on December 31, 1997 and September 30, 1998 was
R$1.1165 per U.S. dollar and R$1.1856 per U.S. dollar, respectively.
ix
<PAGE>
PART I
Item 1: Description of Business
Background
Telebras and the Telebras System
Until 1972, telephone services in Brazil were provided by more than 900
independent companies, which supplied non-integrated basic telephone services.
Telebras was incorporated on November 9, 1972, pursuant to special
legislation, for the principal purposes of (i) acting as a holding company for
operating companies providing public telecommunications services in Brazil and
(ii) implementing the policies of the federal government of Brazil (the
"Federal Government") in the modernization and expansion of the Brazilian
telecommunications system. Between 1972 and 1975, Telebras, through its
subsidiaries, acquired almost all the other telephone companies in Brazil.
Telebras and its operating subsidiaries are referred to collectively herein as
the "Telebras System." Only four operating companies remained outside the
Telebras System, representing approximately 9% of all lines in service in
Brazil at December 31, 1997. Telebras is controlled by the Federal Government
of Brazil and the operations of the Telebras System are subject to regulation
by the Federal Government. The operating subsidiaries of Telebras were
controlled by the Federal Government until August 4, 1998. See "--Regulatory
Reform and Privatization."
At December 31, 1997, Telebras, through 28 operating subsidiaries, was the
primary supplier of public telecommunications services in Brazil. Embratel
owned and operated all of the interstate and international telephone
transmission facilities in Brazil. Through the other 27 operating
subsidiaries, the Telebras System was the primary provider of local and
intrastate telecommunications service and the leading provider of cellular
mobile telephone service. The Telebras System also provided
telecommunications-related services such as data communication, sound and
image transmission and other value-added services throughout Brazil. On
January 30, 1998, each of the operating subsidiaries other than Embratel and
Companhia Telefonica da Borda do Campo-CTBC spun off its cellular telephone
operations as of January 1, 1998 into a separate company.
In 1997, Telebras was the second-largest company in Brazil as measured by
gross revenues of R$20.7 billion.
Regulatory Reform and Privatization
Beginning in 1995, the Federal Government undertook a comprehensive reform
of Brazilian regulation of the telecommunications industry. In August 1995,
the federal Constitution was amended to permit the Federal Government to grant
concessions to private companies to provide telecommunications services. In
July 1997, the federal Congress adopted Law No. 9,472 of July 16, 1997, the
Lei Geral de Telecomunicacoes (the "Telecommunications Law"), which provided
for the establishment of a new regulatory framework, the introduction of
competition and the privatization of the Telebras System. The
Telecommunications Law established an independent regulatory agency called
Agencia Nacional de Telecomunicacoes ("Anatel"), which has begun to adopt a
series of regulatory enactments that implement the provisions of the
Telecommunications Law (together with the regulations, decrees, orders and
plans issued by the President of Brazil on telecommunications, the
"Telecommunications Regulations"). See "--Regulation."
On May 22, 1998, in preparation for the privatization of the Telebras
System, the Telebras System was restructured to form, in addition to Telebras,
the twelve New Holding Companies. Virtually all of the assets and liabilities
of Telebras were allocated to the New Holding Companies, which, together with
their respective subsidiaries, now comprise (a) three regional fixed-line
operators, (b) eight regional cellular operators and (c) one domestic and
international long-distance operator (the "Company"). Prior to the Breakup of
the Telebras System, Embratel provided all interstate telephone service and
the other subsidiaries of Telebras provided fixed-line and cellular service in
their respective territories, which, subject to limited exceptions,
corresponded to the separate Brazilian states. Following the Breakup, each of
the eight cellular operators provides cellular telephone service on Band A in
one of eight cellular regions into which Brazil has been divided for purposes
of cellular telephony and each of the three fixed-line operators provides
local fixed-line telephone service and intra-regional long-distance fixed-line
telephone service in one of three regions into which Brazil has been divided
for purposes
1
<PAGE>
of fixed-line telephone service (each a "Region"). Embratel provides domestic
long-distance telephone service (including intra-regional and interregional
long-distance telephone service) throughout Brazil. Two of the three fixed-
line Regions encompass several states, so the fixed-line operators now provide
interstate telephone services within their Regions, which were exclusively
provided by Embratel prior to the Breakup, while Embratel is now authorized to
provide long-distance services within the states, which it did not provide
prior to the Breakup. In addition to changes in the nature of telephone
services provided by Embratel, the manner in which revenues received by the
fixed-line operators for international and domestic long-distance calls are
divided between such fixed-line operators and the Company has also changed.
See "--Division of Revenues and Access Fees."
On July 29, 1998, the Federal Government sold to twelve buyers (the "New
Controlling Shareholders") its rights to receive shares of the twelve New
Holding Companies upon the distribution of such shares. The total
consideration to be paid to the Federal Government for the twelve New Holding
Companies is R$22.1 billion. In connection with this sale, the Federal
Government assigned to the New Controlling Shareholders substantially all its
economic and voting rights with respect to the New Holding Companies and, as a
consequence, the New Controlling Shareholders now control the New Holding
Companies. Following the distribution of the shares of the New Holding
Companies, Telebras is expected to be delisted from the New York Stock
Exchange and liquidated.
The New Controlling Shareholder of the Registrant is MCI WORLDCOM, Inc.,
through its subsidiary Startel Participacoes Ltda. ("MCI WORLDCOM"). For a
description of the business activities of MCI WORLDCOM, see "Control of
Registrant." MCI WORLDCOM is the entity resulting from the merger of MCI
Communications Corporation ("MCI") and WorldCom, Inc. on September 14, 1998.
In August 1998, MCI agreed to pay R$2.65 billion for the Federal Government's
stake in the Registrant, R$1.06 billion of which was paid on August 4, 1998
and the remainder of which is scheduled to be paid in two equal installments
over the next two years following that date. The entire proceeds of the sale
of the Federal Government's stake in the Registrant will be retained by the
Federal Government.
On August 20, 1998, Brazil's Minister of Communications determined that
Telebras would be dissolved and liquidated. The Minister announced that
Telebras will prepare, within the next twelve months, a liquidation plan to be
submitted to a shareholders' meeting convened to approve the dissolution of
Telebras and its subsequent liquidation.
The adoption of the Telecommunications Law and Telecommunications
Regulations has led, and the privatization of the Telebras System will lead,
to sweeping changes in the operating, regulatory and competitive environment
for Brazilian telecommunications. The changes include (i) the establishment of
an independent regulator and the development of comprehensive regulation of
the telecommunications sector, (ii) the Breakup of Telebras, (iii) the sale of
a controlling interest in the Registrant to one or more new investors and (iv)
the introduction of competition in the provision of all telecommunications
services. All of these developments will materially affect the Company and the
other New Holding Companies, and the Company cannot predict the effects of
these changes on its business, financial condition, results of operations or
prospects. The extensive changes in the structure and regulation of the
Brazilian telecommunications industry must also be carefully considered in
reviewing historical information and in evaluating the future financial and
operating performance of the Company.
The Company
The Registrant is one of the New Holding Companies formed on May 22, 1998 as
part of the Breakup of Telebras. At September 30, 1998, the Registrant held
98.7% of the total and voting share capital of Embratel. Embratel was founded
in 1965 to provide domestic and international long-distance telephone service
and is currently the only provider of such services in Brazil. See
"Presentation of Information--Overview." As a result of the Breakup of
Telebras on May 22, 1998, the privatization of the New Holding Companies on
July 29, 1998 and the announced liquidation of Telebras, the Company is in
default under a substantial portion of the credit agreements to which it is a
party. The Company is currently in negotiations with the appropriate creditors
with respect to the indebtedness in default. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources" and "Defaults upon Senior Securities."
2
<PAGE>
The Company's business consists principally of providing intra-regional
long-distance, interregional long-distance and international long-distance
telephone service as well as data communication, text, telex, sound and image
transmission, internet services and mobile satellite and maritime
communication. The Company operates under a domestic long-distance concession
and an international long-distance concession (together, the "Concession")
granted by Anatel on May 26, 1998. The Company's Concession has been granted
under the Public Regime. For a description of the Public Regime, see "--
Regulation--Concessions and Licenses." The Company, together with the three
regional fixed-line companies, is one of four companies in Brazil operating
under Public Regime concessions. Under the Public Regime, the Company is
required to perform certain obligations, including principally obligations
concerning the continuous provision of service throughout the country
("universal service"), quality of service, and network expansion and
modernization. Anatel has the power, if certain of these obligations are not
met, to impose penalties including revocation of the Company's Concession. See
"--Regulation--Obligations of Telecommunications Companies."
The Company's network connects all of the regional fixed-line and cellular
operators in Brazil, which in turn own and operate telecommunications networks
within their Regions. The Company is currently the sole owner and operator of
domestic long-distance and international long-distance telephone transmission
facilities in Brazil and its network extends to all 26 states of Brazil and
the Federal District. In 1997, the Company's network carried 13,694 million
minutes of domestic long-distance traffic and 1,254 million minutes of
international long-distance traffic. Of the 1,254 million minutes of
international traffic, 777 million minutes were incoming international calls
and 477 million minutes were outgoing international calls. In 1997, the
Company's incoming international traffic increased by 21.4% and outgoing
international traffic increased by 24.5% compared with 1996.
Following the privatization, the competitive environment in which the
Company operates will change. The Company will face new competitors and be
authorized to offer certain services it is currently prohibited from
providing. Following the privatization, Anatel is required to issue two new
licenses to a single new entrant for the provision of interregional long-
distance and international long-distance service in competition with the
Company. In addition, Anatel is required to authorize the Company to compete
with the three regional fixed-line companies in the provision of full intra-
regional long-distance service within their Regions, including the provision
of certain services that had exclusively been provided by the fixed-line
companies. See "--Competition" and "--Regulation."
The Company's business, financial condition, results of operations and
prospects depend in part on the performance of the Brazilian economy. See "--
Brazilian Economic Environment."
The Company's headquarters are located at SCN-Quadra CN2, Lote F, 2(degrees)
Andar, Sala 204, Brasilia-DF, 70710-500, Brazil, and its telephone number is
55-21-519-8182.
Services
Domestic Long-Distance Service
Prior to the Breakup of the Telebras System, Embratel provided all
interstate telephone service and the other subsidiaries of Telebras provided
fixed-line and cellular service within their respective territories, which,
subject to limited exceptions, corresponded to the separate Brazilian states.
Following the Breakup, each of the eight cellular operators provides cellular
telephone service on Band A in one of eight cellular regions into which Brazil
has been divided for purposes of cellular telephony and each of the three
fixed-line operators provides local fixed-line telephone service and intra-
regional long-distance fixed-line telephone service in one of three Regions
into which Brazil has been divided for purposes of fixed-line telephone
service. Embratel provides domestic long-distance telephone service (including
intra-regional and interregional long-distance telephone service) throughout
Brazil. Two of the three fixed-line Regions encompass several states, so the
fixed-line operators will provide interstate telephone services within their
Regions, which were exclusively provided by Embratel prior to the Breakup,
while Embratel will be authorized to provide long-distance services within the
states, which it did not provide prior to the Breakup. Embratel relies upon
the fixed-line telephone companies and the cellular operators to carry most
calls between end users and Embratel's network. The fixed-line telephone
companies and the cellular operators, which previously were affiliates of
Embratel, may become competitors of Embratel.
3
<PAGE>
Before the Breakup and privatization, the Company was the exclusive provider
of interstate long-distance service under Brazilian law. Under the regulatory
regime in effect before the Breakup and privatization, each cellular and
fixed-line company generally operated within one of the 26 states of Brazil or
the Federal District and Embratel had the exclusive right to carry calls
between any two cellular or fixed-line companies. As such, Embratel's
exclusive interstate long-distance telephone service accounted for 47.2% and
49.8% of the Company's total operating revenues during 1996 and 1997,
respectively.
The table below sets forth interstate long-distance telephone traffic
carried by the Company for the periods indicated.
<TABLE>
<CAPTION>
Year ended December 31,
---------------------------------
1993 1994 1995 1996 1997
----- ----- ------ ------ ------
<S> <C> <C> <C> <C> <C>
Total interstate long-distance telephone
traffic (millions of minutes)............... 8,927 8,413 10,757 12,275 13,694
Growth in interstate long-distance telephone
traffic (% per annum)....................... 6.6 (5.6) 27.9 14.1 11.6
Number of fixed-line and cellular access
lines in use (in millions).................. 11.6 13.1 14.9 17.8 21.7
Total interstate long-distance traffic per
fixed-line and cellular access line in use
(minutes)................................... 771.8 644.4 723.2 690.2 632.1
</TABLE>
The Company's traffic volume has increased in all periods since 1993 except
1994. The decrease in 1994 was principally a result of a change in the way
traffic volume was calculated between the Company and the fixed-line
operators. In 1995, improved economic conditions brought about by the Federal
Government's Real Plan led to a sharp increase in interstate long-distance
telephone usage. In 1996 and 1997, reductions in tariff rates and the
continuing stabilization of the Brazilian economy spurred interstate long-
distance telephone traffic growth, although the rate of growth stabilized from
the peak experienced in 1995.
Following the Breakup and privatization, the Company's domestic long-
distance telephone service consists of two types of service: (i) interregional
long-distance telephone service and (ii) intra-regional long-distance
telephone service.
Interregional long-distance telephone service consists of all calls that
originate within one of the three fixed-line Regions and terminate in another
of the three fixed-line Regions, and all calls carried by the Company that
originate in one cellular region and terminate in another cellular region. The
Company is currently the sole provider of interregional long-distance
telephone service, although it is anticipated that following the Breakup
Anatel will license a new entrant to provide such service in competition with
the Company. See "--Competition" and "--Regulation--Concessions and Licenses."
Intra-regional long-distance telephone service consists of all calls that
originate in one local calling area within a fixed-line Region and terminate
in another local calling area within the same fixed-line Region. A local
calling area is generally equivalent to a municipality and there are usually
several local calling areas within an area code. Since the Breakup and
privatization, the Company is authorized to provide such intra-regional long-
distance telephone service. This represents an extension of the service the
Company may offer, since the Company was formerly restricted to providing
interstate long-distance service. See"--Competition" and "--Regulation--
Concessions and Licenses."
International Long-Distance Services
At present, the Company is the sole provider of international long-distance
telephone services in Brazil. It is anticipated that Anatel will soon license
a new entrant to provide such services in competition with the Company. See
"--Competition" and "--Regulation--Concessions and Licenses." The Company's
international long-distance telephone services generated 15.4% and 16.2% of
the Company's total gross operating revenues during 1996 and 1997,
respectively.
Revenues generated by international long-distance telephone services are
primarily derived from (i) other international telecommunications operators
for incoming calls carried through the Company's network once in Brazil and
(ii) charges for international outgoing calls originating in Brazil. A portion
of the revenues received by the Company from the regional fixed-line and
cellular operators for international outgoing calls must be paid
4
<PAGE>
to other international operators on whose networks such calls are carried once
outside of Brazil. Of the Company's 1997 outgoing international long-distance
telephone traffic, 36.1% was traffic to North America, 30.1% was traffic to
Europe, 19.8% was traffic to other South American countries and 8.1% was
traffic to Asia. Of the Company's 1997 incoming international long-distance
telephone traffic, 63.8% was traffic from North America, 16.9% was traffic
from Europe, 9.9% was traffic from other South American countries and 8.4% was
traffic from Asia.
The Company's international long-distance telephone traffic, which is
measured in minutes in both the outgoing and incoming directions, is shown in
the table below for the periods indicated.
<TABLE>
<CAPTION>
Year ended December 31,
-------------------------------------
1993 1994 1995 1996 1997
----- ----- ----- ------- -------
<S> <C> <C> <C> <C> <C>
Outgoing international traffic
(millions of minutes)................. 163.5 199.0 319.3 382.9 476.9
Growth in outgoing international
traffic (% per annum)................. (0.5)% 21.7% 60.5% 19.9% 24.5%
Incoming international traffic
(millions of minutes)................. 373.7 407.1 495.4 639.8 776.7
Growth in incoming international
traffic (% per annum)................. 13.1% 8.9% 21.7% 29.1% 21.4%
Total international traffic (millions
of minutes)........................... 537.2 606.1 814.7 1,022.7 1,253.6
Percentage of international calls (in
minutes) billed in Brazil............. 30.4% 32.8% 39.2% 37.4% 38%
Ratio of incoming traffic to outgoing
traffic............................... 2.29 2.05 1.55 1.67 1.63
</TABLE>
For a description of the new model for the division of revenues between the
Company and the regional fixed-line operators, see "--Division of Revenues and
Access Fees."
Data Communication Services
The Company provides data communication services, including leased high-
speed data communication service, satellite data communication, internet
services, packet-switched data communication, frame relay and message-handling
systems. Data communication services accounted for approximately 27.0% and
24.3% of the Company's total gross operating revenues during each of 1996 and
1997, respectively. The Company owns its own microwave and fiber optic data
transmission network. The packet-switched networks of the regional fixed-line
companies, which are low-speed, are connected to the Company's low-speed
network. However, the Company is the only provider of high-speed packet-
switched data communication services using frame relay technology. The Company
is currently constructing a metropolitan area fiber optic network in major
cities with greater access capacity than currently available networks and is
expanding its fiber optic network throughout Brazil in order to increase the
quality of services currently provided. The Company also uses its satellite
system to provide additional data communication services. Unlike domestic and
international long-distance telephone services, the Company bills customers
directly for the utilization of data communication services.
The three principal customer groups that use the Company's data
communication services are financial institutions, governmental entities and
large corporations. Financial institutions primarily use such services for
banking operations, telecommuting and inter-office communication. Governmental
entities primarily use such services for data processing, legal and other
databases and voice, data and image integration. Large corporations primarily
use such services for e-mail, data processing, voice, data and image
integration and billing and administration.
Other Services
In addition to telephone and data communication services, the Company
provides other services, including text, telex, sound and image transmission
and mobile satellite and maritime communications. These additional services
accounted for 10.4% and 9.7% of the Company's total gross operating revenues
during 1996 and 1997, respectively.
Taxes on Telecommunications Services
The cost of all telecommunications services to the customer includes a
variety of taxes. The Company deducts the amount of such taxes to present net
operating revenue. The principal tax is a state value-added tax,
5
<PAGE>
the Imposto sobre Circulacao de Mercadorias e Servicos--ICMS, which the
Brazilian states impose at varying rates on revenues from the provision of
telecommunications services. The rate in most states is 25% for domestic
telecommunications services and zero for international telecommunications
services.
Other taxes include two federal social contribution taxes, the Programa de
Assistencia aos Servidores de Empresas Publicas--PASEP and Contribuicao para
Financiamento da Seguridade Social--COFINS, imposed at a combined rate of
2.65% on gross operating revenues.
Division of Revenues and Access Fees
Domestic long-distance telephone calls and international long-distance
telephone calls originating in Brazil begin on the network of one of the
fixed-line or cellular companies of the Telebras System and are switched to
the Company's network for transport. In the past, revenues from domestic and
international long-distance calls were divided between the Company and the
fixed-line companies. Under this system, each fixed-line company billed its
customers for all domestic and international long-distance telephone calls and
retained a percentage of the revenues (such percentage was set by the Ministry
of Communications) from all such calls, transferring the remainder of the
revenues to the Company. This percentage varied among the fixed-line companies
but was the same for domestic and international long-distance calls. As of
March 31, 1998, the fixed-line companies transferred an average of 33% of the
total revenue from such calls to the Company.
As part of the liberalization of the telecommunications sector, the division
of revenues system applicable to the fixed-line companies and Embratel was
eliminated as of April 1, 1998 and replaced by a new system which has
historically applied to the cellular companies and Embratel. Under the new
system, the Company receives 100% of the revenues from fixed-line (i)
interregional long-distance calls, (ii) certain intra-regional long-distance
calls and (iii) international long-distance calls that it carries, but is
required to pay certain per-minute interconnection charges to the regional
fixed-line companies for the use of their networks in originating and/or
completing such calls. In addition to such charges, the Company is required to
pay a supplemental per-minute charge, the Parcela Adicional de Transicao (the
"PAT"), until June 30, 2001. See "--Regulation--Rate Regulation." Furthermore,
until the fixed-line companies complete their intra-regional long-distance
network, such companies may lease transmission facilities from Embratel to
carry some interstate calls within their respective regions. The Company does
not expect that implementation of this new system will have a material impact
on its net income. However, it is expected that the allocation to the Company
of 100% of the revenues generated by fixed-line (i) interregional long-
distance calls, (ii) certain intra-regional long-distance calls and (iii)
international long-distance calls that it carries will cause operating
revenues to increase substantially. This increase is expected to be offset by
increased cost of services expenses resulting from the network usage charges
and PAT paid to the fixed-line companies.
Embratel's remuneration with respect to domestic and international long-
distance calls originating on a cellular operator's network was not affected
by the April 1998 changes to the division of revenues system applicable to
Embratel and the fixed-line companies. Embratel will continue to receive from
the cellular operators the revenues relating to cellular long-distance calls
and will continue to pay per-minute interconnection charges to the cellular
operators for connection to and use of their networks in originating and/or
completing such calls.
Billing and Administration
The Company uses its own proprietary billing and collection system called
Faturamento e Cobranca ("FTC") developed to bill services which are collected
directly by the Company from the customer. FTC has four main functions: (i)
customer registration; (ii) customer information consultation; (iii) accounts
payable management; and (iv) billing and collection.
The Company does not bill traditional telephone services to end-customers
directly. At present, the regional fixed-line companies and the cellular
companies bill customers for all domestic and international long-distance
calls, collect payments from customers and transfer to the Company payments
for all interregional, certain intra-regional and all international long-
distance calls carried by the Company. The Company then pays the fixed-line
and cellular companies the interconnection charge applicable to such calls.
See "--Division of Revenues and Access Fees." The Company maintains records of
all calls from and to the fixed-line and cellular telephone
6
<PAGE>
networks and sends this information to the relevant fixed-line company or
cellular company for inclusion in such company's own billing and collection
process. The Company and the respective regional fixed-line company or
cellular company jointly reconcile billing amounts. To date, the Company has
not encountered significant problems reconciling billing amounts and receiving
payments from the regional fixed-line companies or the cellular companies.
However, the process is still in the implementation phase. All of the other
telecommunications and telecommunications-related services provided by the
Company, including "800" and "900" telephony, are billed directly by the
Company. Following the Breakup, the Company will be permitted, if it chooses,
to bill domestic and international long-distance customers directly.
Rates
Rate Regulation and Policy
Rates for most telecommunications services provided by the Company are
subject to the final approval of Anatel, to which the Company submits requests
for rate adjustments. See "--Regulation--Rate Regulation."
Beginning in December 1993, the Federal Government commenced an economic
stabilization program (the "Real Plan") intended to reduce inflation by
reducing certain public expenditures, collecting liabilities owed to the
Federal Government, increasing tax revenues, continuing a privatization
program and introducing a new currency, the real, on July 1, 1994, based on a
new unit of accounts, the Unidade Real de Valor introduced earlier in the
year. The Company's rates were effectively indexed for inflation in May and
June of that year, but no further rate increases were granted to the Company
until December 1995. Consequently, despite the considerable decrease in the
rate of inflation resulting from the implementation of the Real Plan, average
real rates were eroded by inflation throughout the second half of 1994 and
most of 1995. Average real rates declined further during this period as a
result of reductions in measured local telephone service rates and
international telephone rates in November 1994.
In December 1995 and January 1996, the Company was permitted to implement
rate increases for domestic long-distance service. In April and May of 1997,
rates were adjusted to correspond to the costs of the respective services,
substantially lowering the amount of revenues retained by the fixed-line
companies (and thereby increasing the amount of revenues paid by the fixed-
line companies to Embratel) pursuant to the division of revenues system that
was in place prior to April 1, 1998.
Domestic Long-Distance Rates
Rates for domestic long-distance calls, including intra-regional long-
distance and interregional long-distance, are computed on the basis of the
time of day and day of the week when the calls are made, the call's duration,
the distance covered and whether special services, such as operator
assistance, are used. The rates for domestic long-distance calls are
established by Anatel and are uniform throughout Brazil. Domestic long-
distance rates are divided into five distance and location components: 0 to 50
kilometers; 50 to 100 kilometers; 100 to 300 kilometers; over 300 kilometers
and special metropolitan area rates.
Domestic long-distance rates remained unchanged from July 1994 to December
1995, when rates were increased by 22.2%. However, in May 1997, the basic rate
was returned to the December 1995 level and a new system was introduced under
which charges are applied every tenth of a minute after the first minute. The
combined effect of these measures resulted in a rate reduction estimated at
approximately 32%. The following table illustrates the Company's domestic
long-distance rates for the periods indicated in constant reais of December
1997 purchasing power.
<TABLE>
<CAPTION>
As of December 31,
------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
(in R$)
<S> <C> <C> <C> <C> <C>
Domestic long-distance rates(1):
0 to 50 km........................................... 0.79 0.46 0.46 0.42 0.32
50 to 100 km......................................... 1.32 0.78 0.76 0.70 0.54
100 to 300 km........................................ 1.98 1.18 1.16 1.07 0.81
over 300 km.......................................... 2.65 1.57 1.53 1.40 1.08
</TABLE>
- --------
(1) Rates for a domestic long-distance call, three minutes in duration between
the hours of 9 a.m. and 12 p.m. and 2 p.m. and 6 p.m. (peak hours) on
weekdays, net of value-added taxes.
7
<PAGE>
International Rates
Rates charged for outgoing international calls vary depending on the time of
day and day of the week when the calls are made, the call's duration, the
country of destination and whether special services, such as operator
assistance, are used. Rates for international long-distance service are
established by Anatel and are uniform throughout Brazil.
The Company has substantially reduced rates for outgoing international calls
in recent years. This has been in part in response to considerable competition
from companies outside Brazil known as telephone service resellers. Resellers
provide customers with the number of an automated callback system located in a
country with lower international rates, allowing calls to be charged outside
of Brazil. In order to compete more effectively, the Company has reduced the
cost of outgoing calls to levels similar to those charged by resellers. See
"--Competition." Between 1992 and 1995, the cost to the customer of a three-
minute call to the United States decreased by approximately 50%. This decrease
reflected rate reductions in August 1993 and November 1994 and a reduction in
the rate of the state value-added tax in April 1994 from 25% to 13% in almost
all states. The decrease in the state value-added tax alone resulted in an
average reduction of 14% in the cost of a three-minute call to the United
States. In September 1996, the value-added tax rate on international calls was
eliminated. See "--Services--Taxes on Telecommunications Services." Finally,
in April 1997, the rates charged for calls to the United States decreased an
additional 30%. As a result of the foregoing measures, the average cost of a
three-minute call to the United States decreased from R$13.06 in 1992 to
R$3.30 in April 1997, representing a total decrease of approximately 75%.
Between 1992 and 1995, the cost of a three-minute call to Western Europe and
Portugal decreased approximately 51% and 22%, respectively. This was the
result of rate reductions in August 1993 and November 1994, as well as the
state value-added tax decreases mentioned above. In April 1997, the rates
applicable to calls to Europe generally decreased an additional 24% and the
rates applicable to calls to Portugal decreased an additional 22%. The rate
and tax reductions led to a decrease in the average cost to the customer of a
three-minute call to Europe, except calls to Portugal, from R$14.14 in 1992 to
R$5.27 in April 1997. This represented a decrease of approximately 63%. The
average cost to the customer of a similar call to Portugal was reduced from
R$9.86 in 1992 to R$5.17 in April 1997, representing a decrease of
approximately 48%.
The following table illustrates international rates for the periods
indicated in constant reais of December 31, 1997 purchasing power.
<TABLE>
<CAPTION>
As of December 31,
-------------------------
1993 1994 1995 1996 1997
----- ---- ---- ---- ----
(in R$)
<S> <C> <C> <C> <C> <C>
International rates(1):
United States....................................... 13.58 6.60 5.39 4.93 3.05
Mercosur(2)......................................... 12.26 7.20 5.88 5.39 4.00
Western Europe(3)................................... 17.89 8.47 6.92 6.34 5.08
</TABLE>
- --------
(1) Rate for international calls, three minutes in duration between the hours
of 5 a.m. and 8 p.m. on weekdays, net of value-added taxes.
(2) Includes Argentina, Chile, Paraguay and Uruguay.
(3) Includes Andorra, Austria, Belgium, Denmark, Finland, France, Germany,
Holland, Ireland, Italy, Lichtenstein, Norway, Spain, Sweden, Switzerland
and the United Kingdom.
Revenues from international service also reflect payments under
approximately 230 bilateral agreements between the Company and foreign
telecommunications administrations or private carriers, which are influenced
by the guidelines of the international Tariff and Trade Regulations and cover
virtually all international calls to and from Brazil. These agreements set
forth the settlement rates of payment by the Company to foreign carriers for
the use of their facilities in connecting international calls billed in Brazil
and by foreign carriers to the Company for the use of its facilities in
connecting international calls billed abroad. The settlement rates of
8
<PAGE>
payment under such agreements are negotiated with each foreign carrier.
Settlements among carriers are normally made monthly on a net basis.
The major bilateral agreements with carriers in the United States include
American Telephone and Telegraph Company ("AT&T"), Sprint International and
subsidiaries of MCI WORLDCOM. The Company's service agreement with AT&T has
been in force since October 1, 1969, but the terms governing the amounts
payable by each party have been renegotiated from time to time. The service
agreements with the other United States carriers have similar terms. Amounts
payable to the Company in respect of calls billed by United States carriers
have historically exceeded amounts payable to United States carriers in
respect of calls billed by the Company. As a result, the Company receives
substantial monthly settlement payments from United States carriers. In
January 1990, the Company sold to a small number of institutional investors,
the right to receive a portion of future net settlement payments under the
service agreement with AT&T, over a period of approximately 120 months. At
December 31, 1997, the amount remaining to be paid to the purchasers out of
future net settlement payments was approximately US$14,582,000.
Various factors could affect the amount of net settlement payments from
United States carriers to the Company in future years. These include increases
in the proportion of outgoing as opposed to incoming calls. From 1990 to 1993
the percentage of international telephone calls billed as outgoing compared to
the percentage billed as incoming decreased steadily due to increasing
competition from international resellers. For a description of resellers, see
"--Competition." Decreases in the Company's rates in 1993 and 1994 and in the
average rate of state value-added tax on international calls have decreased
the cost to the consumer of outgoing international calls to levels similar to
those charged by resellers, resulting in an increase in the percentage of
total calls billed as outgoing in 1994 and 1995. Calls billed by United States
carriers currently exceed calls billed by the Company.
Net settlement payments from United States carriers could also be affected
by decreases in the rates paid by such carriers. There is currently
considerable pressure to reduce such rates in the United States. In
particular, the United States Federal Communications Commission (the "FCC")
has instituted rulemaking proceedings to modify United States regulation of
international accounting rates that United States carriers use to settle
accounts with foreign telecommunications carriers, in order to promote lower,
more cost-based rates for international services. The FCC has stated that it
may take regulatory action if United States carriers are unable to negotiate
lower rates with foreign carriers. There can be no assurance that the FCC will
not adopt regulations that would result in reductions in the rates charged by
the Company under its service agreements with United States carriers.
Data Communication Rates
The majority of revenues from data communication are provided by monthly
line rental charges for private leased circuits. The balance consists mainly
of nominal charges to customers for access to the only national data
transmission network and measured charges based on the amount of data
transmitted. In April 1997, the Ministry issued new rates for line rental
charges for private leased circuits, representing a 42% reduction. The
following table sets forth the Company's monthly line rental charges for
private leased circuits service for the periods indicated in constant reais of
December 31, 1997 purchasing power. The Company's rates during these periods
correspond to the maximum rates approved by the Ministry.
<TABLE>
<CAPTION>
As of December 31,
-------------------------------------------------
1993 1994 1995 1996 1997
--------- --------- --------- --------- ---------
(in R$)
<S> <C> <C> <C> <C> <C>
Monthly line rental per
leased circuit(1):
9,600 bits/second capacity.. 5,349.11 3,561.41 2,989.46 2,239.21 750.00
64,000 bits/second
capacity................... 11,066.73 9,087.80 8,264.69 3,234.43 2,028.75
2,048,000 bits/second
capacity................... 60,387.25 49,588.90 52,977.76 38,813.10 25,731.20
</TABLE>
- --------
(1) Monthly rates for distances between 300 and 500 kilometers, net of value-
added taxes, for the three principal bandwidths.
9
<PAGE>
Network and Facilities
The Company provides domestic and international telecommunications services
through its basic network, submarine cables, terrestrial fiber, microwave
trunks, switches and satellites. The Company's present long-distance
infrastructure consists of approximately 232,533 microwave channel kilometers
and 415,761 fiber kilometers, of which approximately 70% are digital and
approximately 30% are analog. A significant portion of international traffic
is carried by satellites of the International Telecommunications Satellite
Organization System ("Intelsat"). Intelsat is an international organization
with 142 members, and the Company owns 2.1% of its capital stock. Over 200
countries and territories use the Intelsat system and are interlinked by its
25 satellites located over oceans throughout the world. The Company is
presently focused on making improvements to the switches and other equipment
in its domestic and international infrastructure. See "--Capital
Expenditures."
Domestic Network
The basic network accounts for 89% of the Company's technical fixed assets.
The basic network encompasses a terrestrial fiber network connecting the major
Brazilian cities over 15,185 kilometers, four satellites, Brasilsat A2, B1, B2
and B3 and a total of 83 telephonic earth stations. As of September 30, 1998,
the Company's long-distance network includes 943,800 trunks in 41 transit
exchanges located in 28 cities. The Company's switching capacity is 100%
digital.
The following table sets forth certain details regarding the microwave
network and satellite system of the Company.
<TABLE>
<CAPTION>
Year ended December 31,
----------------------------------
1993 1994 1995 1996 1997
------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C>
Terrestrial network:
Fiber lines (kilometers)................... 23,687 23,804 23,804 23,804 23,976
Optical fiber (kilometers)................. 838 887 2,203 6,988 9,300
Satellite system:
Number of earth stations................... 63 64 69 73 80
</TABLE>
The following table sets forth certain details regarding the principal fiber
optic lines which constitute the Company's basic network.
<TABLE>
<CAPTION>
Transmission Rate
Length (km) (Mbits/sec)
----------- -----------------
<S> <C> <C>
Sao Paulo--Rio de Janeiro......................... 405 565
Rio de Janeiro--Fortaleza......................... 3,463 2,500
Rio de Janeiro--Belo Horizonte.................... 465 565
Belo Horizonte--Brasilia.......................... 812 2,500
</TABLE>
The Company's domestic telecommunications system serves the needs of Brazil
through the basic network and additional networks oriented to each type of
service including the National Telephone Network, the National Telex Network,
the TRANSDATA (leased high-speed data communication service) and RENPAC
(packet-switched data communications) networks, the Multi-Digital data
communication network, the National Television Network and the National
Coastline Station Network.
The Company currently owns and operates an earth station in Guaratiba,
located in the state of Rio de Janeiro. This station, activated in 1985,
accesses the Brasilsat A2, B1 and B2 satellites and will access the B3
satellite once it is operational. These satellites cover the entire territory
of Brazil, Argentina, Uruguay and Paraguay and were launched by Arianespace
S.A. The satellites are maintained and monitored by the Company through its
earth station in Guaratiba.
International Network
Switches. The Company currently owns two automatic and one operator-assisted
international digital switches located in Rio de Janeiro and Sao Paulo. The
combined capacity of these switches is approximately 32,600 channels.
10
<PAGE>
Satellites. The Company currently utilizes satellite channels using earth
telecommunications stations. The Company owns and operates two earth station
complexes, one located in Tangua (in the state of Rio de Janeiro) and one
located in Morungaba (in the state of Sao Paulo). These earth stations,
activated in 1969 and 1986, respectively, access Intelsat satellites
positioned over the Atlantic Ocean with coverage of the entire American
continent, Western Europe, Africa and the Middle East. Communications with
remote locations in the Far East are first routed by submarine cable to an
earth station in Sintra, Portugal, and subsequently to the Intelsat satellite
located over the Indian Ocean with a radius covering the Far East and
Australia. The Company also owns a 35% interest in an antenna located at the
Sintra earth station, in association with Companhia Portuguesa Radio Marconi
S.A. The Company is currently responsible for telemetry, tracking, controlling
and monitoring the Intelsat satellites from its control station in Tangua.
International maritime communications are handled by INMARSAT's
(International Maritime Satellite Organization) satellite system. The
Company's segment is comprised of one earth station also located at Tangua
which connects to a satellite stationed over the Atlantic Ocean. Brazil owns
1.7% of the capital stock of this organization of 55 countries.
Terrestrial Network. The Company's international terrestrial network is
composed of fiber optic digital cables, and digital and analog radio
connections linking Brazil to Uruguay, Bolivia, Paraguay and Argentina.
Submarine Cables. The primary submarine cables in operation are Americas I,
which links Brazil with the United States, and Unisur, which links Brazil with
Uruguay and Argentina. Submarine cable connections with Europe are made
through the United States via Americas I and then to Europe via Columbus II.
Two additional major submarine cables are under construction, one directly
to Europe, Atlantis 2, that will also communicate with Argentina, and Americas
II, which will complete a second link between Brazil and the United States. In
addition, the Company has participations in various submarine cables operating
throughout the world.
Quality of Service
The Company has at times experienced quality of service problems, including
busy circuits and failure to complete international and domestic long-distance
calls. In 1997, maximum busy circuit rates during peak periods (as a
percentage of calls attempted) was 7.5%, and direct dial call completion rates
during peak periods (as a percentage of calls attempted) was 54.3%. Customers
were also unable to access an international operator in 1997 in a significant
number of cases. In 1997, international operator availability (as a percentage
of calls attempted) was 89.2%. In addition, Embratel's network connects
regional fixed-line operators, regional cellular operators and foreign
operators, and the quality of service provided by Embratel may be
significantly affected by the quality of the network on which calls originate
or terminate. For a discussion of future quality of service requirements, see
"--Regulation--Obligations of Telecommunications Companies--Quality of
Service--General Plan on Quality."
As part of Embratel's Concessions and pursuant to the General Plan on
Universal Service and the General Plan on Quality, Embratel will be required
to provide and maintain full-service public telephones available 24 hours a
day with domestic and international direct-dial capability in certain remote
areas of Brazil by December 31, 1999. In addition, Embratel will be required
to respond to repair requests for such public telephones within eight hours by
December 31, 1999. See "--Regulation--Obligations of Telecommunications
Companies--Network Expansion--General Plan on Universal Service" and "--
Quality of Service--General Plan on Quality." At present, management is
seeking clarification from Anatel with regard to the number of public
telephones Embratel will have to provide and maintain in order to comply with
such requirements.
Competition
The Company is currently the exclusive provider of domestic and
international long-distance services in Brazil, although it is subject to
indirect competition from a number of sources. Since 1995, Brazil has adopted
11
<PAGE>
sweeping regulatory changes intended to foster competition in the provision of
telecommunications services. See "--Background--Privatization and Regulatory
Reform" and "--Regulation." Under the Telecommunications Law and
Telecommunications Regulations, Anatel is required, promptly after the
privatization, to open local, intra-regional long-distance, interregional
long-distance and international long-distance telephone services to
competition by granting licenses to new entrants. Anatel is required to
authorize three new entrants to provide local telephone service and intra-
regional long-distance telephone service, with each of the three new entrants
receiving licenses to provide such services in a single fixed-line Region, in
addition to authorizing one new entrant to provide interregional long-distance
telephone service and international long-distance telephone service by
granting licenses to provide such services throughout Brazil. In addition,
Anatel is required to authorize the Company to provide full intra-regional
long-distance telephone service, which includes any calls between local
calling areas in addition to interstate telephone service within each Region.
These licenses will be issued in the Private Regime and, as a result, the
licensees will not be subject to the same obligations to which concessionaires
operating in the Public Regime are subject. See "--Regulation--Concessions and
Licenses." Beginning in 2002, Anatel may grant an unlimited number of
additional licenses for the provision of local, intra-regional long-distance,
interregional long-distance and international long-distance telephone
services. See "--Regulation--Concessions and Licenses."
As a result of the issuance of new licenses after privatization, the Company
will face competition in the provision of interregional and international
long-distance services and the Company will be authorized to provide full
intra-regional long-distance service as a competitor of the regional fixed-
line companies.
In recent years, the Company has experienced considerable competition for
the provision of international long-distance service from companies outside
Brazil known as telephone service resellers. Resellers provide customers with
the number of an automated callback system located in countries with lower
international rates, generally the United States. Use of such callback systems
allow international long-distance calls to originate in Brazil, yet be charged
outside of Brazil, generally at rates significantly below those charged by the
Company. As a result of such competition, the percentage of international
telephone calls billed as outgoing compared to calls billed as incoming
decreased steadily from 1990 to 1993. See "--Services--International Long-
Distance Services" and "--Rates--International Rates."
The identity of new entrants and the scope of increased competition, and any
corresponding adverse effect on the Company's results, will depend on a
variety of factors. Among such factors are the business strategies and
financial and technical capabilities of potential competitors, prevailing
market conditions at the time competition is permitted, applicable Brazilian
regulations with respect to new entrants and the Company, as well as the
effectiveness of the Company's efforts to prepare for increased competition.
The telecommunications industry is subject to rapid and significant changes in
technology. Continuing technological advances in telecommunications make it
impossible to predict the extent of the Company's future competition. There
can be no assurance that the technologies presently employed by the Company
will not become outdated or subject to competition from new technologies in
the future, or that the Company will be able to acquire on reasonable terms,
new technologies necessary to compete in changed circumstances.
The Company is subject to comprehensive regulations that limit its ability
to set tariffs for its various services, and that may limit its ability to
respond to potential or actual competition. Such regulations may limit the
Company's ability to confront competition. See "--Regulation."
Employees
As of September 30, 1998, the Company had 9,793 full-time employees.
Approximately 48% of the Company's employees are employed in repair,
engineering, operations and maintenance, physical plant and other similar
positions, 24% in administrative positions, 19% in customer service, and sales
and marketing positions, and 9% in management positions. Approximately 66% of
all employees are members of state labor unions associated either with the
Federacao Nacional dos Trabalhadores em Telecomunicacoes--Fenattel
("Fenattel")
12
<PAGE>
or with the Federacao Interestadual dos Trabalhadores em Telecomunicacoes--
Fittel ("Fittel"). The Company enters new collective labor agreements every
year with the local unions. The collective agreements currently in force
expire on November 30, 1999.
The Company's management considers the relations of the Company with its
work force to be satisfactory. The Company has never experienced a work
stoppage that had a material effect on its operations.
The Company has established a pension fund, Fundacao Embratel de Seguridade
Social--Telos ("Telos"), the purpose of which is to supplement government-
provided retirement benefits. The Company makes monthly contributions to Telos
currently equal to 19.8% of the aggregate salary and seniority-based bonus of
each employee who is a Telos member. Each employee member also makes a monthly
contribution to Telos based on age and salary. Members of Telos generally
qualify for full pension benefits after reaching age 58 and having completed
at least 35 years of service for men and 30 years of service for women. Telos
operates independently from the Company, and its assets and liabilities are
fully segregated from those of the Company. See Note 21 to the Consolidated
Financial Statements.
Subsequent to the privatization, the Company created a new defined
contribution plan through Telos which is described in further detail under
Note 13 to the Unaudited Consolidated Financial Statements.
Research and Development
Until the Breakup of Telebras, the Company and the other companies of the
Telebras System were required to contribute to the research and development
center operated by Telebras (Centro de Pesquisa e Desenvolvimento da Telebras
or the "Center") and also conducted their own independent research and
development. The Company had aggregate expenditures in respect of research and
development activities of R$20.0 million, R$18.0 million and R$16.0 million
for 1995, 1996 and 1997, respectively.
Following the Breakup of Telebras, the Center will become a private,
independently administered non-profit foundation financed with resources from
the public and private sector and will continue to develop communications
technology. Pursuant to a three-year contract signed in May 1998 between
Telebras and the Company, the Company will be required to contribute up to
R$57 million during the three years ending May 2001 to the Center. During the
effectiveness of this agreement, the Company has access to telecommunications
software developed by the Center and other technological services provided by
the Center such as equipment testing and consulting and training services. It
is possible that the Center will also provide such services to third parties
on a fee-for-service basis. In addition, the Company will continue to conduct
its own independent research and development. The Company does not
independently develop new telecommunications hardware and depends upon the
manufacturers of telecommunications products for the development of new
hardware.
Capital Expenditures
The Company's priorities include expanding and modernizing its entire
domestic and international long-distance network, improving overall quality
and increasing the digitalization of the system as a whole.
Prior to the Breakup of Telebras, capital expenditures were planned and
allocated on a system-wide basis and were subject to approval by the Ministry
of Communications. In addition, the budget for capital expenditures of the
Telebras System was included in the annual budget of the Federal Government
and had to be approved by the federal Congress. In 1995, the Federal
Government instituted a broad investment program for public and private
businesses in the communications and postal sectors for the years 1995 through
2003 (Programa de Recuperacao e Expansao dos Sistemas de Telecomunicacoes e
Postal--PASTE). The Telebras System was required to conform its annual capital
expenditure budget to the guidelines set by PASTE.
Since the privatization of Telebras, none of these requirements has applied.
See "--Regulation." The Company is now permitted to determine its own capital
expenditure budget, subject to compliance with certain obligations to expand
services under the Concessions. See "--Regulation--Obligations of
Telecommunications
13
<PAGE>
Companies." In addition, the financing of capital expenditures is no longer
carried out on a system-wide basis and the Company is required to obtain its
own financing. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
The Company made capital expenditures of R$948 million during the first ten
months of 1998. The Company anticipates that capital expenditures for 1998
will be approximately R$1,283 million, approximately 80% of which is expected
to be funded with internally generated funds from operations and approximately
20% of which is expected to be funded from its existing sources of financing.
The following table sets forth the Company's capital expenditures for each
year in the three-year period ended December 31, 1997 in constant reais of
December 31, 1997 purchasing power and capital expenditures for the ten months
ended October 31, 1998.
<TABLE>
<CAPTION>
Year ended December 31,
-------------------------
1995 1996 1997 1998(1)
------- ------- ------- -------
(in millions of R$)
<S> <C> <C> <C> <C>
Maintenance of operating equipment........... 41 34 40 32
Exchanges.................................... 21 38 108 95
Transmission................................. 416 650 531 564
Data and other specialized network........... 69 90 112 126
Labor and other costs........................ 110 103 92 77
Miscellaneous................................ 47 27 35 54
------- ------- ------- ---
Total capital expenditures................... 704 942 918 948
======= ======= ======= ===
</TABLE>
- --------
(1) Capital expenditures through October 31, 1998.
Regulation
General
The Company's business, including the services it provides and the rates it
charges for telecommunications services, is regulated by Anatel pursuant to
the Telecommunications Law, the Telecommunications Regulations and the
Concession granting the Company the right to provide certain
telecommunications services, subject to certain obligations contained in the
Telecommunications Regulations and the Concession (the "List of Obligations").
Background
From 1962 until 1967, the Brazilian telecommunications sector was regulated
by the Conselho Nacional de Telecomunicacoes (the "National Council of
Telecommunications"), and from 1967 until 1997 by the Ministry of
Communications, pursuant to Law No. 4,117 of August 27, 1962, as well as
certain regulations issued pursuant thereto from 1962 to 1996.
In August 1995, the Brazilian Congress amended the Brazilian Constitution to
allow the restructuring of the telecommunications sector. On July 19, 1996,
the Congress passed Law 9,295, the Lei Minima (the "Minimum Law"), to regulate
cellular and satellite services. The Minimum Law began the process of opening
up the cellular market to competition. The Minimum Law was largely replaced by
the Telecommunications Law, although current cellular concessions granted to
the former Telebras companies ("Band A Operators") and the private companies
that were authorized to compete with the Band A Operators (the "Band B
Operators") contain certain provisions derived from the Minimum Law. In July
1997, the Congress passed the Telecommunications Law, which replaced Law 4,117
and became the main basis for regulation of the telecommunications sector,
except for regulation of broadcasting, which was not addressed by the
Telecommunications Law.
14
<PAGE>
Regulatory Agency--Anatel
The Telecommunications Law provides a framework for telecommunications
regulation. Article 8 of the Telecommunications Law established Anatel to
develop regulations and to enforce such regulations. The specific functions of
Anatel were set forth by the President of Brazil in Decree No. 2338 of October
7, 1997, the Regulamento da Agencia Nacional de Telecomunicacoes (the "Anatel
Decree"). Pursuant to the Telecommunications Law and the Anatel Decree, Anatel
replaces the Ministry of Communications as the regulatory agency for the
telecommunications sector. Anatel, unlike the Ministry of Communications, is
an independent regulatory agency. Anatel is administratively independent,
financially autonomous and not hierarchically subordinated to any organ of the
Brazilian Government, including the Ministry of Communications, in the area of
telecommunications regulation. While independent, Anatel does maintain a close
working relationship with the Ministry of Communications and informs the
Ministry of its activities. Article 19, Section XXIX of the Telecommunications
Law requires Anatel to submit an annual report summarizing its activities to
the Ministry of Communications.
Anatel is managed by a five-member Conselho Diretor ("Board of Directors"),
headed by an executive president. The directors of Anatel are nominated by the
President of Brazil, subject to approval by the Senate. Each director serves
for a single fixed term of 5 years; directors may not be reappointed. In order
further to ensure Anatel's independence, the first directors have been
appointed for different terms, from 3 to 7 years, so that only one director's
mandate will expire per year, ensuring a staggered appointment of directors in
the future. The directors may not exercise any other professional, business
(other than university professor), union or political function, nor may they
hold a significant interest, whether direct or indirect, in any company
related to telecommunications.
Anatel is financed through the Fundo de Fiscalizacao das Telecomunicacoes
("Fistel"). Fistel is a fund administered by Anatel and its funds are
currently the sole source of financing for Anatel's activities. Fistel
receives the proceeds of, among other things, a tax imposed on concessionaires
and fees charged for licenses and concessions.
Any proposed regulation of Anatel is subject to a period of public comment,
including public hearings. Anatel's actions may ultimately be challenged in
Brazilian courts.
Concessions and Licenses
Companies wishing to offer telecommunications services to consumers are
required to apply to Anatel for a concession or license. Concessions and
licenses (autorizacoes) are granted for services in the public regime ("Public
Regime") and services in the private regime ("Private Regime"). The Public
Regime is differentiated from the Private Regime primarily by the obligations
imposed on the companies in the Public Regime rather than the type of services
offered by those companies. There are only four companies in the Public
Regime: Embratel and the three regional fixed-line companies. All other
telecommunications companies, including other companies providing the same
telecommunications services as the four companies in the Public Regime,
operate in the Private Regime.
Fixed-line Services--Public Regime. There are four providers of services in
the Public Regime: Embratel and the three regional fixed-line companies. These
four companies are the primary providers of the following fixed-line-based
services to the general public: local, intra-regional long-distance,
interregional long-distance and international long-distance. Each of these
four companies holds a concession, as required by the Telecommunications Law.
Each Public Regime concession is a specific grant of authority that allows the
concessionaire to offer a wide variety of telecommunications services but
specifically prohibits the concessionaire from offering certain
telecommunications services and imposes certain obligations on the
concessionaire concerning network expansion and modernization, quality and
continuity of service. The main restriction is that, until December 31, 2001,
the regional fixed-line companies will be prohibited from offering
interregional and international long-distance service, while Embratel will be
prohibited from offering local
15
<PAGE>
service unless certain obligations are met as described below. After the
privatization process is complete, Embratel will gain the right to offer full
intra-regional long-distance service, which includes carrying calls between
local calling areas within a fixed Region, which are currently restricted to
the three regional fixed-line companies. See "--Obligations of
Telecommunications Companies--Public Regime--Service Restrictions."
Concessions for Embratel and the three regional fixed-line companies are
granted for a fixed number of years, subject to certain obligations, with the
possibility of full renewal or revocation. See "--Obligations of
Telecommunications Companies--Public Regime Service Restrictions." The initial
concessions for Embratel and the regional fixed-line companies have been
granted until 2005. After 2005, the concessions may be renewed for a period of
20 years. The current concessions granted to the four companies in the Public
Regime have not required the payment of a fee. While terms for the grant of
concessions to new entrants have not yet been determined by Anatel, Embratel
and the three regional fixed-line companies are required to pay renewal fees
every two years after 2005 equal to 2% of annual net revenues from the
provision of fixed-line telecommunications services in the prior year
(excluding taxes and social contributions) during the 20-year renewal period.
Fixed-line Services--Private Regime. Licenses will be granted to new
competitors wishing to offer fixed-line-based services, including local,
intra-regional long-distance, interregional long-distance and international
long-distance, in the Private Regime. Licensees will not be subject to the
same obligations concerning network expansion and modernization, quality and
continuity of service to which concessionaires providing fixed-line-based
services in the Public Regime are subject although individual licenses may
contain certain related obligations. After the privatization process for
Embratel and the three regional fixed-line companies is complete, Anatel is
required to authorize three new entrants to provide local telephone service
and intra-regional long-distance telephone service, with each of the three new
entrants receiving two licenses to provide such services in a single fixed-
line Region, in addition to authorizing one new entrant to provide
interregional long-distance telephone service and international long-distance
telephone service by granting two licenses to provide such services throughout
Brazil. The bidding requirements are expected to contain certain minimum
technical and financial standards. The effective result of the license auction
will be that two companies compete in each of the markets for local service
(one regional fixed-line concessionaire and one licensee), four companies
compete in the markets for intra-regional long-distance service (one incumbent
regional fixed-line company, Embratel, and two licensees), and two companies
compete in the markets for interregional long-distance and international long-
distance (Embratel and one licensee). See "--Competition."
Until December 31, 2001, the four existing Public Regime concessionaires and
the new Private Regime licensees will be the only companies authorized to
offer local, intra-regional long-distance, interregional long-distance and
international long-distance services. Beginning January 1, 2002, the
Telecommunications Regulations require Anatel to end this period of
exclusivity and authorize new licensees wishing to offer such services. See
"--Competition."
The Company offers a number of ancillary telecommunication services pursuant
to licenses. The principal such services are the provision of dedicated analog
and digital lines, packet switched network services, circuit switched network
services, mobile marine telecommunications, telex and telegraph, radio signal
satellite retransmission and television signal satellite retransmission.
Obligations of Telecommunications Companies
Providers of telecommunications services are subject to certain obligations
contained in the List of Obligations of their concessions and licenses. The
four providers of telecommunications services in the Public Regime are subject
to a set of special restrictions regarding the services they may offer,
contained in the Plano Geral de Outorgas ("General Plan of Concessions and
Licenses"), and special obligations regarding service quality, network
expansion and modernization contained primarily in the Plano Geral de
Qualidade ("General Plan on Quality") and the Plano Geral de Universalizacao
("General Plan on Universal Service"). These restrictions and obligations are
also contained in the concessions of the four companies, particularly in the
List of Obligations.
16
<PAGE>
Public Regime--Service Restrictions. Under the General Plan on Concessions
and Licenses, Embratel and the regional fixed-line companies are prohibited
from offering certain basic fixed-line telecommunications services until they
fulfill the list of obligations as described below. Embratel is prohibited
from offering local or cellular services and the three regional fixed-line
companies are prohibited from offering cellular, interregional long-distance
and international long-distance services. After the privatization is effected,
Embratel will gain the right to offer full intra-regional long-distance
service, which includes carrying calls between local calling areas within a
fixed-line Region, as a competitor to the regional fixed-line companies.
The General Plan of Concessions and Licenses provides certain incentives to
encourage Embratel and the three regional fixed-line companies to fulfill the
service quality, network expansion and modernization obligations contained in
the List of Obligations quickly. Under the General Plan of Concessions and
Licenses, the progress of Embratel and the regional fixed-line companies
towards attaining their List of Obligations will be officially measured
annually by Anatel. Two measuring dates, December 31, 2001 and December 31,
2003 (the "2001 Targets" and the "2003 Targets") are of particular importance.
See tables in "--Network Expansion--General Plan on Universal Service" and
"Quality of Service--General Plan on Quality." In the period before the 2001
Targets are measured, Anatel will regularly monitor the progress of Embratel
and the regional fixed-line companies and communicate with them. If they fail
to meet the 2001 Targets, Anatel may, at its discretion, revoke their
concessions. If they meet the 2001 Targets, they may continue to operate. In
the period before the 2003 Targets are measured, Anatel will regularly monitor
the progress of the four companies and communicate with them. If Embratel and
the regional fixed-line companies meet the 2003 Targets, the restrictions on
the services the four companies may offer will be eliminated and the companies
will be allowed to apply for licenses to offer any other service. In addition,
if, in its review for the 2001 Targets, Anatel finds that any of the four
companies has met the 2003 Targets, Anatel will immediately eliminate the
restrictions on the telecommunications services that a company may offer and
will eliminate the restrictions on the geographical territory in which that
company may operate. Anatel may also eliminate the restrictions on a date
other than the official measuring dates of December 31, 2001 and December 31,
2003 if it finds that a company has met the 2003 Targets. Failure to meet the
2003 Targets could result in revocation of the Concession.
In order to attract new entrants and ensure competition, there are also
certain restrictions on alliances, joint ventures, mergers and acquisitions
involving Public Regime concessionaires, including:
. A concessionaire is prohibited from holding 20 percent or more of the
equity in any other concessionaire
. Concessionaires offering different services in the Public Regime in
either the same or different regions are prohibited from offering services
jointly
. Concessionaires offering the same service in the Public Regime in
different regions are prohibited from offering services jointly
. Mergers between fixed-line regional companies and cellular companies are
prohibited
. Companies offering telephony services are prohibited from offering cable
television
Anatel has not yet determined whether the restrictions under its control
will expire in the future or under what conditions they would expire.
Network Expansion--General Plan on Universal Service. Under the General Plan
on Universal Service, the regional fixed-line companies are required to expand
switched, fixed-line service to cover the entire national territory of Brazil
in accordance with the List of Obligations. Embratel is also subject to the
universal service requirement of providing access to direct-dial domestic and
international long-distance service by installing public telephones in remote
regions and isolated communities. Since universal service requirements are
restricted to the provision of switched, fixed-line basic telephony services,
formal universal service requirements do not apply to cellular companies,
although the cellular companies are subject to certain similar requirements
under the cellular List of Obligations and certain cellular regulations,
including obligations to expand their networks and to provide cellular
services without pricing discrimination within customer categories.
17
<PAGE>
Universal service will be financed through two primary mechanisms: (a) the
normal capital expenditure budgets of Embratel and the regional fixed-line
companies, and (b) a universal service fund.
Embratel and the three regional fixed-line companies are themselves
responsible for financing their universal service obligations of network
expansion from their own revenues. No subsidies or other supplemental
financing are anticipated to finance the network expansion obligations
contained in the List of Obligations. However, the General Plan on Universal
Service allows Anatel to waive the network expansion requirements once a
company succeeds in meeting the 2001 Target for maximum waiting time for
installation of a line of four weeks. If any of the three regional fixed-line
companies fails to meet its obligations in its Region, Anatel may grant
licenses to competing companies to provide the service and may compel the
regional fixed-line company to make its network available for the competitor's
use.
The Telecommunications Law also provides for a universal service fund to
contribute to the costs of providing universal service. While the exact nature
of the universal service fund is not yet known, a bill has been submitted to
the Federal Congress that states that if a company, after meeting its
universal service obligations, finds that it cannot operate a certain service
in a certain region at a profit, the company may apply to receive a subsidy
(for costs beyond those necessary to meet its obligations) from the universal
service fund to ensure that it covers its costs in providing the service.
The following table sets forth the network expansion and modernization
obligations of the Company as stated in the List of Obligations for the period
1999-2005 and the Company's status with respect to each obligation as of
December 31, 1997.
Network Expansion and Modernization
<TABLE>
<CAPTION>
Company Status
as of By December 31,
December 31, -----------------------------------
1997 1999 2000 2001 2002 2003 2004 2005
-------------- ----- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Full-Service Public
telephone availability (1)
in areas with no fixed
switched service that are
located 30 km from the
nearest fixed-line telephone
and a population of at
least:...................... 0%(2) 1,000 -- 600 -- 300 -- 100
State capitals connected by
fiber-optic cable
(% of capitals)............ 55.6 74 77.8 -- -- 100 -- --
</TABLE>
- --------
(1) Public telephones available 24 hours a day with domestic and
international long-distance direct-dial capability.
(2) The Company had no full-service public telephone availability at December
31, 1997.
With respect to certain of these requirements, the Company is discussing
with Anatel meeting the obligations by using alternative technologies that
feature equivalent performance parameters but are less costly, such as
providing satellite links to certain state capitals rather than installing
fiber-optic cable.
Quality of Service--General Plan on Quality. The General Plan on Quality
contains a series of service quality obligations that are incorporated into
the List of Obligations for Embratel and each regional fixed-line company.
These include attainment of certain targets such as reducing average dial tone
delay, achievement of certain call completion rates for local, intra-regional
long-distance, and interregional and international long-distance calls,
reducing average operator assistance delay, reducing trouble reports per 100
lines, reducing average time of repair, reducing average time of installation,
increasing billing accuracy, and achieving certain customer satisfaction
levels for public payphones, residential telephony and nonresidential
telephony.
18
<PAGE>
The following table sets forth the quality of service obligations of the
Company as stated in the List of Obligations for the period 1999-2005 and the
Company's status with respect to each obligation as of December 31, 1997.
Quality of Service
<TABLE>
<CAPTION>
Company Status
as of By December 31,
December 31, ----------------------------------
1997 1999 2000 2001 2002 2003 2004 2005
-------------- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Maximum busy circuit rate
during peak periods/1/ (% of
calls attempted)............ 7.5 6 -- 5 -- 4 -- --
Direct-Dial domestic call
completion rate during peak
periods (% of calls
attempted).................. 54.3 60 -- 65 -- 70 -- --
Operator availability/2/ (%
of calls attempted)......... 89.2 92 -- 93 -- 94 -- 95
Public telephone repair
response speed (% within 8
hours)...................... 0 95 -- 96 -- 97 -- 98
</TABLE>
- --------
1 For domestic long-distance calls.
2 Only for international calls.
Failure to meet both network expansion and modernization obligations and the
quality of service obligations in the List of Obligations may result in fines
and penalties of up to R$50,000,000 as well as potential revocation of the
Company's Concession. The Company's ability to meet the obligations in the
List of Obligations will depend upon certain factors outside its control.
While there can be no assurances, the Company believes that it will be able to
meet these requirements.
Interconnection. Interconnection is mandatory between all telecommunications
networks upon request by any party. Interconnection tariffs are subject to a
price-cap established by Anatel. Rates below the applicable price-cap may be
negotiated between the parties. If a company offers an interconnection tariff
below the price-cap, it must offer that price to any other requesting party on
a non-discriminatory basis.
Anatel has stated that it does not expect to grant parties requesting
interconnection the right to co-locate their equipment at this time, but may
do so in the future. Co-location means that a party requesting interconnection
may place its switching equipment in or near the local exchange of the network
operator whose network the requesting party wishes to use and connect to the
network at this point of presence. Co-location is currently a matter for
negotiation between the parties.
Anatel does not currently mandate unbundling of network elements and
services by the providers of such elements and services, although Anatel has
stated that it plans to review the issue on a regular basis and may introduce
unbundling in the future. In an unbundled regime, every network operator is
required to provide a detailed list of network services and elements which may
be purchased by a party requesting interconnection and the requesting party
then has the right to select and purchase a subset of the network elements and
services available.
Collective Interest Obligations. The Company offers a number of ancillary
telecommunication services pursuant to licenses. The principal such services
are the provision of dedicated analog and digital lines, packet switched
network services, circuit switched network services, mobile marine
telecommunications, telex and telegraph, mobile satellite communications,
radio signal satellite retransmission and television signal satellite
retransmission. Under the terms of the licenses relating to these services,
the Company is generally required to continue for an indefinite period to
offer to its existing customers as of July 27, 1998 (the date such licenses
were granted) telex and dedicated line telegraph, radio signal and television
signal satellite retransmission, mobile satellite communications, mobile
marine telecommunications, and certain low speed data communications services.
The Company is also required to continue offering telex services to new
customers through August 2001 (or such later date as is required for another
service provider to offer the same service). The Company is effectively
prohibited from increasing the fees charged for the above described services
(except, in some cases, for increases up to the rate of inflation). The
Company has generated losses from the provision of these services and expects
to continue to do so in the future. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Ancillary Telecommunication
Services."
19
<PAGE>
Number Portability. Number portability is the ability of a customer to move
to a new home or office or switch service providers while retaining the same
telephone number. Full number portability is mandatory within a local area.
Rate Regulation
General. In May 1997, a tariff rebalancing was implemented pursuant to which
monthly subscription charges and measured service charges for all customers
increased, while domestic long distance and international long-distance rates
were lowered. In addition, the previous mechanism for financing the
installation of new lines (auto-financing), which required customers to
purchase shares of Telebras, was eliminated and replaced with a flat
installation charge. As of April 1, 1998, the regime used to divide domestic
and international long-distance revenues between Embratel and the fixed-line
companies was replaced with a network usage charge for interconnection such as
already existed for use of cellular networks by the fixed-line companies and
for use of the fixed networks by cellular operators. In addition to the
network usage charge, Embratel is also required to pay a supplemental per-
minute charge called Parcela Adicional de Transicao ("PAT") that supplements
the network usage charge. Embratel is the only company that is required to pay
PAT charges. Embratel will be required to pay PAT charges for three years,
after which time the PAT charges will be phased out.
Price-Caps. Concessions with the regional fixed-line companies and Embratel,
including the Concession with the Company, provide for a price-cap mechanism
to set and adjust rates on an annual basis. The price-cap mechanism consists
of a maximum amount, or price-cap, stipulated by Anatel, that may be charged
for a particular service and on a weighted average rate for a basket of basic
services. The services include all of the services in the basic service plan,
such as installation charges, monthly subscription fees, local, intra-regional
long-distance, interregional long-distance and international long-distance
service, as well as public telephone service and interconnection charges,
including network usage fees. The main baskets for the regional fixed-line
companies are for local services, including installation charges, the monthly
subscription fee, and measured usage charges, and for interconnection
services, including network usage fees and equipment rental charges. The main
baskets for Embratel are intra-regional long-distance, interregional long-
distance, international long-distance and interconnection.
The initial price-cap established by Anatel in the Concession is based on
the previously existing tariffs. The initial price-cap will be adjusted on an
annual basis under a formula contained in the Concession. The formula allows
two adjustments to the price-cap. First, the price-cap is revised upward to
reflect increases in inflation by multiplying the price-cap by (1+1(y)), where
y represents the rate of inflation as measured by the Indice Geral de Precos-
Disponibilidade Interna ("IGP-DI"), an inflation index developed by the
Fundacao Getulio Vargas, a private Brazilian economic research organization.
Second, the inflation-adjusted price-cap is adjusted downward to ensure
productivity gains by multiplying the inflation-adjusted price-cap by (1-K),
where K represents a set productivity factor (the "K-factor").
In order to provide an incentive to Embratel and the regional fixed-line
companies to increase their efficiency and to reward consumers of
telecommunications services, Anatel applies a K-factor representing annual
productivity adjustments to the tariffs of Embratel and the regional, fixed-
line companies. In the period April 1, 1998 to December 31, 2005, the tariffs
of Embratel and the regional fixed-line companies will be adjusted downward as
follows:
K-Factor Annual Productivity Adjustments
<TABLE>
<CAPTION>
1998 1999 2000 2001 2002 2003 2004 2005
---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fixed-line companies--local............ 0% 0% 0% 1% 1% 1% 1% 1%
Fixed-line companies--local
interconnection....................... 0% 0% 0% 5% 10% 15% 20% 20%
Embratel-domestic long-distance........ 2% 2% 2% 4% 4% 4% 5% 5%
Embratel-international long-distance... 5% 5% 15% 15% 15% 15% 15% 15%
Fixed-line companies--intra-regional
long-distance and long-distance
interconnection....................... 2% 2% 2% 4% 4% 4% 5% 5%
</TABLE>
20
<PAGE>
The price-cap covers a basket of basic services. While the weighted average
tariff for the entire basket may not exceed the price-cap, the tariffs for
individual services within the basket may be increased. The Company may
increase the tariff for any individual service by up to 9% for local services
and 5% for long-distance services, subject to a downward adjustment for
inflation effects already captured in the annual upward adjustments of the
overall price-cap for the basket, so long as it adjusts other prices downward
to ensure that the weighted average tariff does not exceed the price-cap.
The Company may also offer alternative plans in addition to the basic
service plan. For instance, a customer might wish to choose an alternative
plan that allows unlimited calling for a set fee rather than pay the per
minute fee under the basic service plan. Alternative plans must be submitted
to Anatel for approval, but are not currently subject to a price-cap.
For information on the Company's current tariffs and service plans, see "--
Rates."
Domestic Long-Distance Rates. Direct-dial domestic long-distance tariffs are
calculated per minute for the first minute and per tenth of a minute for every
minute thereafter based on the distance a call must travel, duration of a call
the time of day and the day of the week. As part of the April 1997 tariff
rebalancing, domestic long-distance tariffs were substantially reduced, with
an effective reduction of approximately 32%. There are currently 20 domestic
long-distance tariffs, based on combinations of five distance categories and
four day/time categories.
For a breakdown of the Company's current domestic long-distance tariffs, see
"--Rates--Domestic Long-Distance Rates."
International Long-Distance Rates. Direct-dial international long-distance
tariffs are calculated on a per minute basis based primarily on the distance a
call must travel, the time of day and the day of the week. There are currently
18 international long-distance tariffs, based on combinations of nine country
groups and two day/time categories.
For a breakdown of the Company's current international long-distance
tariffs, see "--Rates--International Rates."
Network Usage Charges. Other telecommunications companies wishing to
interconnect with and use the Company's network must pay certain fees,
primarily a network usage fee. The network usage fee is subject to a price-cap
stipulated by Anatel. The price-cap for the network usage fee specified by
Anatel varies from company to company based on the underlying cost
characteristics of each company's network. The fee is charged on a per
distance and/or per minute of use basis which represents an average charge for
a basket of network elements and services.
Brazilian Political Environment
The Brazilian political environment was marked by high levels of uncertainty
after the country returned to civilian rule in 1985, ending 20 years of
military government. The death of a President-elect in 1985 and the
resignation of another President in the midst of impeachment proceedings in
1992, as well as rapid turnover at and immediately below the cabinet level,
adversely affected the implementation of consistent economic and monetary
policies, including consistent policies in the areas of government-owned
enterprises and telecommunications.
Mr. Fernando Henrique Cardoso, the Finance Minister at the time of
implementation of Brazil's latest economic stabilization plan (the "Real
Plan"), was elected President of Brazil in October 1994 and took office in
January 1995. He has generally sought to continue the economic stabilization
and liberalization policies he had developed as Finance Minister from May 1993
through April 1994. Although some important groups remain opposed to
significant elements of his program and the implementation of policies of
economic stabilization and liberalization is subject to significant
compromises and accommodations, President Cardoso is the leader of a coalition
of political parties that represents a majority of the federal Congress.
21
<PAGE>
Elections for the President, Vice-President, state Governors and the members
of the Chamber of Deputies, as well as one third of the members of the Senate
were held on October 4, 1998. President Cardoso was re-elected for a second
term as president. There can be no assurance that the political consensus in
favor of the economic reform program pursued by the Cardoso administration can
or will be sustained in the future.
Brazilian Economic Environment
The financial condition and results of operations of the Company are
dependent on general economic conditions in Brazil, and in particular on (i)
economic growth and its impact on demand for telecommunications services, (ii)
the cost and availability of financing and (iii) exchange rates between
Brazilian and foreign currencies.
For many years, the Brazilian economy was extremely volatile, and the
Federal Government implemented a succession of programs intended to stabilize
the economy and provide a basis for sustainable, non-inflationary growth. The
Company was affected by economic instability and by such programs in a variety
of ways, particularly when they have resulted in contractions in demand or
very high real interest rates or prevented the Company from raising rates to
keep pace with the rate of inflation.
Until the introduction of the Real Plan, measures by the Federal Government
intended to influence the course of Brazil's economy, such as changes in
monetary, credit, tariff and other policies, were frequent and occasionally
drastic. See "Exchange Controls and Other Limitations Affecting Security
Holders." In particular, actions to control inflation, interest rates or
consumption, included freezing bank accounts, imposing capital controls,
introducing high tariffs and other strong measures. Changes in policy, social
instability and other political and economic developments, and the Brazilian
government's responses to such developments, not infrequently have had a
material adverse effect on the Company's business, financial condition and
results of operations.
Beginning in December 1993, the Federal Government introduced the Real Plan,
an economic stabilization program intended to reduce the rate of inflation by
reducing certain public expenditures, collecting liabilities owed to the
Federal Government, increasing tax revenues, continuing to privatize
government-owned entities and introducing a new currency. The real was
introduced as Brazil's currency on July 1, 1994, based on a new unit of
account, the URV, introduced earlier in the year. Since taking office in
January 1995, President Cardoso has continued to implement the Real Plan. The
real generally appreciated through January 1995 and thereafter gradually
declined in value against the dollar, reaching R$1.1164 to US$1.00 at December
31, 1997. Under the Real Plan, the rate of inflation has decreased
significantly and there has been sustained growth in real gross domestic
product. See "--Inflation and Devaluation." Notwithstanding the success of the
Real Plan in lowering inflation and stabilizing the Brazilian economy, the
Real Plan also led to an economic slowdown, a rise in unemployment in some
regions and specific sectors of the economy, and adversely impacted certain
sectors of the economy.
Beginning in August 1998, following the devaluation of the Russian Ruble,
Brazil has experienced substantial capital outflows, significant declines in
its stock markets and speculative attacks on the Brazilian currency. In
response, the Federal Government raised interest rates to approximately 49% as
of December 1998 to contain capital flight and stated that it will continue to
support the value of the real and to abide by the principles inherent in the
Real Plan. In November 1998, reported outflows of approximately US$1 billion
per day led the International Monetary Fund (the "IMF") to arrange for an
international US$41.5 billion financial package to rescue Brazil's economy and
to urge the Brazilian government to pursue an austerity program. The fiscal
deficit, which has exceeded 8% of GDP this year, is scheduled to be cut to
4.7% in 1999, according to a three-year adjustment program.
Brazil's most recent financial crisis began on January 6, 1999 when the
governor of one of Brazil's largest states, Minas Gerais, declared a 90-day
moratorium on his state's debt (totaling R$18.3 billion) to the central
government. A week later, the governor of the Central Bank of Brazil resigned
and the government announced that it had widened the band in which the real
was allowed to trade, resulting in a devaluation of approximately
22
<PAGE>
8%. On January 18, 1999, the Central Bank of Brazil announced that it would
allow the real to float, after four years of a rigid foreign-exchange policy,
but that it would occasionally intervene in the market to limit wide swings in
the value of the real. As of February 24, 1999, the real has devalued 39.66%
from December 31, 1998 and dollar outflows have been reported to aggregate $17
billion from January 1, 1999 through January 31, 1999. Previously, in the
fourth quarter of 1997 Brazil experienced a financial crisis following the
financial and economic crisis in Asia. In response, the Federal Government
adopted several economic measures to protect the Real Plan and the stability
of the Brazilian currency. These measures included (i) an increase in interest
rates, including a near doubling of short-term interest rates, (ii) an
increase in certain tax rates, (iii) a reduction in Federal Government
spending for 1998 and (iv) restrictions on imports. Government policies to
control inflation and to reduce budget and trade deficits could also result in
further actions that could slow or halt Brazilian economic growth. It is not
possible to foresee how measures like these will affect the business,
financial condition and results of operations of the Company.
Brazil's trade deficit for 1998 decreased to US$6.44 billion compared to
US$8.37 billion for 1997, which in turn was an increase compared to the
US$5.54 billion trade deficit for 1996. There can be no assurance that the
Brazilian government will not introduce credit restrictions to subdue domestic
demand in order to reduce the trade deficit, nor that any such credit
restrictions will not have a material adverse effect on the business,
operations, financial condition or results of operations of the Company. A
continuing increase in the trade deficit would substantially reduce Brazil's
approximately US$35.7 billion of reserves at February 23, 1999 and could
negatively affect Brazil's economic development as a whole.
Privatization
The Federal Government, directly or through various state-owned enterprises,
owns many companies and controls a major portion of activities in the oil and
gas sectors. Most of the energy production and postal services companies are
directly or indirectly controlled by the Federal Government.
To reduce its participation in the economy, the Federal Government has
engaged in the privatization of certain state enterprises. The objectives of
the privatization program are (i) to reduce the role of the state in the
economy and allocate more resources to social investment, (ii) to reduce the
public sector debt, (iii) to encourage increased competition and thereby raise
the standards and efficiency of Brazilian industry and (iv) to strengthen the
capital markets and promote wider share ownership. As originally presented the
Real Plan contemplated constitutional amendments which would permit private
participation in the state-controlled petroleum and telecommunications sectors
and in other areas that had constitutionally mandated monopolies, such as
pipeline distribution of gas and the shipping industry. These amendments were
approved by Congress in 1995. A council directly subordinate to the President,
the Conselho Nacional de Privatizacao (the "Privatization Council") and Banco
Nacional de Desenvolvimento Economico e Social (the "National Development
Bank" or "BNDES") are responsible for administering the privatization program.
As of December 31, 1996, a total of 52 state enterprises or divisions
thereof had been privatized, and several minority interests held by Federal
Government companies had been sold for nominal consideration totaling US$13.7
billion (including payment made in Brazilian currency and payment made by
means of qualified debt instruments issued to the Federal Government, its
agencies and state-controlled companies). To date, the privatizations have,
for the most part, been effected through share auctions conducted on Brazil's
stock exchanges. Although the majority of such share auctions have been
successful, there have been instances in which a share auction has failed due
to a lack of bidders. Some of the Brazilian states, such as Sao Paulo, Minas
Gerais, Pernambuco, Paraiba and Maranhao are also conducting privatization
programs in relation to state services. Additionally, 10 licenses for Cellular
Band B were granted, and on the State level eleven companies were privatized.
Brazilian labor unions have opposed certain of the privatization measures
proposed by the Federal Government, but the Federal Government has, to date,
been able to move forward with its program despite such opposition.
23
<PAGE>
Developments in Other Emerging Market Countries; Brazilian Austerity Program
The Brazilian securities markets are, to varying degrees, influenced by
economic and market conditions in other emerging market countries. Although
economic conditions are different in each country, investors' reactions to
developments in one country can have an effect on the securities of issuers in
other countries, including Brazil. For example, since the fourth quarter of
1997, the international financial markets have experienced significant
volatility, and a large number of financial market indices, including those in
Brazil, have declined significantly. The current market volatility in Latin
American and other emerging market countries' securities markets has also been
attributed, at least in part, to the effects of the Asian economic crisis.
There can be no assurance that the Brazilian securities markets will not
continue to be affected negatively by events elsewhere, especially in emerging
markets, or that such events will not adversely affect the value of the ADSs.
In reaction to the growing market volatility in Asia, the Federal Government
implemented several measures intended to curtail the outflow of foreign
investment, as Central Bank reserves were reduced from U.S.$61.2 billion in
September 1998 to U.S.$52.9 billion by the end of October 1998. On October 30,
1998, the Central Bank raised the benchmark interest rate from 20.7% to 43.4%
in order to retain investment funds in the country. On November 10, 1998 the
Federal Government presented a series of fiscal measures aimed at reducing the
budget deficit and bolstering economic conditions. The measures included
certain tax increases, eliminations of budget expenses and reductions in
available fiscal incentives. The package of measures was intended to produce a
savings of R$20 billion, due to the decrease in expenses and the increase in
revenue. These fiscal measures have been substantially implemented.
Constitutional reforms affecting civil servants and social security have also
been accelerated and may result in lower government deficits. However, there
can be no assurance that such measures will be successful in protecting the
Federal Government's price stability program.
Additionally, the decrease in economic activity caused by the increase in
interest rates and the fiscal measures may have substantial negative effects
on companies doing business in Brazil. Projected GDP growth for Brazil for
1998 has been reduced from approximately 4% to approximately 1%. It is
expected that these events may have the effect of reducing the purchasing
power of Brazilian consumers in general.
Events in Asia also may affect the competitiveness of Brazilian exports. In
addition, the proceeds from scheduled privatizations may not reach expected
levels, in which case the current account deficit would cause a deterioration
in foreign reserves, adversely affecting the currency exchange rate policy.
Inflation and Devaluation
Brazil experienced extremely high and generally unpredictable rates of
inflation and of devaluation of Brazilian currency for many years until the
implementation of the Real Plan. Inflation itself, as well as certain
governmental measures to combat inflation, and public speculation about
possible future actions have also historically contributed to economic
uncertainty in Brazil and to heightened volatility in the Brazilian securities
markets. The following table sets forth Brazilian inflation, as measured by
the UFIR for 1995 and the IGP-M for 1996-1998, and the devaluation of the
Brazilian currency against the U.S. dollar for the periods shown.
<TABLE>
<CAPTION>
Year ended December
31,
-------------------
1995 1996 1997 1998
---- ---- ---- ----
(in percentages)
<S> <C> <C> <C> <C>
Inflation (UFIR for 1995; IGP-M for
1996-1998)................................................. 22.5 9.2 7.8 1.8
Devaluation (Brazilian currency vs. US$).................... 15.0 6.9 7.4 8.3
</TABLE>
Since the introduction of the Real Plan in July 1994, the rate of inflation
has decreased considerably. As measured by the IGP-M, the rate of inflation
was 7.8% and 1.8% for 1997 and 1998, respectively. Despite this reduction, the
rate of inflation remains high compared to other countries, and the potential
for distortions or dislocations attributable to changing prices continues to
exist. With the exception of events in January 1999, the exchange rate between
the real and the U.S. dollar has been relatively stable since early July 1994,
compared to
24
<PAGE>
prior periods. However, the potential for continued devaluation or volatility
as well as resurgent inflation persists in light of Brazil's recent financial
crisis. See "Exchange Rates."
Item 2: Description of Property
The principal properties of the Company consist of its basic network,
satellite earth stations, nodes, terrestrial and submarine cables, switches
and certain real estate. At December 31, 1997, the net book value of the
Company's property, plant and equipment was approximately R$6,326.2 million.
The Company's properties are located throughout Brazil, providing both the
necessary infrastructure of a nationwide long-distance telecommunications and
a support network. As of May 1, 1998, the Company owned approximately 62 sites
related to its telecommunications operations used for network equipment of
various types, such as telephone exchanges, transmission stations, microwave
radio equipment and digital switching nodes. The Company conducts a majority
of its management activities from Rio de Janeiro, and owns and leases office
space in such other cities as Rio de Janeiro, Sao Paulo, Porto Alegre, Belo
Horizonte, Curitiba, Brasilia, Salvador, and Belem.
The Company considers it network facilities to be adequate to its
international long-distance and domestic long-distance businesses as currently
operated and contemplated. For a description of the Company's equipment see
"Description of Business--Network and Facilities."
Item 3: Legal Proceedings
The Breakup of Telebras is subject to several lawsuits in which the
plaintiffs have requested, and in certain cases obtained, preliminary
injunctions against the Breakup. All of these preliminary injunctions have
been quashed by decisions of the relevant Federal Court, although several of
such decisions are currently on appeal. If any such appeal is successful, the
shareholders of Telebras will be required to reapprove the Breakup or other
legislative actions may be required.
The lawsuits to which the Breakup has been subjected are based on a number
of legal theories, the principal among which are that (i) Brazil's
Constitution requires that the creation of the twelve New Holding Companies be
specifically authorized by the Telecommunications Law--the Breakup is not so
authorized; (ii) the shareholders' meeting of Telebras held on May 22, 1998
which approved the Breakup was not properly convened; (iii) national
sovereignty will be threatened if the country's telecommunications companies
are controlled by foreign entities; and (iv) the Telecommunications Law
requires that certain matters, such as the entry of new competitors and the
administration of development and technology funds, be regulated prior to the
Breakup and privatization either by an executive order of the President or by
an act of Congress. If any of the plaintiffs in the above-described lawsuits
ultimately prevails, the Breakup will have to be reinitiated. This could
require, depending upon the prevailing plaintiff's theory, any combination of
(i) amendment of the Telecommunications Law, (ii) reconvening the May 22, 1998
Telebras shareholders' meeting and (iii) the passing of additional laws by
Congress or Issuance of executive orders by the President. It is theoretically
possible under Brazilian law for a court to require that the Breakup be
unwound, although the Company believes that this would not be likely to occur.
The Company is a party to certain legal proceedings arising in the normal
course of business. The Company has provided for or deposited in court amounts
to cover its estimated losses due to adverse legal judgments. In the opinion
of management, such actions, if decided adversely to the Company, would not
have a material adverse effect on the Company's business, financial condition
or results of operations.
Telebras, the legal predecessor of the Registrant, is a defendant in a
number of legal proceedings and subject to other claims and contingencies.
Under the terms of the Breakup, liability for any claims arising out of acts
committed by Telebras prior to the effective date of the Breakup remains with
Telebras, except for labor and tax claims (for which Telebras and the New
Holding Companies are jointly and severally liable by operation of law) and
any liability for which specific accounting provisions have been assigned to
the Registrant or one of the other New Holding Companies. Creditors of
Telebras may challenge this allocation of liability until September 14, 1998.
The Company is not aware of any such challenge having been made.
25
<PAGE>
Although Embratel is considered to be the surviving entity of Telebras for
financial reporting purposes under U.S. GAAP, Embratel will not be liable for
any claims arising out of acts committed by Telebras except for such claims as
have been assigned to it under the terms of the Breakup and except for labor
and tax claims as discussed above.
Item 4: Control of Registrant
Of the Registrant's two classes of capital stock outstanding, only the
Common Shares have full voting rights. The Preferred Shares have voting rights
under limited circumstances. See "Description of Securities to be Registered--
Capital Stock--Voting Rights." MCI WORLDCOM owns 51.8% of the Common Shares.
Accordingly, MCI WORLDCOM has the ability to control the election of the
Registrant's Board of Directors and the direction and future operations of the
Company. MCI WORLDCOM has entered into a management agreement with the
Company. See "Interest of Management in Certain Transactions."
The following table sets forth information concerning the ownership of the
Common Shares by MCI WORLDCOM and by the Registrant's officers and directors
as a group. The Company is not aware of any other shareholder owning more than
10.0% of the Common Shares.
<TABLE>
<CAPTION>
Number of Percentage of
Common Outstanding
Name of owner Shares Owned Common Shares
------------- -------------- -------------
<S> <C> <C>
MCI WORLDCOM..................................... 64,405,151,125 51.79%
All directors and executives officers as a group
(5 persons)..................................... 5 0.00%
</TABLE>
The following is a brief description of the business activities of MCI
WORLDCOM.
MCI WORLDCOM. MCI WORLDCOM is a global telecommunications company with
revenue of more than $30 billion and established operations in over 65
countries encompassing the Americas, Europe and the Asia-Pacific regions. MCI
WORLDCOM is a premier provider of facilities-based and fully integrated local,
long distance, international and Internet services. MCI WORLDCOM's global
networks, including its state-of-the-art pan-European network and transoceanic
cable systems, provide end-to-end high-capacity connectivity to more than
38,000 buildings worldwide.
Item 5: Nature of Trading Market
Prior to September 21, 1998, there was no trading market for the Common
Shares or the Preferred Shares of the New Holding Company.
Following the Breakup and until September 21, 1998, the preferred shares of
each of the New Holding Companies, including the Preferred Shares, traded on
the Brazilian Stock Exchanges only as a unit with the preferred shares of
Telebras. Telebras ADSs, each representing 1,000 Telebras preferred shares
and, since the Breakup and until November 16, 1998, each also representing
1,000 preferred shares of each of the New Holding Companies, have continued to
trade on the NYSE.
On September 21, 1998, common shares and preferred shares of each New
Holding Company, including the Preferred Shares, commenced trading separately
on the Brazilian Stock Exchanges. The table below sets forth, for the periods
indicated, the high and low closing sales prices for the Preferred Shares of
the Registrant as reported on the Sao Paulo Stock Exchange.
<TABLE>
<CAPTION>
Prices per 1,000
Preferred Shares of
the Registrant
-------------------
High Low
-------------------
(in nominal reais)
<S> <C> <C>
September 21, 1998 through September 30, 1998........... R$16.50 R$12.50
October 1, 1998 through December 31, 1998............... R$22.00 R$12.00
January 1, 1999 through March 9, 1999................... R$ 30.50 R$12.30
</TABLE>
26
<PAGE>
On November 16, 1998, American Depositary Shares representing preferred
shares of each New Holding Company were issued and commenced trading
separately on the NYSE. The ADSs, each representing 1,000 Preferred Shares of
the Registrant, were issued to the holders of Telebras ADSs pursuant to a
Deposit Agreement (the "Deposit Agreement") among the Registrant, The Bank of
New York, as Depositary (the "Depositary"), and the holders of the ADSs from
time to time. See "Description of Securities to be Registered--Description of
American Depositary Receipts in respect of Preferred Shares."
This Registration Statement had not, at the date of its most recent filing,
been declared effective by the Commission and the ADSs were traded on the NYSE
under the symbol EMT as of that date pursuant to Rule 12a-5 of the Rules and
Regulations of the Exchange Act. Rule 12a-5 provides under certain limited
circumstances a temporary exemption from the requirement of Section 12(a) of
the Exchange Act that securities traded on a national securities exchange
(such as the NYSE) be registered under Section 12. This exemption expires 120
days after commencement of trading and may be terminated earlier under certain
circumstances. The table below sets forth, for the periods indicated, the high
and low closing sales prices for the ADSs of the Registrant as reported on the
New York Stock Exchange.
<TABLE>
<CAPTION>
U.S. Dollars
per ADS
-------------
High Low
------ ------
<S> <C> <C>
November 16, 1998 through November 30, 1998....................... 18.44 15.00
December 1, 1998 through December 31, 1998........................ 16.88 12.38
January 1, 1999 through March 9, 1999............................. 15.50 9.56
</TABLE>
Trading on the Brazilian Stock Exchanges
Of Brazil's nine stock exchanges, the Sao Paulo Stock Exchange and the Rio
de Janeiro Stock Exchange are the most significant. During 1997, the Sao Paulo
Stock Exchange accounted for approximately 93% of the trading value of equity
securities on all Brazilian stock exchanges, and the Sao Paulo Stock Exchange
and the Rio de Janeiro Stock Exchange together accounted for approximately 99%
of the trading value of equity securities on all Brazilian stock exchanges.
Each Brazilian stock exchange is a non-profit entity owned by its member
brokerage firms. Trading on each exchange is limited to member brokerage firms
and a limited number of authorized non-members. The Sao Paulo Stock Exchange
and the Rio de Janeiro Stock Exchange have two open outcry trading sessions
each day, from 10:00 a.m. to 1:00 p.m. and from 2:00 p.m. to 5:00 p.m. Trading
is also conducted during this time on an automated system on the Sao Paulo
Stock Exchange and on the National Electronic Trading System ("SENN"), a
computerized system that links the Rio de Janeiro Stock Exchange
electronically with the seven smaller regional exchanges. Market makers exist
on the Sao Paulo Stock Exchange, but are only authorized to make markets in
options for stock indices which are traded on that exchange and to engage in
transactions on META (Mercado de Empresas Teleassistidas), an electronic
trading system operating at the Sao Paulo Stock Exchange and permitting
trading in the securities of companies registered for that purpose. These
companies must appoint the market makers authorized to deal in their
securities. There are no specialists or market makers for the Company's shares
on the Sao Paulo Stock Exchange. The Comissao de Valores Mobiliarios (the
Brazilian Securities Commission or "CVM") and each of the Brazilian stock
exchanges have discretionary authority to suspend trading in shares of a
particular issuer under certain circumstances. Trading in securities listed on
the Brazilian stock exchanges may be effected off the exchanges in certain
circumstances, although such trading is very limited.
Settlement of transactions is effected three business days after the trade
date without adjustment of the purchase price for inflation. Payment for
shares is made through the facilities of separate clearinghouses for each
exchange, which maintain accounts for member brokerage firms. The seller is
ordinarily required to deliver the shares to the exchange on the second
business day following the trade date. The clearinghouse for the Sao Paulo
Stock Exchange is Calispa S.A., which is owned by the member brokerage firms.
The clearinghouse for the Rio de Janeiro Stock Exchange is CLC-Camara de
Liquidacao e Custodia S.A., which is 99% owned by that exchange.
27
<PAGE>
At December 31, 1997, the aggregate market capitalization of the 536
companies listed on the Sao Paulo Stock Exchange was approximately R$285.0
billion. Substantially the same securities are listed on the Sao Paulo Stock
Exchange and on the Rio de Janeiro Stock Exchange. Although all the
outstanding shares of an exchange-listed company may trade on a Brazilian
stock exchange, in most cases less than half of the listed shares are actually
available for trading by the public, the remainder being held by small groups
of controlling persons that rarely trade their shares. This is particularly
true in the case of mixed-capital companies, such as the Company before the
privatization, of which more than half of the voting shares must by law be
owned by Brazilian governmental entities. For this reason, data showing the
total market capitalization of Brazilian stock exchanges tends to overstate
the liquidity of the Brazilian equity securities market.
Although the Brazilian equity market was Latin America's largest in terms of
market capitalization, it is relatively small and illiquid compared to major
world markets. In 1997, the combined daily trading volumes on these two
exchanges averaged approximately R$945.4 million. In 1997, the five most
actively traded issues represented approximately 72.9% of the total trading in
the cash market on the Sao Paulo Stock Exchange and approximately 50.5% of the
total trading in the cash market on the Rio de Janeiro Stock Exchange.
Trading on Brazilian stock exchanges by non-residents of Brazil is subject
to certain limitations under Brazilian foreign investment legislation. See
"Description of Securities to be Registered."
Regulation of Brazilian Securities Markets
The Brazilian securities markets are regulated by the CVM, which has
authority over stock exchanges and the securities markets generally, and by
the Central Bank of Brazil, which has, among other powers, licensing authority
over brokerage firms and regulates foreign investment and foreign exchange
transactions. The Brazilian securities market is governed by Law No. 6,385
dated December 7, 1976, as amended (the "Brazilian Securities Law"), and the
Brazilian Corporation Law.
Under the Brazilian Corporation Law, a company is either public, a
"companhia aberta," such as the Company, or private, a "companhia fechada."
All public companies are registered with the CVM and are subject to reporting
requirements. A company registered with the CVM may have its securities traded
either on the Brazilian stock exchanges or in the Brazilian over-the-counter
("Brazilian OTC") market. The shares of a public company, including the
Company, may also be traded privately, subject to certain limitations. To be
listed on the Brazilian stock exchanges, a company must apply for registration
with the CVM and the stock exchange where the head office of the company is
located. Once this stock exchange has admitted a company to listing and the
CVM has accepted its registration as a public company, its securities may be
traded on all other Brazilian stock exchanges.
Trading in securities on the Brazilian stock exchanges may be suspended at
the request of a company in anticipation of a material announcement. Trading
may also be suspended on the initiative of a Brazilian stock exchange or the
CVM, among other reasons, based on or due to a belief that a company has
provided inadequate information regarding a material event or has provided
inadequate responses to inquiries by the CVM or the relevant stock exchange.
The Brazilian Securities Law provided for, among other things, disclosure
requirements, restrictions on insider trading and price manipulation, and
protection of minority shareholders. However, the Brazilian securities markets
are not as highly regulated and supervised as the United States securities
markets or markets in certain other jurisdictions.
Item 6: Exchange Controls and Other Limitations Affecting Security Holders
There are no restrictions on ownership of Preferred Shares or Common Shares
of the Registrant by individuals or legal entities domiciled outside Brazil.
Until the Registrant was privatized, it was subject to provisions of
Brazilian corporate law applicable to mixed-capital companies under Brazilian
law. These provisions ceased to apply after the Registrant was privatized. As
a mixed-capital company, the Registrant was not subject to bankruptcy and the
Federal
28
<PAGE>
Government was contingently liable for the obligations of the Registrant for
so long as its assets were encumbered and attached. However, substantial
limitations applied to the attachment or sale of assets of the operating
subsidiaries of the Registrant that were used to provide telecommunications
services pursuant to the Company's concession. Similarly, the sale of shares
representing voting control of operating subsidiaries providing public
telecommunications services was subject to government authorization. The sale
of preferred shares of operating subsidiaries, or of assets not used to
provide telecommunications services, was not subject to these restrictions.
The right to convert dividend payments and proceeds from the sale of shares
into foreign currency and to remit such amounts outside Brazil is subject to
restrictions under foreign investment legislation which generally requires,
among other things, that the relevant investments have been registered with
the Central Bank of Brazil. Such restrictions on the remittance of foreign
capital abroad may hinder or prevent Banco Itau S.A. (the "Custodian"), as
custodian for the Preferred Shares represented by ADSs, or holders who have
exchanged ADRs for Preferred Shares from converting dividends, distributions
or the proceeds from any sale of such Preferred Shares, as the case may be,
into U.S. dollars and remitting such U.S. dollars abroad. Holders of ADSs
could be adversely affected by delays in, or refusal to grant any, required
government approval for conversions of Brazilian currency payments and
remittances abroad of the Preferred Shares underlying the ADSs.
Under Annex IV to Resolution No. 1,289 of the National Monetary Council, as
amended (the "Annex IV Regulations"), qualified foreign investors (which
principally include foreign financial institutions, insurance companies,
pension and investment funds, charitable foreign institutions and other
institutions that (i) seek to invest in financial markets and (ii) meet
certain minimum capital and other requirements) registered with the CVM and
acting through authorized custody accounts managed by local agents may buy and
sell shares on Brazilian stock exchanges without obtaining separate
Certificates of Registration for each transaction. Investors under the Annex
IV Regulations are also entitled to favorable tax treatment. See "Taxation--
Brazilian Tax Considerations." Resolution No. 1,927 of the National Monetary
Council, which is the restated and amended Annex V to Resolution No. 1,289 of
the National Monetary Council (the "Annex V Regulations"), provides for the
issuance of depositary receipts in foreign markets in respect of shares of
Brazilian issuers. The ADS program will be approved under the Annex V
Regulations by the Central Bank of Brazil and the CVM prior to the issuance of
the ADSs. Accordingly, the proceeds from the sale of ADSs by ADR holders
outside Brazil are free of Brazilian foreign investment controls and holders
of the ADSs will be entitled to favorable tax treatment. See "Taxation--
Brazilian Tax Considerations."
A Certificate of Registration will be issued in the name of the Depositary
with respect to the ADSs prior to their issuance and will be maintained by the
Custodian on behalf of the Depositary. Pursuant to the Certificate of
Registration, the Custodian and the Depositary are able to convert dividends
and other distributions with respect to the Preferred Shares represented by
ADSs into foreign currency and remit the proceeds outside Brazil. In the event
that a holder of ADSs exchanges such ADSs for Preferred Shares, such holder
will be entitled to continue to rely on the Depositary's Certificate of
Registration for five business days after such exchange, following which such
holder must seek to obtain its own Certificate of Registration with the
Central Bank of Brazil. Thereafter, any holder of Preferred Shares may not be
able to convert into foreign currency and remit outside Brazil the proceeds
from the disposition of, or distributions with respect to, such Preferred
Shares, unless such holder (i) qualifies under the Annex IV Regulations or
(ii) obtains its own Certificate of Registration, and in the case of (ii), it
will be subject to less favorable Brazilian tax treatment than a holder of
ADSs. See "Taxation--Brazilian Tax Considerations."
Under current Brazilian legislation, the Federal Government may impose
temporary restrictions on remittances of foreign capital abroad in the event
of a serious imbalance or an anticipated serious imbalance of Brazil's balance
of payments. For approximately six months in 1989 and early 1990, the Federal
Government froze all dividend and capital repatriations held by the Central
Bank of Brazil that were owed to foreign equity investors, in order to
conserve Brazil's foreign currency reserves. These amounts were subsequently
released in accordance with Federal Government directives. The imbalance in
Brazil's balance of payments increased during 1997, and there can be no
assurance that the Federal Government will not impose similar restrictions on
foreign repatriations in the future.
29
<PAGE>
Item 7: Taxation
The following summary contains a description of the principal Brazilian and
U.S. federal income tax consequences of the acquisition, ownership and
disposition of Preferred Shares or ADSs, but it does not purport to be a
comprehensive description of all the tax considerations that may be relevant
to a decision to purchase Preferred Shares or ADSs. The summary is based upon
the tax laws of Brazil and regulations thereunder and on the tax laws of the
United States and regulations thereunder as in effect on the date hereof,
which are subject to change. This summary is also based upon the
representations of the Depositary and on the assumption that each obligation
in the Deposit Agreement relating to the ADRs and any related documents will
be performed in accordance with its terms. PROSPECTIVE PURCHASERS OF PREFERRED
SHARES OR ADSs SHOULD CONSULT THEIR OWN TAX ADVISORS AS TO THE TAX
CONSEQUENCES OF THE ACQUISITION, OWNERSHIP AND DISPOSITION OF PREFERRED SHARES
OR ADSs.
Although there is at present no income tax treaty between Brazil and the
United States, the tax authorities of the two countries have had discussions
that may culminate in such a treaty. No assurance can be given, however, as to
whether or when a treaty will enter into force or how it will affect the U.S.
holders of Preferred Shares or ADSs. Prospective holders of Preferred Shares
or ADSs should consult their own tax advisors as to the tax consequences of
the acquisition, ownership and disposition of the Preferred Shares or ADSs in
their particular circumstances.
Brazilian Tax Considerations
The following discussion summarizes the principal Brazilian tax consequences
of the acquisition, ownership and disposition of Preferred Shares or ADSs by a
holder that is not domiciled in Brazil for purposes of Brazilian taxation and,
in the case of a holder of Preferred Shares, that has registered its
investment in Preferred Shares with the Central Bank of Brazil as a U.S.
dollar investment (in each case, a "non-Brazilian holder"). It is based on
Brazilian law as currently in effect. Any change in such law may change the
consequences described below. The following discussion summarizes the
principal tax consequences applicable under current Brazilian law to non-
Brazilian holders of Preferred Shares or ADSs; it does not specifically
address all of the Brazilian tax considerations applicable to any particular
non-Brazilian holder, and each non-Brazilian holder should consult his or her
own tax advisor concerning the Brazilian tax consequences of an investment in
Preferred Shares or ADSs.
Taxation of Dividends
Dividends, including dividends paid in kind, paid by the Registrant (i) to
the Depositary in respect of the Preferred Shares underlying the ADSs or (ii)
to a non-Brazilian holder in respect of Preferred Shares will generally not be
subject to Brazilian withholding tax in the case of distributions of profits
earned as from January 1, 1996. Stock dividends relating to profits generated
prior to December 31, 1995 are not subject to withholding tax in Brazil unless
the stock is redeemed by the Company within five years from such distribution
or the non-Brazilian holder sells the stock in Brazil within such five-year
period.
Brazil has entered into tax treaties with several countries. However, there
is currently no tax treaty between the United States and Brazil. The only
Brazilian tax treaty now in effect that, if certain conditions are met, would
reduce the generally applicable rate of the withholding tax on dividends below
15% is the treaty with Japan, which would reduce such rate to 12.5% under the
circumstances stated in such treaty.
Taxation of Gains
Gains realized outside Brazil by a non-Brazilian holder on the disposition
of ADSs to another non-Brazilian holder are not subject to Brazilian tax.
The withdrawal of Preferred Shares in exchange for ADSs is not subject to
Brazilian tax. The deposit of Preferred Shares in exchange for ADSs is not
subject to Brazilian tax provided that the Preferred Shares are
30
<PAGE>
registered under the Annex IV Regulations. In the event the Preferred Shares
are not so registered, the deposit of Preferred Shares in exchange for ADSs
may be subject to Brazilian capital gains tax at the rate of 10% or 15% as
described below. On receipt of the underlying Preferred Shares, a non-
Brazilian holder who qualifies under the Annex IV Regulations will be entitled
to register the U.S. dollar value of such shares with the Central Bank of
Brazil as described below under "--Registered Capital."
Non-Brazilian holders are not subject to tax in Brazil on gains realized on
sales of Preferred Shares that occur abroad or on the proceeds of a redemption
of, or a liquidating distribution with respect to, Preferred Shares. As a
general rule, non-Brazilian holders are subject to a withholding tax imposed
at a rate of 15% on gains realized on sales or exchanges of Preferred Shares
that occur in Brazil to or with a resident of Brazil outside of a Brazilian
stock exchange. Non-Brazilian holders are generally subject to a withholding
tax at a rate of 10% on gains realized on sales or exchanges in Brazil of
Preferred Shares that occur on a Brazilian stock exchange but will not be
subject to tax if either such a sale is made within five business days of the
withdrawal of such Preferred Shares in exchange for ADSs and the proceeds
thereof are remitted abroad within such five-day period, or such a sale is
made under the Annex IV Regulations by certain qualified institutional non-
Brazilian holders that register with the CVM. Gains realized by an investor
under the Annex IV Regulations are not subject to tax, provided certain
conditions are met. The "gain realized" is the difference between the amount
in Brazilian currency realized on the sale or exchange and the acquisition
cost, measured in Brazilian currency without any correction for inflation, of
the shares sold. The "gain realized" as a result of a transaction with respect
to shares registered as an investment with the Central Bank of Brazil (and not
subject to the Annex IV Regulations) will be calculated based on the foreign
currency amount registered with the Central Bank of Brazil. There can be no
assurance that the current preferential treatment for holders of ADSs and non-
Brazilian holders of Preferred Shares under the Annex IV Regulations will not
be changed. Reductions in the tax rate provided for by Brazil's tax treaties
do not apply to tax on gains realized on sales or exchanges of Preferred
Shares.
Any exercise of preemptive rights relating to the Preferred Shares or ADSs
will not be subject to Brazilian taxation. Any gain on the sale or assignment
of preemptive rights relating to the Preferred Shares by the Depositary will
not be subject to Brazilian taxation.
Distributions of Interest on Net Worth
In accordance with Law No. 9,249, dated December 26, 1995, Brazilian
corporations may make payments to shareholders characterized as distributions
of interest on the Company's net worth. Such interest is limited to the
Federal Government's long-term interest rate (the "TJLP") as determined by the
Central Bank of Brazil from time to time (10.63% per annum for the three month
period starting June 1, 1998), and cannot exceed the greater of (i) 50% of net
income (before taking such distribution and any deductions for income taxes
into account) for the period in respect of which the payment is made or (ii)
50% of retained earnings.
Distributions of interest on net worth in respect of the Preferred Shares
paid to shareholders who are either Brazilian residents or non-Brazilian
residents, including holders of ADSs, are subject to Brazilian withholding tax
at the rate of 15% (except for interest due to the Federal Government, which
is exempt from tax withholding) and shall be deductible by the Registrant for
purposes of the Corporate Income Tax ("IRPJ") and Social Contribution on
Profit ("CSLL") (both of which are levied on the Registrant's profits) as long
as the payment of a distribution of interest is approved in the Registrant's
annual shareholders' meeting. The amount of distributions of interest on net
worth will be determined by the Board of Directors of the Registrant. No
assurance can be given that the Board of Directors of the Registrant will not
determine that future distributions of profits will be made by means of
interest on net worth instead of by means of dividends.
Under Brazilian law and regulations, the amount paid to shareholders as
interest on net worth (net of any withholding tax) may be treated as payment
in lieu of the Mandatory Dividend and Preferred Dividend (as defined under
"Description of Securities to be Registered--Capital Stock--Dividends"). In
addition, any Brazilian corporation distributing interest on net worth is
obligated to distribute to shareholders an amount sufficient to ensure that
the net amount received (after payment of withholding taxes) is at least equal
to the Mandatory Dividend.
31
<PAGE>
Distributions of interest on net worth in respect of the Preferred Shares,
including to holders of ADSs, may be converted into U.S. dollars and remitted
outside of Brazil to U.S. holders, subject to relevant exchange restrictions.
See "Description of Securities to be Registered--Capital Stock--Payment of
Dividends" and "--Description of American Depositary Receipts in respect of
Preferred Shares--Dividends, Other Distributions and Rights."
Other Brazilian Taxes
There are no Brazilian inheritance, gift or succession taxes applicable to
the ownership, transfer or disposition of Preferred Shares or ADSs by a non-
Brazilian holder except for gift and inheritance taxes which are levied by
some States in Brazil on gifts made or inheritances bestowed by individuals or
entities not resident or domiciled in Brazil or in the relevant State to
individuals or entities that are resident or domiciled within such State in
Brazil. There are no Brazilian stamp, issue, registration, or similar taxes or
duties payable by holders of Preferred Shares or ADSs.
Pursuant to Decree 2,219, dated May 2, 1997, a financial transaction tax
(the "IOF") may be imposed on the conversion into Brazilian currency of the
proceeds of a foreign investment in Brazil (including investments in Preferred
Shares and ADSs and investments made under the Annex IV Regulations) and may
also be imposed upon the conversion of Brazilian currency into foreign
currency (e.g., for purposes of paying dividends and interest). The IOF tax
rate is currently 0%. Although the Minister of Finance has the legal power to
increase the rate to a maximum of 25%, any such increase will be applicable
only to transactions occurring after such increase becomes effective.
On January 24, 1997, a temporary tax was enacted. The Contribuicao
Provisoria sobre Movimentacao Financeira ("CPMF Tax"), which was created by
Constitutional Amendment No. 12 of August 16, 1996 and regulated by Law No.
9,311 of October 24, 1996, is levied on debits on bank accounts and certain
other payments made by a bank, at a rate of 0.2%, which may be raised at any
time to 0.25%. The CPMF Tax was initially scheduled to be collected until
February 22, 1998; the CPMF Tax was subsequently extended until January 27,
1999 by Law No. 9,539 of December 12, 1997.
Registered Capital
The amount of an investment in Preferred Shares held by a non-Brazilian
holder who qualifies under the Annex IV Regulations and obtains registration
with the CVM, or by the Depositary representing such holder, is eligible for
registration with the Central Bank of Brazil; such registration (the amount so
registered is referred to as "Registered Capital") allows the remittance
outside Brazil of foreign currency, converted at the Commercial Market Rate,
acquired with the proceeds of distributions on, and amounts realized with
respect to disposition of, Preferred Shares. The Registered Capital for each
Preferred Share purchased in the form of an ADS, or purchased in Brazil, and
deposited with the Depositary in exchange for an ADS, will be equal to its
purchase price (in U.S. dollars). The Registered Capital for a Preferred Share
that is withdrawn upon surrender of an ADS will be the U.S. dollar equivalent
of (i) the average price of the Preferred Share on the Brazilian stock
exchange on which the greatest number of Preferred Shares was sold on the day
of withdrawal, or (ii) if no Preferred Shares were sold on that day, the
average price on the Brazilian stock exchange on which the greatest number of
Preferred Shares were sold in the fifteen trading sessions immediately
preceding such withdrawal. The U.S. dollar value of the Preferred Shares is
determined on the basis of the average Commercial Market Rates quoted by the
Central Bank of Brazil on such date (or, if the average price of Preferred
Shares is determined under clause (ii) of the preceding sentence, the average
of such average quoted rates on the same fifteen dates used to determine the
average price of the Preferred Shares).
A non-Brazilian holder of Preferred Shares may experience delays in
effecting such registration, which may delay remittances abroad. Such a delay
may adversely affect the amount, in U.S. dollars, received by the non-
Brazilian holder.
32
<PAGE>
U.S. Federal Income Tax Considerations
The statements regarding U.S. tax law set forth below are based on U.S. law
as in force on the date of this Registration Statement, and changes to such
law subsequent to the date of this Registration Statement may affect the tax
consequences described herein. This summary describes the principal tax
consequences of the ownership and disposition of Preferred Shares or ADSs, but
it does not purport to be a comprehensive description of all of the tax
consequences that may be relevant to a decision to hold or dispose of
Preferred Shares or ADSs. This summary applies only to purchasers of Preferred
Shares or ADSs who will hold the Preferred Shares or ADSs as capital assets
and does not apply to special classes of holders such as dealers in securities
or currencies, holders whose functional currency is not the U.S. dollar,
holders of 10% or more of the shares of the Registrant, tax-exempt
organizations, financial institutions, holders liable for the alternative
minimum tax, securities traders who elect to account for their investment in
Preferred Shares or ADSs on a mark-to-market basis, and persons holding
Preferred Shares or ADSs in a hedging transaction or as part of a straddle or
conversion transaction.
Each holder should consult such holder's own tax advisor concerning the
overall tax consequences to it, including the consequences under foreign,
state and local laws, of an investment in Preferred Shares or ADSs.
In this discussion, references to "ADSs" also refer to Preferred Shares,
references to a "U.S. holder" are to a holder of an ADS (i) that is a citizen
or resident of the United States of America, (ii) that is a corporation
organized under the laws of the United States of America or any state thereof,
or (iii) that is otherwise subject to U.S. federal income taxation on a net
basis with respect to the ADS.
For purposes of the U.S. Internal Revenue Code of 1986, as amended (the
"Code"), holders of ADRs will be treated as owners of the ADSs represented by
such ADRs.
Taxation of Dividends
A U.S. holder will recognize ordinary dividend income for U.S. federal
income tax purposes in an amount equal to the amount of any cash and the value
of any property distributed by the Registrant as a dividend to the extent that
such distribution is paid out of the Registrant's current or accumulated
earnings and profits ("e&p"), as determined for U.S. federal income tax
purposes, when such distribution is received by the Custodian or by the U.S.
holder, in the case of a holder of Preferred Shares. To the extent that such a
distribution exceeds the Registrant's e&p, it will be treated as a non-taxable
return of capital, to the extent of the U.S. holder's tax basis in the ADS (or
Preferred Shares, as the case may be), and thereafter as capital gain. The
amount of any distribution will include the amount of Brazilian tax withheld
on the amount distributed and the amount of a distribution paid in reais will
be measured by reference to the exchange rate for converting reais into U.S.
dollars in effect on the date the distribution is received by the Custodian,
or by a U.S. holder, in the case of a holder of Preferred Shares. If the
Custodian (or U.S. holder, in the case of a holder of Preferred Shares), does
not convert such reais into U.S. dollars on the date it receives them, it is
possible that the U.S. holder will recognize foreign currency loss or gain,
which would be ordinary loss or gain, when the reais are converted into U.S.
dollars. Dividends paid by the Registrant will not be eligible for the
dividends received deduction allowed to corporations under the Code.
Distributions out of e&p with respect to the ADSs generally will be treated
as dividend income from sources outside of the United States and generally
will be treated separately along with other items of "passive" (or, in the
case of certain U.S. holders, "financial services") income for purposes of
determining the credit for foreign income taxes allowed under the Code.
Subject to certain limitations, the Brazilian withholding tax paid in
connection with any distribution with respect to the ADSs may be claimed as a
credit against the U.S. federal income tax liability of a U.S. holder if such
U.S. holder elects for that year to credit all foreign income taxes, or such
Brazilian withholding tax may be taken as a deduction. Under new rules enacted
by Congress in 1997 and other guidance recently released by the U.S. Treasury,
foreign tax credits will not be allowed for withholding taxes imposed in
respect of certain short-term or hedged positions in securities or in respect
of arrangements in which a U.S. holder's expected economic profit, after non-
U.S. taxes, is insubstantial. U.S. holders should consult their own tax
advisors concerning the implications of these rules in light of their
particular circumstances.
33
<PAGE>
Distributions of additional shares to holders with respect to their ADSs
that are made as part of a pro rata distribution to all shareholders of the
Registrant generally will not be subject to U.S. federal income tax.
A holder of an ADS that is a foreign corporation or non-resident alien
individual (a "non-U.S. holder") generally will not be subject to U.S. federal
income tax or withholding tax on distributions with respect to ADSs that are
treated as dividend income for U.S. federal income tax purposes, and generally
will not be subject to U.S. federal income tax or withholding tax on
distributions with respect to ADSs that are treated as capital gain for U.S.
federal income tax purposes unless such holder would be subject to U.S.
federal income tax on gain realized on the sale or other disposition of ADSs,
as discussed below.
Taxation of Capital Gains
Upon the sale or other disposition of an ADS, a U.S. holder will recognize
gain or loss for U.S. federal income tax purposes in an amount equal to the
difference between the amount realized in consideration for the disposition of
the ADS (excluding the amount of any distribution paid to the Custodian but
not distributed by the Custodian prior to the disposition) and the U.S.
holder's tax basis in the ADS. Such gain or loss generally will be subject to
U.S. federal income tax and will be treated as capital gain or loss. Under
recently enacted legislation, long-term capital gains recognized by an
individual holder generally are subject to a maximum rate of 20 percent in
respect of property held for more than one year, effective for amounts
properly taken into account on or after January 1, 1998. The deductibility of
capital losses is subject to certain limitations. Gain realized by a U.S.
holder on a sale or disposition of ADSs generally will be treated as U.S.
source income. Consequently, in the case of a disposition of Preferred Shares
in Brazil (which, unlike a disposition of ADSs, would be taxable in Brazil),
the U.S. holder might not be able to use the foreign tax credit for Brazilian
tax imposed on gain.
A non-U.S. holder will not be subject to U.S. federal income tax or
withholding tax on gain realized on the sale or other disposition of an ADS
unless (i) such gain is effectively connected with the conduct by the holder
of a trade or business in the United States, or (ii) such holder is an
individual who is present in the United States of America for 183 days or more
in the taxable year of the sale and certain other conditions are met.
U.S. Backup Withholding and Information Reporting
The information reporting requirements of the Code generally will apply to
distributions to a U.S. holder. Distributions to non-U.S. holders generally
will be exempt from information reporting and backup withholding under current
law but a non-U.S. holder may be required to establish its non-U.S. status in
order to claim such exemption.
Item 8: Selected Financial Data
General
The table set forth below presents selected financial information for the
Company at and for the periods indicated. The information as of December 31,
1996 and 1997 and for the three year period ended December 31, 1997 is derived
from and should be read in conjunction with, and is qualified in its entirety
by reference to, the Consolidated Financial Statements and the notes thereto
included elsewhere in this Registration Statement. The Consolidated Financial
Statements have been audited by KPMG Peat Marwick, independent auditors, and
their report on such Consolidated Financial Statements appears elsewhere in
this Registration Statement. The unaudited information as of September 30,
1998 and for the nine-month periods ended September 30, 1997 and 1998 is
derived from and should be read in conjunction with, and is qualified in its
entirety by reference to, the Unaudited Consolidated Condensed Financial
Statements and the notes thereto included elsewhere in this Registration
Statement. The Unaudited Consolidated Condensed Financial Statements have been
prepared by the Company, without audit, pursuant to the rules and regulations
of the Commission for interim information. In the opinion of management, these
unaudited financial statements contain all adjustments, which are of a normal
recurring nature, necessary to present fairly the Company's financial position
as of September 30, 1998 and the
34
<PAGE>
results of operations for the nine months ended September 30, 1997 and 1998.
Results of operations for the nine months ended September 30, 1998 are not
necessarily indicative of results for the full 1998 year or any other period.
The Consolidated Financial Statements and the Unaudited Consolidated
Condensed Financial Statements are prepared in accordance with Brazilian GAAP
which differ in certain material respects from generally accepted accounting
principles in the United States ("U.S. GAAP"). See Note 29 to the Consolidated
Financial Statements and Note 17 to the Unaudited Consolidated Condensed
Financial Statements for a summary of such differences and a reconciliation to
U.S. GAAP of the Company's shareholders' equity and net income from continuing
operations for the periods and as of the dates presented. In addition, under
U.S. GAAP, Embratel is considered to be the continuing entity of the Telebras
System for financial reporting purposes through December 31, 1997. As a
result, all operations of Telebras and its subsidiaries, except for Embratel,
are considered to be discontinued operations for purposes of U.S. GAAP
disclosure through December 31, 1997. See Note 29 to the Consolidated
Financial Statements, which also includes condensed financial statement
schedules of the Company prepared in accordance with Brazilian GAAP, in a U.S.
GAAP reporting format, reflecting discontinued operations through December 31,
1997. All other selected financial information has been derived from the
Company's accounting records.
The Unaudited Consolidated Condensed Financial Statements reflect certain
classifications that differ from those reflected in the Consolidated Financial
Statements. The principal such differences are: (A) certain expenses
classified as selling expense in the Consolidated Financial Statements are
classified as cost of services in the Unaudited Consolidated Condensed
Financial Statements (R$76.5 million in the 1997 interim period and R$102.0
million in the 1998 interim period) and (B) certain expenses classified as
cost of services in the Consolidated Financial Statements are classified as
general and administrative expense in the Unaudited Consolidated Condensed
Financial Statements (R$75.4 million in the 1997 interim period and R$96.1
million in the 1998 interim period).
The Consolidated Financial Statements and the Unaudited Consolidated
Condensed Financial Statements included herein reflect the accounts of the
Registrant and its subsidiary, Embratel. The portion of equity and income
attributable to shareholders other than the Registrant at December 31, 1997
and September 30, 1998 is reflected as "minority interests" in the
Consolidated Financial Statements and the Unaudited Consolidated Condensed
Financial Statements. At December 31, 1997 and September 30, 1998, such
minority shareholders owned 1.7% and 1.25%, respectively, of the share capital
of Embratel.
The formation of the Registrant through the spin-off from Telebras has been
accounted for as a reorganization of entities under common control in a manner
similar to a pooling of interests. The assets and liabilities of Telebras that
were spun-off from Telebras were transferred at their indexed historical cost.
See Notes 2 and 28 to the Consolidated Financial Statements.
Certain of the constant real-denominated information herein has been
translated into U.S. dollars using the September 30, 1998 Commercial Market
Rate published by the Central Bank of Brazil of R$1.1856 to US$1.00. These
translations are presented solely for the convenience of the reader and should
not be construed as implying that local currency amounts represent, or could
have been, or could be, converted into U.S. dollars at such rates or any rate.
The Consolidated Financial Statements and, unless otherwise specified, all
financial information for periods ending on or before December 31, 1997
included in this Registration Statement, have been restated to recognize
certain effects of inflation and expressed in constant reais of December 31,
1997 purchasing power. Such restatement has been effected in accordance with
Brazilian GAAP using the integral restatement method (correcao integral)
required under Brazilian GAAP through December 31, 1997. Inflationary gains or
losses on monetary assets and liabilities have been allocated to their
corresponding income or expense caption in the income statement. Inflationary
gains or losses without a corresponding income or expense caption have been
allocated to other net operating income (expense). See Note 2a to the
Consolidated Financial Statements. The
35
<PAGE>
Unaudited Consolidated Condensed Financial Statements for the nine months
ended September 30, 1997 were prepared on a fully indexed basis to recognize
the effects of changes in the purchasing power of the Brazilian currency
during the periods presented and are stated in constant currency as of
December 31, 1997.
Until December 31, 1995, the relevant inflation index selected by the CVM
and the one used for the constant currency method under Brazilian GAAP was the
UFIR. Since January 1, 1996, the CVM has no longer required that the constant
currency method of accounting be used in preparation of the financial
statements of publicly traded Brazilian companies. Restatement in constant
currency is now optional under CVM rules and any general price index may be
used. The Brazilian Institute of Accountants has recommended that the IGP-M be
used for this purpose. The Company's management believes that the IGP-M is the
most appropriate measure of inflation in Brazil and has elected to use the
IGP-M for purposes of preparing its Consolidated Financial Statements in
accordance with the constant currency method effective January 1, 1996.
In July 1997, the three-year cumulative inflation rate for Brazil fell below
100%. However, for accounting purposes, the constant currency method continued
to be applied through December 31, 1997. Although the Brazilian Institute of
Accountants has not yet issued instructions to discontinue restating financial
information to constant currency, the Company's management has concluded that
the effects of inflation at the rate of 1.6% for the nine months ended
September 30, 1998 are not material. Accordingly, the restated balances of
nonmonetary assets and liabilities of the Company as of December 31, 1997
became the new basis for accounting, and the consolidated statement of income
for the nine months ended September 30, 1998 has not been restated for
inflation, except for the effect of depreciation expense being calculated
using balances for fixed assets restated to December 31, 1997.
36
<PAGE>
Selected Financial Information
<TABLE>
<CAPTION>
Year Ended December 31, Nine Months Ended September 30,
----------------------------------------------------------------- ------------------------------------------
1993 1994 1995 1996 1997 1997 1998(1) 1998
------------ ------------ ----------- ----------- ----------- ----------- ----------- ----------------
Income Statement (in thousands of constant reais of December 31, 1997, (in thousands
Data (Continuing except per share data) of U.S. dollars,
Operations, except per
unless otherwise share data)(2)
stated):
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Brazilian GAAP
Net operating
revenue from
telecommunications
services:........ R$ 1,858,720 R$ 1,831,940 R$1,721,196 R$2,087,630 R$2,212,956 R$1,679,355 R$2,794,150 US$1,422,828
Cost of services.. (975,452) (1,134,074) (1,142,720) (1,145,613) (1,097,563) (819,849) (1,993,463) (1,015,105)
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Gross profit...... 883,268 697,866 578,476 942,017 1,115,393 859,506 800,687 407,723
Operating
expenses:
Selling expense.. (160,151) (159,791) (147,556) (160,243) (230,808) (85,999) (130,214) (66,306)
General and
administrative
expense......... (243,711) (297,109) (245,372) (237,216) (213,617) (219,018) (298,584) (152,044)
Other net
operating income
(expense)....... (148,482) (66,113) 36,400 (47,812) (84,621) (77,348) (475,807) (242,289)
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Operating income
(loss) before
interest......... 330,924 174,853 221,948 496,746 586,347 477,141 (103,918) (52,916)
Interest income... 132,456 70,037 54,992 86,622 97,809 48,083 114,663 58,388
Interest expense.. (30,014) 131,162 -- (30,723) (40,110) (29,834) (79,918) (40,696)
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Operating income
(loss)........... 433,366 376,052 276,940 552,645 644,046 495,390 (69,173) (35,224)
Write off of
property and
equipment from
physical
inventory(3)..... -- -- (94,298) -- -- -- -- --
Net other
nonoperating
income
(expense)........ (57,790) 76,709 (53,221) (95,962) (284,179) (137,725) (77,560) (39,495)
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Income (loss)
before taxes and
other charges.... 375,576 452,761 129,421 456,683 359,867 357,665 (146,733) (74,719)
Income and social
contribution tax
(expense)
benefit.......... 290,774 27,242 54,661 (13,861) 52,018 (34,072) 119,022 60,608
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Income (loss)
before employees'
profit share and
minority
interests........ 666,350 480,003 184,082 442,822 411,885 323,593 (27,711) (14,111)
Employees' profit
share............ -- -- (21,766) (22,642) (30,622) (25,485) (18,000) (9,166)
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Income (loss)
before minority
interests........ 666,350 480,003 162,316 420,180 381,263 298,108 (45,711) (23,277)
Minority
interests(4)..... (8,379) (6,036) (2,041) (5,253) (4,766) (3,726) 571 291
------------ ------------ ----------- ----------- ----------- ----------- ----------- ------------
Net income
(loss)........... R$ 657,971 R$ 473,967 R$ 160,275 R$ 414,927 R$ 376,497 R$ 294,382 R$ (45,140) US$ (22,986)
============ ============ =========== =========== =========== =========== =========== ============
U.S. GAAP:(5)
Operating income from continuing operations.. R$ 347 R$ 180,704 R$ 360,682 R$ 416,725 R$ 273,428 US$ 139,234
Income from continuing operations............ 148,229 350,939 451,550 241,591 255,447 130,078
Income from discontinued operations(6)....... 716,803 1,976,429 3,127,941 -- -- --
----------- ----------- ----------- ----------- ----------- ------------
Net income(7)................................ 865,032 2,327,368 3,579,491 241,591 255,447 130,078
=========== =========== =========== =========== =========== ============
Net income (loss) per thousand shares--
basic(8)
Common shares:
Continuing operations..................... 0.46 1.10 1.41 0.75 0.78 0.40
Discontinued operations................... 2.24 6.16 9.75 -- -- --
----------- ----------- ----------- ----------- ----------- ------------
Total(7)............................... 2.70 7.26 11.16 0.75 0.78 0.40
=========== =========== =========== =========== =========== ============
Preferred shares:
Continuing operations..................... 0.46 1.10 1.41 0.75 0.78 0.40
Discontinued operations................... 2.24 6.16 9.75 -- -- --
----------- ----------- ----------- ----------- ----------- ------------
Total(7)............................... 2.70 7.26 11.16 0.75 0.78 0.40
=========== =========== =========== =========== =========== ============
</TABLE>
<TABLE>
<CAPTION>
At December 31, At September 30,
----------------------------------------------------------- -------------------------------
1993 1994 1995 1996 1997 1998(1) 1998
----------- ----------- ----------- ----------- ----------- ----------- -------------------
(in thousands
(in thousands of constant reais of December 31, 1997) of U.S. dollars)(2)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance Sheet Data (continuing
operations):
Brazilian GAAP
Property, plant and
equipment, net......... R$5,941,515 R$6,205,214 R$6,246,882 R$6,319,963 R$6,326,208 R$6,512,796 US$3,316,425
Total assets............ 7,133,636 7,195,043 7,407,176 7,809,883 7,998,934 8,620,790 4,389,851
Loans and financing--
current portion........ 80,530 87,798 135,122 150,692 108,406 136,475 69,495
Loans and financing--
noncurrent portion..... 534,939 440,418 402,311 448,578 471,468 500,680 254,955
Shareholders' equity ... 5,139,708 5,564,947 5,936,299 5,879,183 5,908,044 5,925,958 3,017,598
U.S. GAAP
Property, plant and equipment, net.......................... 5,649,204 5,833,519 6,081,659 3,096,883
Total assets................................................ 7,570,111 7,891,234 8,431,465 4,293,444
Loans and financing--current portion........................ 137,109 487,190 585,475 298,134
Loans and financing--noncurrent portion..................... 448,578 79,825 51,680 26,316
Shareholders' equity........................................ 5,231,809 5,452,054 5,436,378 2,768,295
U.S. GAAP--Total Operations
Total assets including net assets of discontinued
operations(5)(6)........................................... 32,634,242 34,482,612 -- --
</TABLE>
<TABLE>
<CAPTION>
May 22, 1998
----------------
<S> <C>
New Holding Company--Brazilian GAAP Shareholders' Equity(9)
<CAPTION>
(in thousands of
constant reais)
<S> <C>
Share capital................................................. 2,134,427
Income reserves............................................... 2,336,988
Retained earnings............................................. 1,467,977
-----------
Total Shareholders' equity................................. R$5,939,392
===========
</TABLE>
37
<PAGE>
- --------
(1) The Unaudited Consolidated Condensed Statement of Income for the nine
months ended September 30, 1998 has not been restated for inflation,
except for the effect of calculating depreciation expense using balances
for fixed assets restated to December 31, 1997.
(2) The translation of Brazilian real amounts into U.S. dollar amounts is
unaudited and included solely for the convenience of the reader. Such U.S.
dollar amounts have been translated from reais at the Commercial Market
Rate published by the Central Bank of Brazil for February 1, 1999, which
was R$1.9638 to US$1.00. It should be noted that the convenience
translation does not accurately reflect the U.S. dollar balance of debt
denominated in U.S. dollars at September 30, 1998. This translation should
not be construed as a representation that the real amounts actually
represent such U.S. dollar amounts or could be converted into U.S. dollars
at the rate indicated. See "Business Description--Inflation and
Devaluation" and "Exchange Rates."
(3) Physical inventories of property and equipment performed in 1995, 1996 and
1997 resulted in write-offs of R$94,298 thousand, R$13,386 thousand and
R$17,246 thousand, respectively, in relation to equipment which had been
removed from service before it was fully depreciated. The inventory counts
disclosed the need for the write-offs by identifying differences between
equipment in service as physically identified and that which was recorded
in the accounting records. The 1996 and 1997 write-offs are reflected
under net other non operating income (expense). See Note 7 to the
Consolidated Financial Statements.
The physical inventory in 1995 resulted in an adjustment which was unusually
large as this was the first such inventory to have been performed in 17
years. With respect to equipment removed from service in any year prior to
1995, the write-off should have been accounted for as the correction of an
error requiring restatement of the financial statements for such earlier
year. The Company was not able, however, to determine the years in which
equipment was removed from service and, accordingly, it recognized the
entire amount of the write-off in 1995 and did not restate earlier years. If
it had been able to do so, the restatement would have resulted in (a) in
each affected earlier year, a charge under "net other nonoperating income
(expense)", a related reduction in tax expense and a corresponding reduction
in net income and (b) in 1995, a smaller charge under "write-off of property
and equipment from physical inventory", a related increase in tax expense
and correspondingly higher net income. See Note 15(e) to the Consolidated
Financial Statements. The Company's inability to restate its financial
statements for earlier years affects the comparability of reported net
income for each year through 1995, but the Company is unable to determine
the magnitude of this effect.
(4) Minority interests represent the portion of net income attributable to
shareholders other than the Registrant.
(5) Under US GAAP, the Company was considered to be the continuing entity of
the Telebras System for financial reporting purposes. As a result, all
operations of Telebras and its subsidiaries, except for Embratel, were
considered to be discontinued operations through December 31, 1997.
Although the Holding Company was not formed until May 22, 1998, the spin-
off was effective using balances as of February 28, 1998, and includes all
income and expense for the period from January 1, 1998 through February
28, 1998 except for interest income arising from minor allocations of cash
from Telebras at February 28, 1998.
(6) The discontinued operations pertain to the operations of Telebras (other
than Embratel) in connection with the restructuring of the Telebras
System. See Notes 28 and 29 to the Consolidated Financial Statements for
additional discussion, including Condensed Financial Statement schedules
prepared in accordance with Brazilian GAAP, in a US GAAP reporting format,
reflecting discontinued operations through December 31, 1997. US GAAP
income from discontinued operations for the nine months ended September
30, 1997 is not presented.
(7) US GAAP net income and net income per thousand shares for the nine months
ended September 30, 1997 does not include net income relating to the
discontinued operations of Telebras and its subsidiaries, except for those
operations of Embratel. (See Note 29 to the Consolidated Financial
Statements for the years ended December 31, 1995, 1996 and 1997.)
(8) Reflects US GAAP net income per thousand shares of the Registrant. The
Registrant was not formed until subsequent to December 31, 1997.
Accordingly, the equity structure utilized for the earnings per share
computations is that of the Registrant as of May 22, 1998 (the date of its
formation). At the date of formation, the Registrant had 124,351,903
thousand Common Shares (net of 17,128 thousand common shares in treasury)
and 196,311,647 thousand Preferred Shares outstanding (exclusive of
13,718,350 thousand Preferred Shares resulting from the settlement in
April 1998 with Telebras). See Note 28(a) to the Consolidated Financial
Statements. In April 1998, 13,718,350 thousand preferred shares were
issued. These shares are included in the weighted average shares
outstanding for the nine months ended September 30, 1998.
In February 1997, the Financial Accounting Standards Board issued SFAS No.
128 "Earnings per Share." This new statement became effective for
consolidated financial statements for periods ending after December 15,
1997, and provides computation, presentation and disclosure requirements for
earnings per share.
Since the preferred and common stockholders have different dividend, voting
and liquidation rights, Basic and Diluted earnings per share have been
calculated using the "two-class" method. The "two-class" method is an
earnings allocation formula that determines earnings per share for preferred
and common stock according to the dividends to be paid as required by the
Company's by-laws and participation rights in undistributed earnings. Basic
earnings per share is computed by dividing income available to common and
preferred shareholders by the weighted-average number of common and
preferred shares outstanding, respectively, during the period. The weighted-
average number of Common and Preferred Shares used in computing basic
earnings per share for 1997 was 124,351,903 thousand and 196,311,647
thousand, respectively. There were no common stock equivalents outstanding
during the year ended December 31, 1997 or the nine months ended September
30, 1998.
(9) On May 22, 1998 the shareholders of Telebras approved Telebras' division
into the New Holding Companies, whereby existing shareholders received
shares in the New Holding Companies in proportion to their holdings in
Telebras. In addition to approving the allocation of assets and
liabilities to the New Holding Companies at the May 22, 1998 meeting, the
shareholders also approved a specific structure for the shareholders'
equity of each New Holding Company which included an allocation of a
portion of the retained earnings of Telebras. In this manner, the balances
of capital, reserves and retained earnings, together with the
corresponding assets and liabilities, for the formation of the Registrant
were established.
For US GAAP purposes, the "retained earnings" allocated from Telebras would
be referred to as Distributable Capital as this amount represents capital
allocated from Telebras. See Note 28 to the Consolidated Financial
Statements.
Item 9: Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion of the consolidated financial condition and results
of operations of the Company for the nine months ended September 30, 1997 and
1998 and for the years ended December 31, 1995, 1996 and 1997 should be read
in conjunction with the Consolidated Financial Statements including the Notes
thereto, and the Unaudited Consolidated Condensed Financial Statements
including the Notes thereto, included elsewhere in this Registration
Statement. The Consolidated Financial Statements and the Unaudited
Consolidated Condensed Financial Statements have been prepared in accordance
with Brazilian GAAP, which differs in certain significant
38
<PAGE>
respects from U.S. GAAP. Note 29 to the Consolidated Financial Statements and
Note 17 to the Unaudited Consolidated Condensed Financial Statements provide a
description of the principal differences between U.S. GAAP and Brazilian GAAP
as they relate to the Company, and a reconciliation to U.S. GAAP of net income
and total shareholders' equity for the periods and as of the dates presented.
Formation of the Registrant and Presentation of Financial Information
On May 22, 1998, in preparation for the privatization of the Telebras
System, the Telebras System was restructured to form, in addition to Telebras,
the twelve New Holding Companies. The restructuring of the Telebras System was
accomplished by means of a procedure under Brazilian law called cisao or
"split-up". Virtually all the assets and liabilities of Telebras were
allocated to the New Holding Companies which, together with their respective
subsidiaries, comprise (a) three regional fixed-line operators, (b) eight
regional cellular operators and (c) one domestic and international long-
distance operator. The Registrant is one of the New Holding Companies that was
formed on May 22, 1998 as part of the Breakup of Telebras. In the Breakup,
certain assets and liabilities of Telebras, including 98.7% of the total share
capital of Embratel, were transferred to the Registrant.
The Consolidated Financial Statements and the Unaudited Consolidated
Condensed Financial Statements included herein reflect the accounts of the
Registrant and its subsidiary, Embratel. The portion of equity and income
attributable to the shareholders other than the Registrant at December 31,
1997 and September 30, 1998 is reflected as "minority interests" in the
Registrant's financial statements. At December 31, 1997 and September 30,
1998, such minority shareholders owned 1.7% and 1.25%, respectively, of the
share capital of Embratel.
The formation of the Registrant through the spin-off from Telebras has been
accounted for as a reorganization of entities under common control in a manner
similar to a pooling of interests. The assets and liabilities of Telebras that
were spun-off from Telebras were transferred at their indexed historical cost.
See Notes 2 and 28 to the Consolidated Financial Statements.
At the May 22, 1998 Telebras shareholders' meeting, the shareholders
approved a specific structure for the shareholders' equity of each New Holding
Company, which included an allocation of a portion of the retained earnings of
Telebras. In this manner, the balances of capital, reserves and retained
earnings, together with the corresponding assets and liabilities, for the
formation of the Registrant were established. Telebras retained within its own
shareholders' equity sufficient retained earnings from which to pay certain
dividends and other amounts. Telebras allocated to each New Holding Company
the balance of its retained earnings in proportion to the total net assets
allocated to each such Company. This value of allocated retained earnings does
not represent the historical retained earnings of the New Holding Companies
and resulted, in the case of the Registrant, in a decrease of R$210,432,000 in
relation to the Company's historical retained earnings. See Note 28 to the
Consolidated Financial Statements. Allocated retained earnings and future
retained earnings will be the basis from which future dividends will be
payable.
Effects of Inflation, Devaluation and Interest Rates
In accordance with Brazilian GAAP, the Consolidated Financial Statements
recognize certain effects of inflation and restate data from prior periods in
constant reais of December 31, 1997 purchasing power. Such restatement has
been effected in accordance with Brazilian GAAP using the integral restatement
method (correcao integral) through December 31, 1997. See "Selected Financial
Data." In periods of inflation, monetary assets generate inflationary loss and
monetary liabilities generate inflationary gain, due to the decline in
purchasing power of the currency. In the Consolidated Financial Statements,
inflationary gains or losses on monetary assets and liabilities have been
allocated to their corresponding income or expense captions in the income
statement. Inflationary gains or losses without a corresponding income or
expense caption have been allocated to other net operating income (expense).
See Note 2a to the Consolidated Financial Statements.
Until December 31, 1995, the relevant inflation index selected by the CVM
and the one used for the constant currency method under Brazilian GAAP was the
UFIR. Since January 1, 1996, the CVM has no longer required that the constant
currency method of accounting be used in preparation of the financial
statements of publicly
39
<PAGE>
traded Brazilian companies. Restatement in constant currency is now optional
under CVM rules and any general price index may be used. The Brazilian
Institute of Accountants has recommended that the IGP-M be used for this
purpose. The Company's management believes that the IGP-M is the most
appropriate measure of inflation in Brazil and has elected to use the IGP-M
for purposes of preparing its Consolidated Financial Statements in accordance
with the constant currency method effective January 1, 1996.
In July 1997, the three-year cumulative inflation rate for Brazil fell below
100%. However, for accounting purposes, the constant currency method continued
to be applied through December 31, 1997. Although the Brazilian Institute of
Accountants has not yet issued instructions to discontinue restating financial
information to constant currency, the Company's management has concluded that
the effects of inflation at the rate of 1.6% for the nine months ended
September 30, 1998 are not material. Accordingly, the restated balances of
nonmonetary assets and liabilities of the Company as of December 31, 1997
became the new basis for accounting, and the consolidated statement of income
for the nine months ended September 30, 1998 has not been restated for
inflation, except for the effect of calculating depreciation expense using
balances for fixed assets restated to December 31, 1997.
Substantially all of the Company's revenues from international operations
are denominated in U.S. dollars or other foreign currencies or equivalents,
while the majority of its costs, other than payments to other international
operators and interest paid on foreign denominated debt, are denominated in
reais. The Company's results of operations are therefore affected by the
relative movements of inflation and exchange rates.
Period to period comparisons of the Company's international incoming traffic
revenues, as restated in constant reais, have been significantly affected by
the real appreciation of the real against the U.S. dollar. If foreign currency
international incoming traffic revenues for any periods being compared are the
same, but between the periods the rate of devaluation of the reais has been
slower than the rate of Brazilian inflation (i.e., the real has appreciated in
real terms), the related revenues expressed in constant reais will decline
from one period to the next. Conversely, if the rate of devaluation has
exceeded the rate of inflation, such revenue expressed in constant reais will
increase from one period to the next. The Company does not currently hedge
against such foreign currency fluctuations.
The Company's financial condition and results of operations may be affected
by changes in market rates of interest (primarily the London Interbank Offered
Rate (LIBOR) and medium- and long-term U.S. interest rates). The Company is
exposed to interest rate risk as a consequence of its floating rate debt and
limited floating rate interest earning assets. At September 30, 1998,
approximately 44% of the Company's interest bearing liabilities bore interest
at floating rates. The Company has not entered into derivative contracts or
made other arrangements to hedge against this risk. Accordingly, should market
interest rates rise (principally LIBOR and U.S. medium- and long-term interest
rates), the Company's financing expenses will increase. See "Quantitative and
Qualitative Disclosures about Market Risk."
Certain Taxes
Revenues from telephone services are subject to taxes that are deducted in
arriving at net operating revenues. The principal such tax is a value-added
tax, the Imposto Sobre Circulacao de Mercadorias e Servicos ("ICMS"), on gross
operating revenues from the provision of telecommunications services. This
value-added tax is imposed at varying rates by each Brazilian state. The ICMS
rate for telephone services (expressed as a percentage of gross operating
revenues) in most states is 25.0%, except that for international long-distance
services the maximum rate was reduced to 13.0% in most states in April 1994
and then to zero in September 1996. In January 1998, the ICMS rate for
domestic long-distance services in the state of Rio de Janeiro was increased
from 25% to 37%. Federal social contribution taxes, including the Programa de
Assistencia aos Servidores de Empresas Publicas ("PASEP") and Contribucao para
Financiamento da Seguridade Social ("COFINS"), were imposed at a combined rate
of 2.65% on gross operating revenues until January 31, 1999, a combined rate
of 3.65% being effective as from February 1, 1999. The average rate of all
such taxes, as a percentage of gross operating revenues, was 22.1%, 20.6% and
19.2% in 1995, 1996 and 1997, respectively. For the nine months ended
September 30, 1997 and 1998 the average rate of all such taxes as a percentage
of gross operating revenues was 19.3% and 22.6%, respectively. See
"Description of Business--Services--Taxes on
40
<PAGE>
Telecommunications Services." Generally, a reduction in the tax rate results
in an increase in traffic volume, and conversely, an increase in the tax rate
results in a decrease in traffic volume. The Company's results of operations
are therefore affected by movements in the rate of taxes imposed on its gross
operating revenues. The composition of operating revenues by category of
service for the three-year period ended December 31, 1997 is presented in the
Consolidated Financial Statements and in the discussion below before deduction
of taxes.
The Company does not withhold for Brazilian income tax from amounts paid to
foreign communications companies. In addition, the Company does not pay income
tax with respect to its foreign source operating income. The Company believes
that both these practices are in accordance with Brazilian law and regulation
and these practices have never been challenged by the Brazilian tax
authorities. If the Brazilian tax authorities were successfully to challenge
these practices, the Company's total liability would have been approximately
R$1,288 million as of September 30, 1998. Management continually monitors and
is evaluating its position with respect to these tax contingencies to
determine if there have been changes, which could result in an unfavorable
outcome to the Company. See Note 20 to the Consolidated Financial Statements.
Political, Economic, Regulatory and Competitive Factors
The following discussion should be read in conjunction with the "Description
of Business" section included elsewhere in this Registration Statement. As set
forth in greater detail below, the Company's financial condition and results
of operations are significantly affected by Brazilian telecommunications
regulation, including regulation of tariffs. See "Description of Business--
Regulation." The Company's financial condition and results of operations also
have been, and are expected to continue to be, affected by the political and
economic environment in Brazil. See "Description of Business--Brazilian
Political Environment" and "--Brazilian Economic Environment." In particular,
the Company's financial performance will be affected by (i) national economic
growth and its impact on demand for telecommunications services, (ii) the cost
and availability of financing and (iii) the exchange rates between Brazilian
and foreign currencies.
The Company's results of operations have been, and will continue to be,
affected in large part by the regulatory framework of the Brazilian
telecommunications sector. See "Description of Business--Rates" and "--
Regulation--Rate Regulation." Rates for domestic and international long-
distance service will be set annually by Anatel based on a formula contained
in the Company's Concession. This formula currently provides that domestic
long-distance rates will be reduced by 2% for each of the years 1998 through
2000 and by a further 4% in each of 2001 and 2002. Similarly, international
long-distance rates are expected to be reduced by 5% in each of the years 1998
through 2002. Such rate reductions will also be subject to upward adjustments
to reflect any increases in inflation. See "Description of Business--
Regulation--Rate Regulation." The Company believes that these rate reductions
will be principally offset by increases in long-distance telephone traffic,
cost-cutting measures and latent demand for telephone services in Brazil.
In April and May 1997, a tariff rebalancing was implemented pursuant to
which certain rates were adjusted and the percentage of revenues retained by
the fixed-line companies for domestic and international long-distance calls
pursuant to the division of revenues system in place prior to April 1998 was
lowered. The principal rate increases occurred with respect to monthly
subscription charges and local measured service charges. These increases were
partially offset by a decrease in domestic long-distance and international
long-distance rates. The monthly subscription charge increased from R$3.73 to
R$13.82 and the local measured service charge increased from R$0.05 per pulse
to R$0.08 per pulse. Average domestic long-distance and international long-
distance rates were reduced by approximately 16.7% and 17%, respectively. If
the tariff rebalancing had been effective as of January 1, 1997, the
composition of the Company's net operating revenues would have been
significantly affected and its total net operating revenues would have been
higher. Pro forma information reflecting the April and May 1997 rate changes
as if they had been in effect from January 1, 1997 has not been presented
because management believes that it is not possible to quantify with any
reasonable degree of certainty the influence on volume of telephone use that
would have been caused by such changes in the first quarter of 1997.
Until April 1, 1998, revenues for fixed-line domestic and international
long-distance calls were divided between the Company and the regional fixed-
line companies. Under this system, each fixed-line company billed
41
<PAGE>
its customers for all domestic and international long-distance telephone calls
and retained a percentage of the revenues (such percentage was set by the
Ministry of Communications) from all such calls, transferring the remainder of
the revenue to the Company. This percentage varied by regional fixed-line
company. As of March 31, 1998, the regional fixed-line companies transferred
an average of 33% of the total revenue from such calls to Embratel.
As part of the liberalization of the Brazilian telecommunications sector,
this revenue-sharing system was eliminated as of April 1, 1998 and replaced by
a new system which has historically applied to the cellular companies and
Embratel. Under the new system, the Company receives 100% of the revenues from
fixed-line (i) interregional long-distance calls, (ii) certain intra-regional
long-distance calls and (iii) international long-distance calls that it
carries, but must pay certain per-minute interconnection charges to the
regional fixed-line companies for connection to and use of their networks in
originating and/or completing such calls. In addition, until June 30, 2001,
the Company must pay a supplemental per-minute charge for such
interconnection, the Parcela Adicional Temporaria (the "PAT"). Furthermore,
until the fixed-line companies complete their intra-regional long-distance
network, such companies may lease transmission facilities from Embratel to
carry some interstate calls within their respective regions. The Company does
not expect that implementation of this new system will have a material impact
on its net income. However, it is expected that the allocation to the Company
of 100% of the revenues generated by fixed-line (i) interregional long-
distance calls, (ii) certain intra-regional long-distance calls and (iii)
international long-distance calls that it carries will cause operating
revenues to increase substantially. This increase is expected to be offset by
increased cost of services expenses resulting from the network usage charges
and PAT paid to the fixed-line companies.
Following the privatization of the telecommunications sector, the Company,
currently the exclusive provider of domestic and international long-distance
services in Brazil, will face increased competition from new entrants.
However, the Company will be authorized to provide full intra-regional long-
distance service as a competitor of the regional fixed-line companies. The
Company anticipates that, as a consequence of the competition, prices for
long-distance service will decline and its operating margins may diminish. The
exact identity of new entrants, the scope of increased competition and any
adverse effects on the Company's results and market share will depend on a
variety of factors that cannot now be assessed with precision and that are
beyond the Company's control. See Note 28b to the Consolidated Financial
Statements.
Year 2000 Compliance
Year 2000 compliance is the ability of computer hardware and software to
respond to the problems posed by the fact that computer programs traditionally
have used two digits rather than four to define the applicable year. As a
consequence, any of the Company's computer programs that has date-sensitive
software may recognize a date using "00" as the year 1900 rather than 2000.
This could result in a system failure or miscalculations causing disruption of
operations, including temporary inability to process transactions, send
invoices or engage in normal business activities.
Since 1997, the Company has been implementing a year 2000 program intended
to ensure that its systems, infrastructure, networks and applications are year
2000 compliant. This program includes creating an inventory of the Company's
hardware, software and equipment, assessing the impact of the year 2000
problem on such hardware, software and equipment, implementing any necessary
remedial changes, testing those changes and formulating contingency plans. The
Company's main corporate applications are currently in the remediation phase
and approximately 75% of application code has been made year 2000 compliant.
The Company expects the remaining code to be year 2000 compliant by January
1999. The operating system utilized by the Company's central computer system
was recently upgraded to OS/390, which is year 2000 compliant.
The Company's year 2000 program also covers its telecommunications systems
and infrastructure. In this regard, the Company has been in contact with each
of its telecommunications equipment suppliers regarding the implementation of
year 2000 solutions. The Company is scheduled to commence testing of all of
its telecommunications systems in December 1998, although some of the
Company's suppliers have requested that
42
<PAGE>
it postpone testing until 1999. The Company believes that most of its network
infrastructure is already year 2000 compliant and that the remainder of its
network infrastructure will be made year 2000 compliant by means of software
and firmware upgrades prior to March 30, 1999. Although the Company expects to
incur costs associated with addressing problems arising from the year 2000
issue, management believes the cost of evaluating and addressing the year 2000
issue will not be material. The Company may, however, be affected by year 2000
problems to the extent that other entities not affiliated with the Company,
including the other New Holding Companies, international carriers and local
banks, are unsuccessful in achieving year 2000 compliance. Despite the
preventative measures taken by the Company, no assurances can be given that
the year 2000 issue will not have an adverse affect on the financial condition
and results of operations of the Company. As of November 30, 1998, the Company
is determining its most probable worst case scenarios in relation to the year
2000 issue and is formulating contingency plans in respect of such scenarios.
However, the Company expects to test the various contingency plans during
1999. The Company expects that the total cost of year 2000 compliance will be
approximately R$14 million.
CVM Instruction 276, which was issued on May 8, 1998 requires all Brazilian
public companies to be year 2000 compliant by December 31, 1998. Unless a
discretionary extension is granted by the CVM, failure to be year 2000
compliant by the CVM's deadline could have resulted in the imposition of fines
of R$500 per day. A new CVM Instruction 293, which was issued on October 31,
1998, postponed the year 2000 compliance deadline to June 30, 1999, and
lowered the fines to R$100 per day. Since the date is further than the Company
compliance date, the Company does not expect to ask for an extension, nor does
it expect to be subject to any fines.
Ancillary Telecommunication Services
The Company offers a number of ancillary telecommunication services pursuant
to licenses. See "Description of Business--Regulation--Obligations of
Telecommunications Companies--Collective Interest Obligations." Under the
terms of the licenses, the Company is generally required to continue for an
indefinite period to offer to its existing customers at July 27, 1998 (the
date such licenses were granted) telex and dedicated line telegraph, radio
signal and television signal satellite retransmission, mobile satellite
communications, mobile maritime telecommunications and certain data
communications services. The Company is also required to continue to offer
telex services to new customers through August 2001 (or such later date as is
required for another service provider to offer the same service). The Company
is effectively prohibited from increasing the fees charged for the above-
described services (except, in some cases, for increases up to the rate of
inflation). The Company has generated losses from the provision of these
services and expects to continue to do so in the future.
Management does not consider the services described above to constitute a
separate line or lines of business and historically has not accounted for them
separately. Management estimates that these activities generated gross losses
(net operating revenues less cost of services) of approximately R$78 million
in each of 1995 and 1996, R$45 million in 1997 and R$32 million in the first
nine months of 1998. Management expects that these activities will continue to
generate losses and that the aggregate of such losses will range from
approximately R$120 and 150 million between September 1998 and September 2001.
This estimate was computed by comparing projected direct costs (mainly labor,
materials and depreciation) of the services over the three years from August
1998 (or shorter periods, in some cases) to revenues projected to be generated
by the services over the same periods. Management believes that the level of
losses will decline after 2001, by which time management believes it should be
possible to substantially reduce the provision of such services.
Results of operations for the nine months ended September 30, 1997 and 1998
General
The following table sets forth, for each of the periods indicated, selected
components of the Company's results of operations (in thousands of constant
reais of December 31, 1997 with respect to the results for the
43
<PAGE>
nine months ended September 30, 1997 and in thousands of reais with respect to
the results for the nine months ended September 30, 1998), the selected
components as a percentage of net operating revenues, and the percentage
change of each from the prior period. The Company's results of operations for
the nine months ended September 30, 1997 and 1998 reflect certain
classifications that differ from those reflected in the results of operations
for the full years ended December 31, 1995, 1996 and 1997. The principal such
differences are: (A) certain expenses classified as selling expense in the
full year results are classified as cost of services in the interim results
(R$76.5 million in the 1997 interim period and R$102.0 million in the 1998
interim period) and (B) certain expenses classified as cost of services in the
full year results are classified as general and administrative expense in the
interim periods (R$75.4 million in the 1997 interim period and R$96.1 million
in the 1998 interim period). Results of operations for the nine months ended
September 30, 1997 and 1998 are not necessarily indicative of the operating
results for the full year or any other period.
<TABLE>
<CAPTION>
Nine Months Ended September 30, Percentage Change
---------------------------------- -----------------
1997 % 1998 % 1997 vs. 1998
----------- --- ----------- --- -----------------
<S> <C> <C> <C> <C> <C>
Net operating revenues.. R$1,679,355 100% R$2,794,150 100% 66.4
Cost of services........ (819,849) (49) (1,993,463) (71) 143.2
----------- --- ----------- --- ------
Gross profit............ 859,506 51 800,687 29 (6.8)
=========== === =========== === ======
Operating expenses:
Selling expense....... (85,999) (5) (130,214) (4) 51.4
General and
administrative
expense.............. (219,018) (13) (298,584) (11) 36.3
Other net operating
income (expense)..... (77,348) (5) (475,807) (17) 515.2
----------- --- ----------- --- ------
Operating income (loss)
before interest........ 477,141 28 (103,918) (3) (121.8)
Net interest income..... 18,249 1 34,745 1 90.4
Net other nonoperating
expense................ (137,725) (8) (77,560) (3) (43.7)
----------- --- ----------- --- ------
Income (loss) before
taxes and other
charges................ 357,665 21 (146,733) (5) (141.0)
Income and social
contribution tax
benefit (expense)...... (34,072) (2) 119,022 4 (449.3)
----------- --- ----------- --- ------
Income (loss) before
employees' profit share
and minority
interests.............. 323,593 19 (27,711) (1) (108.6)
Employees' profit
share.................. (25,485) (2) (18,000) (1) (29.4)
Minority interests...... (3,726) -- 571 -- (115.3)
----------- --- ----------- --- ------
Net income (loss)....... R$ 294,382 17 R$ (45,140) (2) (115.3)
=========== === =========== === ======
</TABLE>
Third quarter 1998 pre-tax charges
Consolidated results for the nine months ended September 30, 1998 include
third quarter pre-tax charges of R$511.6 million (R$168.6 million under U.S.
GAAP). The charges are discussed in more detail below and comprise: (i) R$341
million (R$59 million under U.S. GAAP) related to management's decision to
convert the Company's defined benefit pension plan to a defined contribution
plan; (ii) R$56 million (R$0 under U.S. GAAP) related to management's decision
to offer to "buy-out" employees who elect to exit the post-retirement health
care plan; (iii) R$57.6 million under Brazilian and U.S. GAAP related to
accelerated depreciation; (iv) R$52 million for U.S. GAAP only, related to the
sale by the Federal Government of preferred shares of Telebras to Embratel's
employees at a price which represented a 50% discount from market price at the
time the government proposed the plan; and (v) R$57 million (R$0 under U.S.
GAAP) related to a voluntary termination program offered by the Company to
employees engaged in activities that are expected to be outsourced.
Employee offering
As part of the privatization of the Telebras System, the Federal Government
offered Telebras System employees the right to purchase the Federal
Government's entire holding of Telebras preferred shares and preferred shares
of each of the New Holding Companies (representing 2.18% of the outstanding
capital stock of
44
<PAGE>
Telebras and of each New Holding Company) at a price of R$69.24 per lot of
13,000 shares (each a "lot" and comprised of 1,000 preferred shares of each of
Telebras and the twelve New Holding Companies). This price represents a 50%
discount from the market price of 1,000 Telebras preferred shares at the time
the Federal Government authorized the plan. Each employee has the right to
purchase up to 144 lots of 13,000 preferred shares, subject to proration if
the shares are oversubscribed. The Federal Government has made 7.2 million
lots available for sale, or 60% of the 12.1 million lots that would be taken
up if each employee purchased the maximum 144 lots allowed. On August 4, 1998,
the date on which the offer to employees commenced and the measurement date
for 60% of the shares, the market price of 1,000 Telebras preferred shares was
R$127.20. Under U.S. GAAP, this offering gives rise to a third quarter charge
to employee compensation expense of approximately R$52 million, which
represents Embratel's share of the offer price/market price differential on
60% of the shares offered, for which the measurement date was August 4, 1998.
As of October 30, 1998, the original expiration date of the program, Embratel
employees had subscribed to 859,584 lots. This amount is slightly below the
60% pro rata portion available to those employees; however no reduction of
expense was recorded in the fourth quarter because the Brazilian government
has extended the program to April 9, 1999. Pursuant to the extension,
employees can rescind their subscriptions at any time prior to April 9, 1999
and shares relating to rescinded subscriptions will be reassigned to the
remaining subscribers on a pro rata basis. Any difference between the 60% of
the shares already recorded and the ultimate number of shares subscribed by
Embratel employees will be recorded at the new expiration date. Based on
subscriptions as of October 30, 1998 and the fact that the market price of the
shares is still higher than the exercise price, the Company believes that
there will not be a significant change in the original amount of shares
recorded.
Although the Federal Government, rather than the Company or Telebras,
offered the shares to employees, under U.S. GAAP the deemed compensation
amount is "pushed down" to each of the New Holding Companies in accordance
with the number of shares purchased by each New Holding Company and its
subsidiaries' employees.
Net operating revenues
The Company's net operating revenues consist of gross operating revenues
from domestic and international long-distance telecommunications services,
data communication services and other telecommunications services, net of
sales taxes collected with respect to such services. See "--Certain Taxes."
The table below sets forth, for each of the periods indicated, the principal
components of the Company's net operating revenues (in thousands of constant
reais of December 31, 1997 with respect to the results for the nine months
ended September 30, 1997 and in thousands of reais with respect to the results
for the nine months ended September 30, 1998), the principal components as a
percentage of net operating revenues, and the percentage change of each from
the prior period.
<TABLE>
<CAPTION>
Percentage
Nine Months Ended September 30, Change
---------------------------------- ----------
1997 vs.
1997 % 1998 % 1998
----------- --- ----------- --- ----------
<S> <C> <C> <C> <C> <C>
Domestic long-distance.......... R$ 995,334 59 R$2,222,588 80 123.3
International long-distance..... 342,782 20 563,144 20 64.3
Data communication.............. 537,782 32 616,025 22 14.5
Other(1)........................ 203,728 12 206,135 7 1.2
----------- --- ----------- --- -----
Gross operating revenues...... 2,079,626 -- 3,607,892 -- 73.5
Taxes on operating revenues..... (400,271) (24) (813,742) (29) 103.3
----------- --- ----------- --- -----
Total......................... R$1,679,355 100 R$2,794,150 100 66.4
=========== === =========== === =====
</TABLE>
(1) Includes text transmission, sound and image transmission, leased analog
lines and certain mobile satellite communication services.
45
<PAGE>
The Company had consolidated net operating revenues of R$2,794.2 million in
the first nine months of 1998, which represented a 66.4% increase from
R$1,679.4 million in the first nine months of 1997. This increase reflects
principally the implementation of the new interconnection regime among the
Company and Brazil's three regional fixed-line operators. As part of the
liberalization of the telecommunications sector, Anatel eliminated the
division of revenues system applicable to Embratel and the fixed-line
companies and implemented a new interconnection regime effective April 1,
1998. Under this new regime, Embratel has begun receiving remittances from the
fixed-line operators for switched services provided to end-customers. Embratel
has also begun paying interconnection charges associated with this service to
the regional fixed-line operators. In addition to such charges, Embratel is
required to pay a supplemental per-minute charge for interconnection until
June 30, 2001. The publicly stated intent of the new regime was to minimally
impact the profitability of Embratel and the three regional fixed-line
operators. See "--Political, Economic, Regulatory and Competitive Factors" and
"Description of Business--Division of Revenues and Access Fees."
The Company estimates that the change in the interconnection regime resulted
in an increase in domestic and international long-distance revenues and cost
of services expenses of approximately R$1,303.9 million (R$1,030 million after
deducting taxes on operating revenues) and R$1,025 million, respectively, for
the first nine months of 1998. Excluding the increase in domestic and
international long-distance revenues arising from the change in the
interconnection regime, gross operating revenues in the first nine months of
1998 compared to the first nine months of 1997 increased approximately 11%.
Such increase reflected principally growth in all core service lines,
including increases in the volume of long-distance calls due to growth in the
number of telephone customers in Brazil. Such increases were offset in part by
a reduction in tariffs.
Domestic long-distance telephone service. Revenues from domestic long-
distance telephone service increased 123.3% to R$2,222.6 million in the first
nine months of 1998 from R$995.3 million in the first nine months of 1997.
This increase reflected principally an increase of approximately R$1,078.8
million in revenues resulting from the implementation of the new
interconnection regime among the Company and Brazil's three fixed-line
operators described above. Excluding the effect of the $1,078.8 million in
revenues from the change in the interconnection regime revenues from domestic
long-distance services increased 15% to R$1,143.8 million in the first nine
months of 1998. This increase was mainly due to a 46.7% increase in the volume
of domestic long-distance cellular calls. Domestic long-distance calls
decreased by 0.2% from 8,799 million minutes to 8,784 million minutes for
calls from fixed lines but increased 46.7% from 1,080 million minutes to 1,584
million minutes for calls from cellular lines.
International long-distance telephone service. Revenues from international
long-distance telephone service increased 64.3% to R$563.1 million in the
first nine months of 1998 from R$342.8 million in the first nine months of
1997. This increase reflected principally an increase of approximately R$225.1
million in revenues resulting from the implementation of the new
interconnection regime among the Company and Brazil's three fixed-line
operators described above. Excluding the effect of the R$225.1 million in
revenues from the change in the interconnection regime in 1998 and a R$21
million gain on inflation adjustments for liabilities to international phone
carriers in 1997, revenues from international long-distance services increased
5% to R$338.0 million in the first nine months of 1998, mainly due to a 19.7%
increase in the volume of outgoing international calls and an 8% increase in
the volume of incoming international calls. The total increase in volume was
offset in part by a reduction in the tariff in April 1997.
Data communication services. Revenues from data communication services
increased 14.5% to R$616.0 million in the first nine months of 1998 from
R$537.8 million in the first nine months of 1997. This increase was mainly due
to increases in revenues for Datasat (a satellite data communications
service), Megadata (a high speed digital circuit service for data
transmission) and Internet services. Datasat revenues grew principally as a
result of a 112% increase in the number of stations supplied, offset in part
by an average 30% price reduction due to technological advances and economies
of scale. The increase in Megadata revenues was mainly due to a 142% increase
in the number of rented circuits, offset in part by a 28% decrease in average
rates effective April 1997. The increase in Internet revenues reflected mainly
a 34.6% increase in the number of ports sold and a change in customer usage to
higher priced, higher speed ports. These increases in Datasat, Megadata and
Internet
46
<PAGE>
revenues were offset in part by decreases in revenues from Transdata (a low
speed data communications service) and Renpac (domestic packet-switched data
communications). These decreases were primarily due to a 28% and 25% decrease
in average rates for Transdata and Renpac services, respectively.
Other telecommunications services. Revenues from other telecommunications
services (which include text, sound and image transmission, leased analog
lines and certain mobile satellite communication services) increased 1.2% to
R$206.1 million in the first nine months of 1998 from R$203.7 million in the
first nine months of 1997. The increase reflected a 39% increase in revenues
from sound and image transmission, which was almost entirely offset by a
R$21.1 million and R$13.5 million decline in revenues from voice and text
transmission, respectively.
Cost of services
Cost of services relates directly to the provision of telecommunications
services and includes depreciation and amortization expenses, personnel
expenses for network maintenance and expenses related to third party services
and other costs of service.
The table below sets forth, for each of the periods indicated, the
components of cost of services (in thousands of constant reais of December 31,
1997 with respect to the nine months ended September 30, 1997 and in thousands
of reais with respect to the nine months ended September 30, 1998) and the
percentage change of such expenses from the prior period.
<TABLE>
<CAPTION>
Nine Months Ended Percentage
September 30, Change
--------------------- ----------
1997 vs.
1997 1998 1998
--------- ----------- ----------
<S> <C> <C> <C>
Depreciation and amortization.................. R$497,243 R$ 578,745 16.4
Personnel...................................... 169,168 176,728 4.5
Third party services(1)........................ 55,163 65,068 18.0
Facilities and interconnection(2).............. 89,738 1,157,367 --
Other(3)....................................... 8,537 15,555 82.2
--------- ----------- -----
Total cost of services....................... R$819,849 R$1,993,463 143.2
========= =========== =====
</TABLE>
(1) Third party services includes expenses relating to the maintenance of the
Company's network and equipment, insurance costs, transportation costs and
electricity expense.
(2) Facilities and interconnection expenses include lease payments to the
local fixed-line telephone companies for the use of private line circuits
and interconnection charges paid to the local fixed-line telephone
companies under the new interconnection regime that became effective April
1, 1998.
(3) Other includes rental payments and certain municipal tax expense.
Cost of services increased 143.2% to R$1,993.5 million for the nine months
ended September 30, 1998 from R$819.8 million for the same period of the prior
year primarily due to increased payments for interconnection charges
associated with the new interconnection regime as discussed above under "--Net
operating revenues."
Depreciation and amortization expenses. Depreciation and amortization
expenses increased 16.4% to R$578.7 million in the first nine months of 1998
from R$497.2 million during the same period in the prior year. The increase
primarily reflected R$57.6 million of accelerated depreciation resulting from
the Company's Board of Directors resolving in the first quarter of 1998 to
depreciate the remaining book value of the Company's analog transmission
equipment on a straight line basis from January 1, 1998 to December 31, 1999.
This accelerated depreciation will give rise to approximately R$76.6 million
of additional depreciation expense during each of 1998 and 1999 (see "--
Results of operations for the years ended December 31, 1995, 1996 and 1997--
Net other nonoperating expense"). Other factors that contributed to the
increase were the addition of R$350 million in transmission and other
equipment during the first nine months of 1998. These asset additions had
shorter useful lives and were therefore depreciated at a higher rate than the
Company's average.
47
<PAGE>
Personnel expenses. Personnel expenses increased 4.5% to R$176.7 million in
the first nine months of 1998 from R$169.2 million during the same period in
the prior year. This increase principally reflected the payment of R$7.6
million in severance in connection with ordinary workforce reductions and
additional payroll expense of approximately R$2.6 million due to a 1.5%
increase in salaries. In addition, during the period ended September 30, 1997,
costs were reduced by R$1.7 million in inflationary gains on accrued
liabilities with respect to certain personnel expenses such as bonuses and
vacation pay. Partially offsetting these increases was a R$4.5 million
reduction due to lower staffing in 1998.
Third party services. Expenses related to third party services increased
18.0% to R$65.1 million in the first nine months of 1998 from R$55.2 million
during the same period in the prior year. This increase was primarily
attributable to an increase in network and maintenance costs amounting to
approximately R$4.0 million and R$1.4 million relating to utility costs. In
addition, during the nine months ended September 30, 1997, costs were reduced
by inflationary gains on related liabilities.
Facilities and interconnection. Expenses related to facilities and
interconnection consist of lease payments to the local fixed-line telephone
companies for the use of private line circuits and interconnection charges
paid by Embratel to the three regional fixed-line telephone companies under
the new interconnection regime that became effective April 1, 1998. As part of
the liberalization of the telecommunications sector, Anatel eliminated the
division of revenues system applicable to Embratel and the fixed-line
operators and implemented the new interconnection regime. Under this new
regime, Embratel receives remittances from the fixed-line operators for
switched services provided to end-customers and pays interconnection charges
associated with such services, as well as a supplemental per-minute charge for
interconnection, to the regional fixed-line operators. During the nine months
ended September 30, 1998, these interconnection charges totaled approximately
R$1,025 million. Expenses relating to facilities increased 47% to R$132
million in the first nine months of 1998 from R$90 million during the same
period in the prior year, primarily as a result of an increase in the number
of circuits and other facilities leased in response to increases in data
communications.
Other. Other costs of services increased 82.2% to R$15.6 million in the
first nine months of 1998 from R$8.5 million in the first nine months of 1997.
This increase was primarily due to R$2.4 million of higher materials expense,
R$2.2 million of insurance payments for the Brasilsat B3 satellite that came
into operation in 1998 and R$2.5 million on taxes payable to finance the Fundo
de Fiscalizacao das Telecomunicacoes ("Fistel").
Operating expenses
The Company's operating expenses increased 136.6% to R$904.6 million for the
nine months ended 1998 from R$382.4 million for the same period in the prior
year.
The table sets forth below, for the periods indicated, the components of
operating expenses (in thousands of constant reais of December 31, 1997 with
respect to the nine months ended September 30, 1997 and in thousands of reais
with respect to the nine months ended September 30, 1998) and the percentage
change of such expenses from the prior period.
<TABLE>
<CAPTION>
Nine Months Ended Percentage
September 30, Change
------------------- ----------
1997 vs.
1997 1998 1998
--------- --------- ----------
<S> <C> <C> <C>
Selling expense.................................. R$ 85,999 R$130,214 51.4
General and administrative expense............... 219,018 298,584 36.3
Other net operating expense...................... 77,348 475,807 515.2
--------- --------- -----
Total operating expenses....................... R$382,365 R$904,605 136.6
========= ========= =====
</TABLE>
Selling expense. Selling expense increased 51.4% to R$130.2 million for the
nine months ended September 30, 1998 from R$86.0 million for the same period
in the prior year. This increase principally reflected R$43 million in
provisions to the allowance for accounts that are not considered probable of
collection during
48
<PAGE>
the first nine months of 1998. These provisions reflected management's belief
that, in the 1998 period there was a significantly greater portion of the
Company's accounts receivable as to which collection was improbable than in
the 1997 period, as well as a 46% increase in the balance of the Company's
accounts receivable during the first nine months of 1998 due to the change in
the interconnection regime, which increased the Company's billings by more
than 50%. The Company did not record any such provision in the nine months
ended September 30, 1997 because management believed, based on its experience
up to that time, that substantially all of the Company's accounts receivable
at that date would be collected. The change in management's belief reflected
two changes in the Company's operating environment resulting from the
privatization of the Telebras System. First, because Embratel and the local
fixed line telephone companies ceased to be affiliates under the common
control of the Brazilian government, such companies are no longer willing to
suspend service to their customers when such customers fail to pay amounts
owing to Embratel. As a result, after the privatization, those end-users
directly billed by Embratel for services can fail to pay Embratel without
risking the loss of their local telephone service. Second, because Embratel
and the local fixed line and cellular telephone companies are no longer
affiliates, Telebras and the government are no longer able to use their
influence as controlling shareholders to require the local telephone companies
to turn off the dial tone of a customer simply because he refuses to pay his
bill to Embratel and, consequently, such customers have less incentive to pay
Embratel. The payment relationship with the local fixed line and cellular
telephone companies is now similar to any other relationship with an external
customer and thus subject to collectibility risk.
It has been the Company's policy to maintain an allowance for past due
accounts receivable equal to management's estimate of probable future losses
on such accounts, based on historical losses on accounts receivable, the
Company's current level of overdue accounts and other factors. Subsequent to
the privatization of the Telebras System, the Company has relied on the
accounts receivable loss experiences of MCI WORLDCOM in other developing
nations following the privatization of the national telephone systems in those
countries. The Company expects provisions for past due accounts receivable to
increase slightly in 1999 as competition increases and as the Company
increasingly relies on direct billing to customers and the credit and
collection burden shifts from the fixed line providers for traditional
telephone services to end-customers. The Company expects to take advantage of
customer registration information and past billing and collection information
to minimize any such exposure. In the fourth quarter of 1998, the Company
recorded an additional R$24.4 million of provisions for past due accounts
receivable.
General and administrative expense. General and administrative expenses
increased 36.3% to R$298.6 million for the nine months ended September 30,
1998 from R$219.0 million for the same period in the prior year. The increase
of R$79.6 million consisted mainly of management service support costs of
R$31.5 million paid to MCI in connection with a management agreement between
the Company and MCI (see "Interest of Management in Certain Transactions" for
a description of the terms of the management agreement), a R$35.9 million
increase payments to third parties for publicity and technical services and a
R$11.7 million increase in personnel expenses.
Other net operating expense. Other net operating expense increased 515.2% to
R$475.8 million for the nine months ended September 30, 1998 from R$77.3
million for the same period of the prior year. The increase primarily relates
to certain third quarter 1998 charges, more fully described below.
The third quarter charges included in other net operating expense for the
nine months ended September 30, 1998 comprise: (i) R$341 million (R$59 million
under U.S. GAAP) related to management's decision to convert the Company's
defined benefit pension plan to a defined contribution plan (see Note 13 to
the Unaudited Consolidated Condensed Financial Statements). Employees were
offered the option to convert to a defined contribution plan in the third
quarter of 1998. The option expires on December 31, 1998. The pension
obligation arising from such conversions is expected to be funded over
seventeen years, which is the actuarial estimate of the average remaining
working life of the converting employees. Management expects that such funding
will be made from operating cash flows. The third quarter charge is based on
such actuarial estimates. In accordance with U.S. GAAP, this charge has been
treated as a curtailment under SFAS No. 88, resulting in a charge of R$59
million, which is lower than the Brazilian GAAP charge due to the fact that a
large portion of those
49
<PAGE>
liabilities had been previously recorded under SFAS No. 87 for U.S. GAAP
purposes; (ii) R$56 million (R$0 under U.S. GAAP) related to management's
decision during the third quarter of 1998 to offer to "buy-out" employees who
elect to exit the post-retirement health care plan (see Note 13 to the
Unaudited Consolidated Condensed Financial Statements). Under U.S. GAAP, the
settlement and curtailment results in a gain of R$43 million, which will be
recognized in the fourth quarter of 1998, which is when the election period
for this offer ends. A lump sum payment will be made on January 15, 1999.
Management plans to fund this expenditure with available cash or cash
generated from operations; and (iii) R$57 million related to a voluntary
termination program offered by the Company to employees engaged in activities
that are expected to be outsourced or discontinued (see Note 14 to the
Unaudited Consolidated Condensed Financial Statements). Under Brazilian GAAP,
this amount was accrued when the expense became probable and reasonably
estimable. Embratel's prior voluntary termination programs (which had similar
terms and conditions) provide a basis for estimating the expected employee
acceptance rate and cost of the program. Under U.S. GAAP, the charge for the
voluntary termination program will be recognized in the fourth quarter of 1998
in accordance with SFAS No. 88. This statement requires an employer that
offers special termination benefits to employees to recognize a liability and
a loss when the employees accept the offer and the amount can be reasonably
estimated. The offer expired on November 27, 1998 and 1,537 of the Company's
employees accepted the offer, resulting in actual severance payments of
R$72 million. For Brazilian GAAP, the difference of R$15 million between the
amount accrued in the third quarter and the actual amount will be recorded in
the fourth quarter of 1998. Severance payments will be made under this program
in the fourth quarter of 1998. Management plans to fund such payments with
available cash or cash generated from operations.
Excluding the third quarter 1998 pre-tax charges discussed above, net other
operating expense decreased 71.8% to R$21.8 million for the nine months ended
September 30, 1998 from R$77.3 million for the same period in the prior year.
The decrease was principally due to the nonrecurrence of a R$59 million
expense recorded in the nine months ended September 30, 1997 as a result of
the reversal of a R$42.9 million COFINS-related tax credit taken in 1995 and
R$16.1 million in related penalties. See "--Results of operations for the
years ended December 31, 1995, 1996 and 1997 --Operating expenses--Other net
operating income (expense)."
Net interest income
Net interest income represents the net effect of interest income, interest
expense, foreign exchange gains and losses and gains and losses arising from
the effect of inflation on the net balance of monetary assets and liabilities.
Net interest income increased 90.4% to R$34.7 million for the nine months
ended September 30, 1998 from R$18.2 million for the same period in the prior
year principally due to an increase in the average rate earned on the
Company's interest earning assets and R$7.5 million in increased penalties
paid by suppliers, offset in part by an increase in the Company's effective
cost of indebtedness as a result of the real devaluating at a faster rate than
the rate of inflation.
Net other nonoperating expense
Net other nonoperating expense for the nine months ended September 30, 1998
decreased 43.7% to R$77.6 million from R$137.7 million for the same period of
the prior year.
This decrease principally reflected a R$108.6 million decline in write-offs
of impaired assets, offset in part by a R$40 million increase in losses on the
disposal of permanent assets. See Note 5 to the Unaudited Consolidated
Condensed Financial Statements. The Company had losses on equipment disposals
during the nine months ended September 30, 1998 of R$104.4 million which
included R$8.0 million in sales of land and buildings and R$96.4 million in
losses incurred upon the scrapping of equipment, principally transmission
equipment (R$49.8 million) and switching equipment (R$33.8 million) that,
although fully operational, was replaced with more advanced technology. The
level of scrapped equipment was higher in the 1998 period than in the 1997
period because more new equipment was purchased to replace old equipment in
the 1998 period. The decline in write-offs of impaired assets reflected the
nonrecurrence of R$108.6 million in telex write-offs taken in the 1997 period.
50
<PAGE>
The Company's principal equipment write-offs during the first nine months of
1997 were as follows. The Company wrote off R$108.6 million in telex equipment
and recorded R$64.4 million in losses upon the disposal of equipment in the
ordinary course of business. See "--Results of operations for the years ended
December 31, 1995, 1996 and 1997--Net other nonoperating expenses."
Income and social contribution taxes
The Company reported a net tax charge of R$34.1 million for the nine months
ended September 30, 1997 and a net tax credit of R$119.0 million for the nine
months ended September 30, 1998. Brazilian income taxes are comprised of
Federal income tax and the social contribution tax. For the nine months ended
September 30, 1997 and 1998 the rate for income tax was 25% and social
contribution tax was 8%. As a result of legislation enacted in 1996 the social
contribution tax was no longer deductible for its own computation basis, nor
was it deductible for income tax purposes. The changes produced a combined
statutory rate of 33% in the 1997 and 1998 periods. See Note 6 to the
Unaudited Consolidated Condensed Financial Statements.
Employees' profit share
All Brazilian companies are required under Brazilian law to compensate
employees, in addition to their salary and benefits, with profit sharing. The
amount of such profit sharing is determined by negotiation between the Company
and the labor unions representing the employees. For state owned companies,
such profit sharing payments are limited to 25% of total proposed dividends.
Prior to the privatization of the Company, Telebras had established two
additional limits. In addition to the 25% limit imposed on all state owned
companies, companies in the Telebras System were required to limit employees'
share of profits to the lower of (i) the aggregate of the employees' annual
compensation and (ii) 50% of the Company's net income adjusted for dividends.
Following the privatization of the Company, employee profit share has been
limited only by the 25% of dividends limit and may be renegotiated by the
Company and the unions representing its employees. The Company's employees'
profit share for the nine months ended September 30, 1997 and 1998 was R$25.5
million and R$18.0 million, respectively.
Results of operations for the years ended December 31, 1995, 1996 and 1997
The following table sets forth, for each of the periods indicated, selected
components of the Company's results of operations in constant reais of
December 31, 1997 and as a percentage of net operating revenues, as well as
the percentage change of each from the prior year.
<TABLE>
<CAPTION>
Year Ended December 31, Percentage Change
------------------------------------------------------- ---------------------------
1995 % 1996 % 1997 % 1995 vs. 1996 1996 vs. 1997
------------ --- ------------ --- ------------ --- ------------- -------------
(in thousands of constant reais of December 31, 1997, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net operating revenues.. R$ 1,721,196 100% R$ 2,087,630 100% R$ 2,212,956 100% 21.3% 6.0%
Cost of services........ (1,142,720) (66) (1,145,613) (55) (1,097,563) (50) 0.3 (4.2)
Operating expenses...... (356,528) (21) (445,271) (21) (529,046) (24) 24.9 18.8
------------ --- ------------ --- ------------ --- ------ ------
Operating income before
interest............... 221,948 13 496,746 24 586,347 26 123.8 18.0
Net interest income..... 54,992 3 55,899 3 57,699 3 1.6 3.2
Write off of property
and equipment from
physical inventory..... (94,298) (5) -- -- -- -- -- --
Net other nonoperating
expense................ (53,221) (3) (95,962) (5) (284,179) (13) 80.3 196.1
------------ --- ------------ --- ------------ --- ------ ------
Income before taxes and
other charges.......... 129,421 8 456,683 22 359,867 16 252.9 (21.2)
Income and social
contribution taxes..... 54,661 3 (13,861) (1) 52,018 2 (125.4) (475.3)
------------ --- ------------ --- ------------ --- ------ ------
Income before employees'
profit share and
minority interests..... 184,082 11 442,822 21 411,885 18 (140.6) (7.0)
Employees' profit
share.................. (21,766) (2) (22,642) (1) (30,622) (1) 4.0 35.2
------------ --- ------------ --- ------------ --- ------ ------
Income before minority
interests.............. 162,316 9 420,180 20 381,263 17 158.9 (9.3)
Minority interests...... (2,041) -- (5,253) -- (4,766) -- 157.4 (9.3)
------------ --- ------------ --- ------------ --- ------ ------
Net income.............. R$ 160,275 9 R$ 414,927 20 R$ 376,497 17 158.9 (9.3)
============ === ============ === ============ === ====== ======
</TABLE>
51
<PAGE>
Net operating revenues
The Company's net operating revenues consist of gross operating revenues
from domestic and international long-distance telecommunications services,
data communication services and other telecommunications services, net of
sales taxes collected with respect to such services. See "--Certain Taxes."
The Company's net operating revenues increased 6.0% to R$2,213 million in 1997
from R$2,088 million in 1996, which in turn represented an increase of 21.3%
from R$1,721 million in 1995. The increase in net operating revenues in 1997
was attributable primarily to a 11.6% and 22.6% increase in domestic and
international long-distance traffic volume, respectively. The increase in net
operating revenues in 1996 was attributable primarily to a 13.5% and 25.4%
increase in domestic and long-distance traffic volume, respectively, and a
22.2% increase in domestic long- distance rates.
The table below sets forth, for each of the periods indicated, the principal
components of the Company's net operating revenues, in constant reais of
December 31, 1997 and as a percentage of those revenues, and the percentage
change of each from the prior year.
<TABLE>
<CAPTION>
Year Ended December 31, Percentage Change
---------------------------------------------------------------------------------------
1995 1996
1995 % 1996 % 1997 % vs.1996 vs. 1997
------------ ------------------ ------------------ ---------------------------------
(in thousands of constant reais of December 31, 1997, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Domestic long-distance.. R$1,127,294 65% R$1,239,927 59% R$ 1,366,622 62% 10.0% 10.2%
International long-
distance............... 367,943 21 405,317 19 443,987 20 10.2 9.5
Data communication...... 507,135 29 735,560 35 718,688 32 45.0 (2.3)
Other(1)................ 207,079 12 248,052 12 213,095 10 19.8 (14.1)
------------ ---- ------------ ---- ------------ ---- --------- ----------
Gross operating
revenues.............. 2,209,451 -- 2,628,856 -- 2,742,392 -- 19.0 4.3
Taxes on operating
revenues............... (488,255) (28) (541,226) (26) (529,436) (24) 10.8 (2.2)
------------ ---- ------------ ---- ------------ ---- --------- ----------
Total................. R$1,721,196 100% R$2,087,630 100% R$2,212,956 100% 21.3% 6.0%
============ ==== ============ ==== ============ ==== ========= ==========
</TABLE>
- --------
(1) Includes text transmission, sound and image transmission, leased analog
lines and certain mobile satellite communication services.
Domestic long-distance telephone service. Revenues from domestic long-
distance telephone service increased 10.2% to R$1,366.6 million in 1997 from
R$1,239.9 million in 1996, which in turn represented a 10.0% increase from
R$1,127.3 million in 1995. In 1997, the increase in revenues was mainly due to
a 11.6% increase in volume and a 25.4% increase in the amount of revenues
received from the fixed-line companies pursuant to the Telebras revenue-
sharing system that was terminated on April 1, 1998. See "Description of
Business--Division of Revenues and Access Fees" and "Regulation--Rate
Regulation." This increase was offset in part by a 18.2% tariff rebalancing
reduction in rates in May 1997 and the implementation of a new billing system
pursuant to which calls are billed in 6-second increments instead of in full
minute increments. The combined effect of these measures resulted in a rate
reduction of approximately 32%. The increase in revenues in 1996 was
principally due to an increase in traffic volume of 13.5% and a rate increase
of approximately 22.2%. See "Description of Business--Rates--Domestic Long-
Distance Rates."
International long-distance telephone service. Revenues from international
long-distance telephone service increased 9.5% to R$444.0 million in 1997 from
R$405.3 million in 1996, which in turn represented an increase of 10.2% from
R$367.9 million in 1995. The increase in revenues in 1997 was attributable to
a 22.6% increase in traffic volume and a 35.5% increase in the amount of
revenues received from the fixed-line companies pursuant to the Telebras
revenue sharing system that was terminated on April 1, 1998, partially offset
by a decrease in average rates used to settle payments among foreign operators
and a 14.5% reduction in the average rate for outgoing international calls.
The increase in revenues from international long-distance telephone service in
1996 was attributable to an increase in traffic volume of 25.4%, offset in
part by a 22% decrease in the average rate for outgoing international calls.
See "Description of Business--Rates--International Rates."
Data communication services. Revenues from data communication services
(approximately 91% and 9% of which are derived from domestic and international
transmission, respectively), decreased 2.3% to R$718.7
52
<PAGE>
million in 1997 from R$735.6 million in 1996, which in turn represented a
45.0% increase from R$507.1 million in 1995. The decrease in 1997 was
primarily attributable to a 42% decrease in average monthly line rental
charges for private leased circuits, offset in part by a 62.4% increase in
traffic volume on the Domestic Packet-Switched Data Communications Center
(RENPAC), an increase in the number of leased circuits on the High Speed Data
Communications Center (TRANSDATA) and a R$27 million increase in revenues from
internet services. The increase in revenues in 1996 was primarily a result of
a 111% increase in traffic volume on Renpac, a 97.7% increase in the number of
leased circuits on Transdata and a R$22.9 million increase in revenues from
internet services (which was introduced during the second half of 1995),
offset in part by a reduction in rates for most of the Company's data
communication services.
Other telecommunications services. Revenues from other telecommunications
services (which includes revenues from text, sound and image transmission,
leased analog lines and certain mobile satellite communication services)
decreased 14.1% to R$213.1 million in 1997 from R$248.1 million in 1996, which
in turn represented an increase of 19.8% from R$207.1 million in 1995. The
decrease in revenues in 1997 was due primarily to a significant decrease in
demand for leased analog lines and mobile satellite communication services as
a result of increasing competition from digital services and to a 50.4%
decline in telex transmission services. The increase in revenues in 1996 as
compared to 1995 reflects primarily an increase in rates for text, sound and
image transmission, partially offset by a decrease in revenues from leased
analog lines and mobile satellite communication services.
Cost of services
Cost of services relates directly to the provision of telecommunications
services and includes depreciation and amortization expenses, personnel
expenses for network maintenance and expenses related to third party services
and other costs of service. Cost of services decreased 4.2% to R$1,097.6
million in 1997 from R$1,145.6 million in 1996, which in turn represented an
increase of 0.3% from R$1,142.7 million in 1995. The decrease in recorded cost
of services for 1997 was primarily due to a decrease in personnel expenses as
a result of the implementation in 1996 of the Company's voluntary resignation
incentive program. The slight increase in 1996 was mainly due to an increase
in personnel expenses.
The table below sets forth, for the periods indicated, the components of
cost of services in constant reais of December 31, 1997 and the percentage
change of such expenses from the prior year.
<TABLE>
<CAPTION>
Year Ended December 31, Percentage Change
----------------------------------- ---------------------------
1995 1996 1997 1995 vs. 1996 1996 vs. 1997
----------- ----------- ----------- ------------- -------------
(in thousands of constant reais of December 31, 1997)
<S> <C> <C> <C> <C> <C>
Depreciation and
amortization........... R$ 637,517 R$ 618,512 R$ 659,233 (3.0)% 6.6%
Personnel............... 392,312 413,478 313,506 5.4 (24.2)
Third party
services(1)............ 77,285 81,030 101,526 4.8 25.3
Other(2)................ 35,606 32,593 23,298 (8.5) (28.5)
----------- ----------- -----------
Total cost of
services......... R$1,142,720 R$1,145,613 R$1,097,563 0.3 (4.2)
=========== =========== ===========
</TABLE>
- --------
(1) Third party services includes expenses relating to the maintenance of the
Company's network and equipment, insurance costs, transportation costs and
electricity expense.
(2) Other includes rental payments and certain municipal tax expense.
Depreciation and amortization expenses. Depreciation and amortization
expenses were R$659.2 million, R$618.5 million and R$637.5 million in 1997,
1996 and 1995, respectively. Although the Company made capital investments to
expand and improve its network during this three-year period, depreciation and
amortization expenses remained relatively constant due to the write-off of
certain obsolete assets, principally telex and analog equipment, during such
period. Management believes that the Company's total depreciation expense may
increase in 1998 and thereafter as a consequence of a possible reduction in
the remaining estimated useful lives of the Company's property, plant and
equipment. Management is currently reviewing such estimated useful lives in
light of the advent of competition in the Brazilian long distance market. One
of the anticipated effects of such
53
<PAGE>
competition is the potential requirement to accelerate the rate of
depreciation and replacement of the Company's existing analog equipment. In
the first quarter of 1998, for example, the Company's Board of Directors
resolved to depreciate the remaining net book value of the Company's analog
transmission equipment in equal monthly installments through December 1999,
when such equipment is expected to be removed from service. This accelerated
depreciation will give rise to approximately R$76.6 million of additional
depreciation expense during each of 1998 and 1999. See "--Net other
nonoperating expense."
Personnel expenses. Personnel expenses decreased 24.2% to R$313.5 million in
1997 from R$413.5 million in 1996, which in turn represented a 5.4% increase
from R$392.3 million in 1995. The significant decrease in payroll expenses in
1997 reflected a 6.9% reduction in the number of the Company's employees
resulting from the implementation in 1996 of the Company's voluntary
resignation incentive program. The increase in 1996 was mainly due to an
increase in payroll expense resulting from the payment of a one-time bonus in
December 1996, partially offset by a 7.4% reduction in the number of the
Company's employees.
The Company's voluntary resignation incentive program was launched in 1996
and offered a variety of incentives to encourage certain employees to take
early retirement. A total of 882 employees (who exercised an option to resign
or take early retirement by the deadline of December 31, 1996) left the
Company through the program from January to May 1997 (when the program was
terminated), at a total cost of R$39 million plus certain fringe benefit
payments (including TELOS, medical, dental and life insurance) estimated to be
R$23.5 million. Substantially all expenses associated with the program were
incurred in 1996.
Third party services. Expenses related to third party services increased
25.3% to R$101.5 million in 1997 from R$81.0 million in 1996. This increase
was primarily attributable to higher network and equipment maintenance
expenses. In 1996, expenses related to third party services did not materially
increase from R$77.3 million in 1995.
Other. Other costs of service decreased 28.5% to R$23.3 million in 1997 from
R$32.6 million in 1996, which in turn represented an 8.5% decrease from R$35.6
million in 1995. The decreases in 1997 and 1996 were primarily due to lower
rental payments for facilities and office space as a result of an internal
reorganization of the Company whereby a customer service department was
created. Upon such reorganization, expenses relating to rent for facilities
dedicated to the newly created customer service department were allocated
under operating expenses. See "Operating expenses--Selling expense."
Operating expenses
The Company's operating expenses increased 18.8% to R$529,046 million in
1997 from R$445,271 million in 1996, which in turn represented a 24.9%
increase from R$356,528 million in 1995.
The table below sets forth, for the periods indicated, the components of
operating expenses in constant reais of December 31, 1997 and the percentage
change of such expenses from the prior year.
<TABLE>
<CAPTION>
Year Ended December 31, Percentage Change
------------------------------ ---------------------------
1995 1996 1997 1995 vs. 1996 1996 vs. 1997
--------- --------- --------- ------------- -------------
(in thousands of constant reais of December 31, 1997)
<S> <C> <C> <C> <C> <C>
Selling expense(1)...... R$147,556 R$160,243 R$230,808 8.6% 44.0%
General and
administrative
expense................ 245,372 237,216 213,617 (3.3) (9.9)
Other net operating
(income) expense(2).... (36,400) 47,812 84,621 231.4 77.0
--------- --------- ---------
Total operating
expenses........... R$356,528 R$445,271 R$529,046 24.9 18.8
========= ========= =========
</TABLE>
- --------
(1) Selling expense includes personnel expenses relating to the Company's
sales network, payments to other telecommunications providers for certain
services and advertising expense.
(2) Other net operating expense includes certain federal social contribution
taxes, provisions for contingencies, expenses related to the
implementation of a voluntary resignation incentive program in 1996 and
fines and expenses recovered. See Note 8 to the Consolidated Financial
Statements.
54
<PAGE>
Selling expense. Selling expenses increased 44.0% to R$230.8 million in 1997
from R$160.2 million in 1996, which in turn represented an 8.6% increase from
R$147.6 million in 1995. The increases in 1997 and 1996 were primarily due to
higher payments to other telecommunications providers and an increase in costs
relating to the use of certain data equipment. The increases also reflected an
internal reorganization at the Company whereby employees in technical support
and administrative positions were transferred to a newly created customer
service department. Such reorganization represented an initiative by the
Company to become more customer-oriented and improve the quality of customer
services in preparation for the entry of competition following the
privatization of the Registrant.
General and administrative expense. General and administrative expenses
decreased 9.9% to R$213.6 million in 1997 from R$237.2 million in 1996, which
in turn represented a 3.3% decrease from R$245.4 million in 1995. The decrease
in 1997 reflected a decrease of approximately R$15.0 million in expenses for
third party services.
Other net operating income (expense). Other net operating expenses increased
77.0% to R$84.6 million in 1997 from R$47.8 million in 1996, which in turn
represented a 231.4% increase from R$36.4 million of net other operating
income in 1995. The increase in 1997 was principally due to the reversal of a
R$42.9 million COFINS-related tax credit taken in 1995, the accrual of R$16.1
million in related penalties and the establishment of a R$18.8 million
provision for potential worker claims relating to electricity exposure. The
increase in 1996 was mainly due to the recognition of R$62.5 million in
expenses related to the implementation of the Company's voluntary resignation
incentive program and the non-recurrence of the R$42.9 million COFINS-related
tax credit recorded in 1995. See Note 20 to the Consolidated Financial
Statements. The 1995 COFINS-related tax credit was taken as a consequence of a
decision of the Brazilian Supreme Court declaring unconstitutional a number of
tax increases relating to a predecessor tax of COFINS, and several 1995
federal court decisions allowing set off of overpaid COFINS taxes against
other federal taxes. The Company reversed this credit in 1997, notwithstanding
the continuing validity of the Supreme Court's decision, in order to resolve a
related dispute with the taxing authorities.
Net interest income (expense)
Net interest income (expense) represents the net effect of interest income,
interest expense, foreign exchange gain and loss and gain and loss on net
monetary position arising from the effect of inflation on the net balance of
monetary assets and liabilities. Net interest income increased 3.2% to R$57.7
million in 1997 from R$55.9 million in 1996, which in turn represented a 1.7%
increase from R$55.0 million in 1995. During the three-year period, interest
income increased due to an increase in the Company's level of investments and
interest-bearing deposits at the Central Bank. These increases in interest
income were partially offset by an increase in the Company's effective cost of
indebtedness as a result of the real devaluating at a faster rate than the
rate of inflation. In 1995, the excess of the inflation rate over the
devaluation rate resulted in inflationary gains that completely offset the
Company's interest expense in that year.
Write-off of property and equipment from physical inventory
In 1995, the Company conducted a physical inventory of equipment that
resulted in a write-off R$94.3 million of equipment that had been taken out of
service since the Company's previous physical inventory was conducted in 1978.
With respect to equipment removed from service in any year prior to 1995, the
write-off should have been accounted for as the correction of an error
requiring restatement of the financial statements for such earlier year. The
Company was not able, however, to determine the years in which equipment was
removed from service and, accordingly, it recognized the entire amount of the
write-off in 1995 and did not restate earlier years. If it had been able to do
so, the restatement would have resulted in (a) in each affected earlier year,
a charge under "net other nonoperating income (expense)", a related reduction
in tax expense and a corresponding reduction in net income and (b) in 1995, a
smaller charge under "write-off of property and equipment from physical
inventory", a related increase in tax expense and correspondingly higher net
income. See Note 15(e) to
55
<PAGE>
the Consolidated Financial Statements. The Company's inability to restate its
financial statements for earlier years affects the comparability of reported
net income for each year through 1995, but the Company is unable to determine
the magnitude of this effect.
Since 1995, the Company has performed annual physical inventories of
equipment resulting in the smaller 1996 and 1997 write-offs discussed below
under "Net other nonoperating expense." The Company has adopted measures to
further improve controls over, and to facilitate the recording of, physical
inventories, including the attachment of bar code tags to all inventoried
equipment and the implementation of a comprehensive set of procedures to track
and coordinate the movement of the Company's equipment. See Note 15(e) to the
Consolidated Financial Statements.
Net other nonoperating expense
Net other nonoperating expense increased 196.1% to R$284.2 million in 1997
from R$96.0 million in 1996, which in turn represented a 80.3% increase from
R$53.2 million in 1995. See Note 7 to the Consolidated Financial Statements.
Net nonoperating expense in 1997 was comprised principally of R$108.6 million
in telex equipment write-offs, R$98.7 million in Transdata equipment write-
offs, a R$44.4 million loss due to the scrapping of analog submarine cables,
R$43.8 million in miscellaneous other write-offs and losses on disposals and
R$17.2 million in other equipment write-offs resulting from the Company's
annual physical inventory of equipment, offset in part by R$36.9 million in
proceeds from asset disposals. The telex equipment write-off, which comprised
the entire remaining book value of the Company's telex equipment, resulted
from a 71% increase in the cost of leasing the dedicated lines required for
the provision of telex services at the end of 1996. Management believed that
market conditions would not allow this additional cost to be passed on to
telex consumers and, as a result, expected the line of business to become
increasingly unprofitable. The amount of the 1997 telex write off (and the
smaller telex equipment write offs taken in 1995 and 1996 discussed below) was
determined by providing in full against the remaining net book value of the
equipment at the time it was removed from service. The Transdata low speed
data transfer line was profitable in 1996 and prior years. However, as a
result of a steep decline in revenues in 1997 resulting in losses from this
line followed by a further decline in revenues early in 1998, the net book
value of this equipment was written off at December 31, 1997. In particular,
revenue declined in the second quarter of 1997 as a result of the
implementation of a new pricing structure in April 1997, as required by the
regulatory authority, whereby the price for data transmission at all speeds
was reduced significantly. The price for a typical combination of speed and
distance factors declined by 63%. This price reduction was not offset by an
increase in volume and as a result, the Transdata service line became
unprofitable. The analog submarine cables were removed from service in
December 1997, before the end of their estimated useful lives, due to
declining demand for international analog transmission equipment and the
existence of alternative digital transmission capacity; the analog submarine
cables thereafter did not generate revenues.
As of December 31, 1997 all of the Company's telephone switching equipment
and 70% of its long-distance transmission equipment was digital. The Company
expects that substantially all remaining analog transmission equipment (R$242
million at December 31, 1997 net book values) will be taken out of service at
the end of 1999. Such equipment is comprised of analog equipment and multiplex
transmission equipment. In view of this expectation, the Company's Board of
Directors resolved in the first quarter of 1998 to depreciate the remaining
net book value of such equipment in equal monthly installments through
December 1999. This accelerated depreciation will give rise to approximately
R$77.0 million of additional depreciation expense during each of 1998 and
1999. See "--Cost of services--Depreciation and amortization expenses."
Net nonoperating expense in 1996 was comprised principally of R$46 million
in telex equipment write-offs, a R$20.6 million write-off of an analog
submarine cable, R$33 million in miscellaneous other write-offs and R$13.4
million in other equipment write-offs resulting from the Company's annual
physical inventory of equipment, partially offset by the proceeds from asset
disposals. Net non-operating expense in 1995 principally reflected R$67.9
million in telex equipment write-offs, partially offset by R$11.3 million in
proceeds from asset disposals. The 1995 and 1996 telex equipment write-offs
were the result of rapidly declining customer demand
56
<PAGE>
for telex services. The number of telex terminals in service in Brazil
decreased 23% in 1995 to 48,000 terminals at year end and 40% in 1996 to
28,000 terminals at year end. These decreases, which reflected a significant
decline in demand, allowed the Company to concentrate its telex switching
operations in a few of the larger cities in Brazil and, consequently, remove
from service a substantial portion of its older equipment.
The R$33 million in miscellaneous write-offs in 1996 related to the removal
from service of analog equipment prior to the end of its useful life as a
result of the Company's replacing such equipment with digital equipment. An
analog submarine cable was written off as a result of a decision of the
consortium that owned and operated the cable to remove it from service and
rely entirely on a recently completed digital cable. The consortium approved
the removal of the cable in December 1996, and the cable was subsequently
removed from service in January 1997.
The amount of the write-offs in each year were equal to the book value of
the equipment removed from service in such year.
Income and social contribution taxes
The Company recorded a net tax credit of R$54.7 million in 1995, a net tax
charge of R$13.9 million in 1996 and a net tax credit of R$52.0 million in
1997. The aggregate effective rate of income and social contribution taxes was
(42.2%), 3.0% and (14.5)% in 1995, 1996 and 1997, respectively. See Note 8 to
the Consolidated Financial Statements.
Employees' profit share
All Brazilian companies are required under Brazilian law to compensate
employees, in addition to their salary and benefits, with profit sharing. The
amount of such profit sharing is determined by negotiation between the Company
and the labor unions representing the employees. For state owned companies,
such profit sharing payments are limited to 25% of total proposed dividends.
Telebras has established two additional limits. In addition to the 25% limit
imposed on all state owned companies, companies in the Telebras System must
limit employees' share of profits to the lower of (i) the aggregate of the
employees' annual compensation and (ii) 50% of the Company's net income
adjusted for dividends. Following the privatization of the Company, employee
profit share will be limited only by the 25% of dividends limit and will be
renegotiated by the Company and the unions representing its employees. The
Company's employees' profit share was R$21.8 million, R$22.6 million and
R$30.6 million in 1995, 1996 and 1997, respectively.
Net income
Net income decreased 9.3% to R$376.5 million in 1997 from R$414.9 million in
1996, which in turn represented a 158.9% increase from R$160.3 million in
1995. The increase in 1996 was attributable primarily to increased revenues
from domestic and international long-distance service and successful cost
management. The net decrease in 1997 was attributable principally to equipment
write-offs discussed under net other nonoperating expense above.
Liquidity and Capital Resources
The Registrant is a holding company and its principal assets are the shares
of its operating subsidiary Embratel. The Registrant relies almost exclusively
on dividends from Embratel to meet its needs for cash, including for the
payment of dividends to its shareholders. Under Law No. 6,404 of December 15,
1976, as amended (the "Brazilian Corporation Law"), dividends may be paid only
out of retained earnings or accumulated profits in any given fiscal year. See
"Description of Securities to be Registered--Capital Stock--Dividends."
Management believes that the Registrant's shareholding in Embratel is
sufficient to allow the Registrant to control the payment of dividends by
Embratel. The Registrant currently is able to nominate and elect all the
57
<PAGE>
members of the boards of directors of Embratel. However, under Brazilian law
and the regulations of the Brazilian Securities Commission, persons holding
more than 10% of the voting stock of a company (a percentage that may decrease
up to 5% in the case of listed companies) may require the company to adopt
cumulative voting. Management believes that, based on current holdings in its
operating subsidiary, if cumulative voting were required, the Registrant would
still be able to control the payment of dividends by Embratel which, with
respect to the Mandatory Dividend, could be limited only under very strict
circumstances: Board members, even if elected by one specific shareholder,
have fiduciary duties toward the Company and all its shareholders. The
minority voting shareholders of Embratel elect one member of the Audit
Committee of Embratel. The remaining members of the Audit Committee are
selected by the controlling shareholder.
The Company's principal liquidity and capital resource requirements are to
finance capital expenditures and investments related to the expansion,
improvement and maintenance of its property, plant and equipment.
Historically, the Company has financed its capital expenditures and
investments with internally generated funds and indebtedness.
The Company made capital expenditures of R$819 million during the nine
months ended September 30, 1998 and R$704 million, R$942 million and R$918
million in 1995, 1996 and 1997, respectively. The principal expenditures
related primarily to the expansion and modernization of the Company's
transmission network. See "Description of Business--Capital Expenditures." In
addition, the Company paid dividends of R$296.1 million for the nine months
ended September 30, 1998 and R$165.2 million, R$87.1 million and R$234.2
million in 1995, 1996 and 1997, respectively.
The Company anticipates that capital expenditures for 1998 will be
approximately R$1,283 million, 80% of which is expected to be funded with
internally generated funds from operations. See "Description of Business--
Capital Expenditures." The Company expects to finance its capital
expenditures, debt service obligations and dividend payments from internally
generated funds and from its existing sources of debt financing.
The Company's primary source of funds is cash generated from operations. Net
cash flow generated by operating activities was R$1,081.1 million for the nine
months ended September 30, 1998 and R$938.3 million, R$1,378.3 million and
R$1,211.7 million in 1995, 1996 and 1997, respectively.
The Company's total long-term indebtedness was R$500.7 million, R$402.2
million, R$448.6 million and R$471.5 million as of September 30, 1998,
December 31, 1995, 1996 and 1997, respectively. The increase in long-term
indebtedness at September 30, 1998 from December 31, 1997 was due to foreign
exchange rate fluctuations. The increase in long-term indebtedness in 1996 as
compared to 1995 reflected additional loans and financing required for the
acquisition of the Brasilsat B3 satellite and for the installation of the
fiber optic cable system. R$87.4 million and R$133.6 million of the Company's
debt matures in 1998 and 1999, respectively.
At September 30, 1998, the Company had available approximately R$103.3
million in committed lines of credit for long-term financing, of which R$51.3
million was outstanding as of September 30, 1998. All of the Company's long-
term indebtedness at September 30, 1998 was denominated in foreign currencies,
88.7% of which is in U.S. dollars. The effective cost to the Company of
borrowing in foreign currencies depends principally on the exchange rate
between the real and the currencies in which its borrowings are denominated.
The Company does not hedge its obligations under its foreign currency-
denominated indebtedness. During the first month of 1999, the real devalued
against the U.S. dollar by 37.5%. If this devaluation is sustained, or
worsens, the cost in reais of servicing the Company's U.S. dollar-denominated
debt will increase proportionately. See "Description of Business--Brazilian
Economic Environment." Foreign currency denominated debt bears fixed interest
rates varying from 5.71% per annum to 10.14% per annum and variable interest
rates varying from 0.25% to 3.30% per annum over LIBOR. The LIBOR rate at
September 30, 1998 was 5.25% per annum. The Company's foreign currency-
denominated debt is evidenced by credit agreements that contain certain
restrictions and covenants, including negative pledge provisions, prohibitions
on the reduction of capital, prohibitions on mergers and consolidations and
prohibitions on the selling, transferring or otherwise disposing of all or
substantially all of its assets.
58
<PAGE>
Certain of the Company's credit agreements also contain covenants
restricting, among other things, (i) the ability of Telebras to dispose of all
or a substantial part of its assets or to cease to control a company that was
an operating subsidiary of the Telebras System and (ii) the ability of the
Federal Government to dispose of its controlling interest in the Telebras
System. The Breakup of Telebras on May 22, 1998, the privatization of the New
Holding Companies on July 29, 1998 and the announced liquidation of Telebras
constitute events of default under such credit agreements. In addition, most
of the Company's other credit agreements include cross-default provisions and
cross-acceleration provisions that would permit the holders of such
indebtedness to declare the indebtedness to be in default and to accelerate
the maturity thereof if a significant portion of the principal amount of the
Company's debt is in default or accelerated. The total amount of the Company's
outstanding debt as of September 30, 1998 which is currently or is expected to
be in default is R$449.0 million. The Company is currently in negotiations
with the appropriate creditors with respect to this indebtedness. Although
none of the Company's creditors have notified the Company that they intend to
pursue their rights and remedies with respect to these defaults, there can be
no assurance that the Company will be able to obtain waivers or that the
creditors will not exercise their rights and remedies under the credit
agreements.
The Company's two principal categories of indebtedness at September 30, 1998
were the following:
Financial institutions (R$527.4 million). Borrowings (principal and
interest) from financial institutions consist of various unsecured medium-
and long-term loans, generally in foreign currencies. The policy of the
Company is to avoid relying on short-term real-denominated bank borrowings
because of their high cost.
Supplier credits (R$109.7 million). Supplier credits (in the form of
principal and accrued interest) are available for purchases of imported
equipment, principally fiber optic transmission equipment. A portion of the
supplier credits, amounting to R$5.0 million at September 30, 1998, is
guaranteed by Telebras.
Reconciliation to U.S. GAAP
The Company prepares its consolidated financial statements in accordance
with Brazilian GAAP, which differs in significant respects from U.S. GAAP. The
principal differences between Brazilian GAAP and U.S. GAAP as they affected
the Company's results of operations during the reported periods are: (i) under
Brazilian GAAP, loans and financing balances in default are not always
classified as current liabilities while under U.S. GAAP, loans and financings
in default or expected to be in default within a year of the balance sheet
date are classified as current obligations unless creditors have provided the
Company waivers for such defaults; a substantial portion of the Company's
outstanding debt at September 30, 1998 is in default as a result of the
Breakup of the Telebras System and the Company's privatization (see "--
Liquidity and Capital Resources"); (ii) under Brazilian GAAP, interest on
loans to finance construction in progress is capitalized at the rate of 12%
per annum of the total value of construction in progress, regardless of the
amount of interest actually incurred on such loans while under U.S. GAAP
interest is capitalized at the interest rate of the debt incurred up to the
lower of the amount of construction in progress and the total loans incurred;
(iii) until December 31, 1993 capitalized interest under Brazilian GAAP was
not added to individual assets but was capitalized separately and amortized
over a time period different from the estimated useful lives of the related
assets while under U.S. GAAP capitalized interest is added to the cost of
individual assets and is amortized over their estimated useful lives; (iv) the
write-off of certain impaired, long-lived assets under U.S. GAAP; (v)
adjustments to the Company's provision for pension and other post-retirement
benefits resulting from the application of SFAS 87--"Employer's accounting for
pensions" and SFAS 106--"Employer's accounting for post retirement benefits
other than pensions" as required under U.S. GAAP; (vi) under Brazilian GAAP,
the deferred tax liability arising from the indexation of assets and
liabilities for financial reporting purposes was recorded against retained
earnings while under U.S. GAAP such effects would be charged to income and
social contribution taxes in the statement of income; (vii) under Brazilian
GAAP, proposed dividends are accrued for in the consolidated financial
statements in anticipation of their approval at the shareholders' meeting
while under U.S. GAAP, dividends are not accrued until they are formally
declared; and (viii) under the Statement of Financial Accounting Standards No.
5, the Company is required to reverse the R$42.9 million COFINS-related tax
credit taken in 1995
59
<PAGE>
under Brazilian GAAP. The Company's income from continuing operations under
U.S. GAAP would have been R$164.4 million, R$148.2 million, R$350.9 million
and R$451.6 million for the nine months ended September 30, 1998, and the
years ended December 31, 1995, 1996 and 1997, respectively. In addition, under
US GAAP, Embratel is considered to be the continuing entity of the Telebras
System for financial reporting purposes through December 31, 1997. As a
result, all operations of Telebras and its subsidiaries, except for Embratel,
are considered to be discontinued operations through December 31, 1997. Income
from discontinued operations under U.S. GAAP amounted to R$716.8 million,
R$1,976.4 million and R$3,127.9 million for the years ended December 31, 1995,
1996 and 1997, respectively. See Note 29 to the Consolidated Financial
Statements, which also includes condensed financial statement schedules of the
Company prepared in accordance with Brazilian GAAP, in a U.S. GAAP reporting
format, reflecting discontinued operations. See Note 17 to the Unaudited
Consolidated Condensed Financial Statements for an additional discussion of
U.S. GAAP differences which arose during 1998. See "--Results of operations
for the nine months ended September 30, 1998--Third quarter 1998 pre-tax
charges."
Recent Events
The Company had consolidated net operating revenues of R$4,000 million in
the twelve months ended December 31, 1998, which represented a 85% increase
from R$2,164 million in the twelve months ended December 31, 1997. The Company
had consolidated net income of R$124 million in the twelve months ended
December 31, 1998 compared to consolidated net income of R$419 million in the
twelve months ended December 1997. Such amounts have been determined in
accordance with the Brazilian Corporation Law and standards issued by the CVM
and have not been indexed for inflation occurring after December 31, 1995 or
expressed in constant reais. Accordingly, such amounts are not comparable to
the amounts included in the Financial Statements included herein, which have
been so indexed and expressed. Had consolidated net operating revenues and
consolidated net income for the years ended December 31, 1997 and December 31,
1998 been indexed for inflation and expressed in constant reais on the same
basis as the amounts presented in the Financial Statements, such adjustments
would have had no material effect on net operating revenues and would have
resulted in decreases of approximately R$113 million and approximately R$42
million to net income for the years ended December 31, 1998 and December 31,
1997, respectively (principally reflecting additional depreciation, net of
related tax effects). As measured by the IGP-M, the cumulative rate of
inflation from the period December 31, 1995 to December 31, 1998 was 19.83%.
Management believes that the material adjustments that would be required to
reconcile net income as reported for the year ended December 31, 1998 to U.S.
GAAP are comparable in nature to those discussed in Notes 17 and 18 to the
Unaudited Consolidated Condensed Financial Statements.
On September 24, 1998, the Board of Directors of the Registrant authorized
the acquisition by the Company of up to 5,996,387,940 Common Shares and
21,002,999,706 Preferred Shares within the three month period ending December
24, 1998. The Company may from time to time purchase the Registrant's Common
Shares and Preferred Shares but had not done so as of the date of this
Registration Statement.
In September 1998, the Board of Directors of the Registrant appointed Arthur
Andersen as the Company's independent auditors and it is expected that the
Company's consolidated financial statements as of and for the year ended
December 31, 1998 will be audited by Arthur Andersen.
Item 9A: Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to market risk from changes in both foreign currency
exchange rates and interest rates. The Company is exposed to foreign exchange
rate risk because certain of its costs are denominated in currencies
(primarily the U.S. dollar) other than those in which it earns revenues
(primarily the real). Similarly, the Company is subject to market risk
deriving from changes in interest rates which may affect the cost of its
financing. The Company does not use derivative instruments, such as foreign
exchange forward contracts, foreign currency options, interest rate swaps and
forward rate agreements, to manage these market risks, nor does it hold or
issue derivative or other financial instruments for trading purposes.
60
<PAGE>
Exchange Rate Risk
The Company has exchange rate exposure with respect to the U.S. dollar and,
to a lesser extent, other currencies. At September 30, 1998, approximately
R$660 million of the liabilities of the Company, which included R$637 million
in loans and financing and R$23 million in accounts payable to international
operators, was denominated in U.S. dollars, and approximately R$68 million of
the Company's indebtedness was indexed to other foreign currencies which
included French Francs, Deutsch Marks and Japanese Yen. The potential
immediate loss to the Company that would result from a hypothetical 10% change
in foreign currency exchange rates based on this position would be
approximately R$80 million. In addition, if such a change were to be
sustained, the Company's cost of financing would increase in proportion to the
change. This sensitivity analysis assumes an unfavorable 10% fluctuation in
all of the exchange rates affecting all the foreign currencies in which the
indebtedness described above are denominated and does not take into account
the offsetting effect of such a change on the Company's foreign-currency
denominated revenues (principally payments from international operators).
Since consistently and simultaneously unfavorable movements in all relevant
exchange rates are unlikely, this assumption may overstate the impact of
exchange rate fluctuations on the Company's results of operations. During the
first month of 1999, the real devalued against the U.S. dollar by 37.5%. If
this devaluation is sustained, or worsens, the Company would expect to incur a
substantial loss.
Interest Rate Risk
At September 30, 1998, the Company had approximately R$637 million in loans
and financing outstanding, of which approximately R$355 million bore interest
at fixed interest rates and approximately R$282 million bore interest at
floating rates of interest (primarily LIBOR-based). Embratel invests its
excess liquidity (R$736 million at September 30, 1998) mainly in short-term
instruments. The potential loss to the Company over one year that would have
resulted from a hypothetical, instantaneous and unfavorable change of 100
basis points in the interest rates applicable to financial assets and
liabilities on September 30, 1998 would be approximately R$4 million. The
above sensitivity analyses are based on the assumption of an unfavorable 100
basis point movement of the interest rates applicable to each homogenous
category of financial assets and liabilities and sustained over a period of
one year. A homogenous category is defined according to the currency in which
financial assets and liabilities are denominated and assumes the same interest
rate movement within each homogenous category (e.g. U.S. dollars). As a
result, the Company's interest rate risk sensitivity model may overstate the
impact of interest rate fluctuations for such financial instruments as
consistently unfavorable movements of all interest rates are unlikely.
Item 10: Directors and Officers of Registrant
Board of Directors
The Registrant is administered by a Board of Directors (Conselho de
Administracao) and a Board of Executive Officers (Diretoria). The Board of
Directors is comprised of five members serving for a term of three years. The
Board of Directors holds a regular meeting once a month and holds special
meetings when called by the Chairman or by two members of the Board of
Directors.
The following are the current members of the Board of Directors and their
respective positions. Unless otherwise indicated, all current members were
appointed in August 1998.
<TABLE>
<CAPTION>
Name Position
---- --------
<S> <C>
Daniel Eldon Crawford Chairman
Michael James Rowny Director
Luis Fernando Motta Rodrigues Director
Dilio Sergio Penedo Director
Francisco dos Santos Pires
Albuquerque Director
</TABLE>
Set forth below are brief biographical descriptions of the Directors.
61
<PAGE>
Daniel Eldon Crawford, 58 years old, has served as Chairman of the Board of
Directors since February 1999 and member of the Board since September 1998. He
serves as Senior Vice President, Venture Management, for MCI WORLDCOM. From
1994 to 1998 he served as Chief Operating Officer of Avantel, S.A., a joint
venture of MCI WORLDCOM and Grupo Financiero Banamex-Accival., which competes
in the Mexican long-distance marketplace. Previously, he held a number of
positions at MCI, including president of the Network Services Division and
president of MCI's Southwest Division. He holds a bachelor of science degree
in electrical engineering from the University of Nebraska and a master's
degree in electrical engineering from New York University.
Michael James Rowny, 48 years old, has served as a member of the Board of
Directors since September 1998 and Chairman of the Board of Directors from
September 1998 to February 1999. In addition to his position as Chairman of
the Board of Directors of the Company, he also serves as Executive Vice
President of MCI WORLDCOM. Before returning to MCI, he was Vice President and
Chief Financial Officer of ICF Kaiser International; Chairman and Chief
Executive Officer of Ransohoff Company; Chief Executive Officer of Hermitage
Holding Company; Vice President and Treasurer of MCI Communications
Corporation; Vice President for Strategic Planning and Ventures at Bendix
Corporations; and Deputy Staff Director of The White House during the Carter
Administration. He holds a bachelor of science degree from the Massachusetts
Institute of Technology and a law degree from Georgetown University Law
Center.
Luis Fernando Motta Rodrigues, 36 years old, has served as a member of the
Board of Directors since August 1998. In addition, he has served as President
of MCI do Brasil, MCI Solutions Ltda. ("MCI"), Startel Participacoes Ltda. and
President of the Administrative Board of Empresa Brasileira de
Telecomunicacoes S.A.--Embratel ("Embratel"), the operating subsidiary of the
Company. Before working for MCI, he served in various positions in the
operational and commercial areas of Embratel's international office. He holds
a degree in telecommunications engineering from the Fluminense Federal
University, Niteroi, RJ.
Dilio Sergio Penedo, 56 years old, has served as a member of the Board of
Directors since May 1998. He served as General Area Manager for South America
at SAFT, a company of the Alcatel Alsthom Group; President of Nife--Argentina;
Superintendent Director of Indesul--Saft Equipamentos Eletronicos; and
Superintendent Director of Nife Brasil--Sistemas Eletricos. In addition, he
served as President of Embratel from 1995 to 1998. He holds a degree in
electrical engineering from the Catholic University of Rio de Janeiro.
Francisco dos Santos Pires Albuquerque, 58 years old, has served as a member
of the Board of Directors since August 1998. He served as Development Director
of Embratel, from 1990 to 1995 and Executive Vice-President of
Telecomunicacoes do Rio de Janeiro S.A.--Telerj from 1995 to 1997. In addition
to his position as a member of the Board of Directors of the Company, he has
also served as Superintendent Director of Telos-- Fundacao Embratel de
Seguridade Social (Embratel Social Security Foundation). He holds an
engineering degree from Pontifical Catholic University of Rio de Janeiro.
Board of Executive Officers
The Board of Executive Officers consists of one President and one Vice-
President elected by the Board of Directors for a term of three years. An
Executive Officer may be removed from office at any time. The President must
be chosen from among the members of the Board of Directors.
The following are the Executive Officers and their respective positions.
Unless otherwise indicated, all current members were appointed in August 1998.
<TABLE>
<CAPTION>
Name Position
---- --------
<S> <C>
Daniel Eldon Crawford President
Dilio Sergio Penedo Vice-President and Investor Relations Director
</TABLE>
Brief biographical descriptions of the Executive Officers are set forth
above.
62
<PAGE>
Item 11: Compensation of Directors and Officers
For the year ended December 31, 1997, the aggregate amount of compensation
paid by the Registrant's subsidiaries to all directors and executive officers
of the Registrant's subsidiaries as a group was approximately R$1.0 million.
For the year ended December 31, 1997, the aggregate amount set aside or
accrued by the Registrant's subsidiaries to provide pension, retirement or
similar benefits for officers and directors of the Registrant's subsidiaries
was approximately R$225.3 thousand. The Registrant did not have any officers
or directors for the year ended December 31, 1997 because it was not formed
until May 22, 1998 as part of the Breakup of Telebras.
Item 12: Options to Purchase Securities from Registrant or Subsidiaries
None.
Item 13: Interest of Management in Certain Transactions
The Company and MCI WORLDCOM have entered into a Management Agreement
effective August 4, 1998, which was approved by the shareholders of the
Company other than MCI WORLDCOM, pursuant to which MCI WORLDCOM will provide
advice regarding the management, operations and business of the Company. Under
the agreement, Embratel is to pay MCI WORLDCOM as compensation for its
management services in 1998, 1999 and 2000, an amount equal to one percent of
Embratel's annual revenue during each such year. The compensation for
management services to be provided in 2001 and 2002 is one half percent of
Embratel's annual revenue in each such year. For 2003, the compensation for
management services to be provided is two tenths percent of Embratel's annual
revenue for such year. Under the Management Agreement, Embratel separately
reimburses MCI WORLDCOM for any expenses incurred in connection with the
provision of services under the Management Agreement. Embratel had at
September 30, 1998 accrued R$27.9 million and R$3.6 million for management
services fees and expense reimbursement, respectively, pursuant to the
Management Agreement with respect to management services provided from August
4, 1998 to September 30, 1998. Pursuant to the terms of the Management
Agreement, the amount of fees accrued with respect to such services was
determined based on revenues reported during the period from January 1, 1998
through September 30, 1998.
63
<PAGE>
PART II
Item 14: Description of Securities to be Registered
Capital Stock
Set forth below is a brief summary of the material provisions of the
Preferred Shares and Common Shares, the By-laws and the Brazilian Corporation
Law. This description is qualified by reference to the By-laws, which have
been filed (together with an English translation) as an exhibit to this
Registration Statement, and to the Brazilian Corporation Law. A copy of the
By-laws (together with an English translation) is available for inspection at
the principal office of the Depositary Information on the trading market for
the Preferred Shares is set forth under "Nature of Trading Market" and
information on ownership of the Registrant's shares is set forth under
"Control of Registrant."
General
The capital stock of the Registrant is comprised of Preferred Shares and
Common Shares, all without par value. At May 22, 1998, there were 210,029,997
thousand outstanding Preferred Shares and 124,351,903 thousand outstanding
Common Shares. The Company's share capital may be increased only by a
shareholder vote.
The Preferred Shares are non-voting except under limited circumstances and
are entitled to a preferential, noncumulative dividend and to priority over
the Common Shares in the case of liquidation of the Registrant.
Under the Brazilian Corporation Law, the number of non-voting shares or
shares with limited voting rights, such as the Preferred Shares, may not
exceed two-thirds of the total number of shares. The Federal Government was
required by law prior to the privatization to own more than 50% of the voting
stock of the Registrant.
The majority of the members of the Board of Directors will be elected by the
controlling shareholders of Common Stock of the Registrant. Board members,
even if elected by one specific shareholder, have fiduciary duties towards the
Company and all its shareholders.
Dividends
Pursuant to its By-laws, the Registrant is required to distribute as
dividends in respect of each fiscal year ending on December 31, to the extent
amounts are available for distribution, an aggregate amount equal to at least
25% of Adjusted Net Income (as defined below) on such date (the "Mandatory
Dividend"). The annual dividend distributed to holders of Preferred Shares
(the "Preferred Dividend") has priority in the allocation of Adjusted Net
Income. Remaining amounts to be distributed are allocated first to the payment
of a dividend to holders of Common Shares in an amount equal to the Preferred
Dividend and the remainder is distributed equally among holders of Preferred
Shares and Common Shares. Under the Brazilian Corporation Law, a company is
permitted to suspend the Mandatory Dividend in respect of common shares and
preferred shares not entitled to a fixed or minimum dividend if its Board of
Directors and Audit Committee report to the shareholders' meeting that the
distribution would be incompatible with the financial circumstances of such
company and the shareholders ratify this conclusion at the shareholders'
meeting. In this case, (i) the Board of Directors must forward to the CVM
within five days of the shareholders' meeting an explanation justifying the
information transmitted at the meeting and (ii) the profits which were not
distributed for such reason are to be recorded as a special reserve and, if
not absorbed by losses in subsequent fiscal years, are to be paid as dividends
as soon as the financial situation of such company permits. The Preferred
Shares of the Registrant are entitled to a minimum dividend and thus the
Mandatory Dividend may be suspended only with respect to the Common Shares.
See "--Priority and Amount of Preferred Dividends." Dividends may be paid by
the Registrant out of retained earnings or accumulated profits, in any given
fiscal year.
64
<PAGE>
For the purposes of the Brazilian Corporation Law, accumulated profits are
defined as net income after income tax and social contribution for such fiscal
year, net of any accumulated losses from prior fiscal years and any amounts
allocated to founders' shares, income bonds, employees' and management's
participation in a company's profits.
At each annual shareholders' meeting, the Board of Directors is required to
recommend how net profits for the preceding fiscal year are to be allocated.
Under the Brazilian Corporation Law, the Registrant is required to maintain a
statutory reserve, to which it must allocate 5% of net profits for each fiscal
year until the amount of such reserve equals 20% of the Registrant's paid-in
capital (the "Statutory Reserve"). Net losses, if any, may be charged against
the statutory reserve.
The Brazilian Corporation Law also provides for two additional discretionary
allocations of net profits that are subject to approval by shareholders at the
annual shareholders' meeting. First, a percentage of net profits may be
allocated to the contingency reserve for anticipated losses that are deemed
probable in future years (the "Contingency Reserve"). Any amount so allocated
in a prior year must be either (i) reversed in the fiscal year in which the
loss was anticipated if such loss does not in fact occur or (ii) written off
in the event that the anticipated loss occurs. Second, if the amount of
Unrealized Revenue exceeds the sum of (i) the Statutory Reserve, (ii) the
Contingency Reserve and (iii) retained earnings, such excess may be allocated
to the reserve (the "Unrealized Revenue Reserve"). Such allocations may not
hinder the payment of dividends on the Preferred Shares. "Unrealized Revenue"
is defined under the Brazilian Corporation Law as the sum of (i) the share of
equity earnings of affiliated companies which is not paid as cash dividends
and (ii) profits from installment sales to be received after the end of the
next succeeding fiscal year.
For the purposes of the Brazilian Corporation Law, and in accordance with
the Registrant's By-Laws, the "Adjusted Net Income" is an amount equal to the
Registrant's net profit adjusted to reflect allocations to and from (i) the
Statutory Reserve; (ii) the Contingency Reserve and (iii) the Unrealized
Revenue Reserve.
The amounts available for distribution are determined on the basis of
financial statements prepared in accordance with the Brazilian Corporation
Law, which differ from financial statements, such as the Consolidated
Financial Statements included herein, that are prepared using the constant
currency method according to Brazilian GAAP.
In order to allow the payment of dividends after the Breakup, the
shareholders of Telebras approved, as a part of the Breakup, the allocation of
a proportional part of the retained earnings and reserves of Telebras
transferred to the Registrant as retained earnings of the Registrant. These
earnings and reserves (which amount to R$3,918.7 million) are available for
payment of future dividends by the Registrant, if so decided by the
shareholders, although the Registrant is not legally obligated to do so.
Priority and Amount of Preferred Dividends
The Registrant's By-laws provide for a minimum yearly per share dividend for
the Preferred Shares equal to 6% of the amount obtained by dividing the total
share capital by the total number of shares of the Company. As a result of
such provision, holders of Preferred Shares are entitled to receive in any
year distributions of cash dividends prior to the holders of Common Shares
receiving any distribution of cash dividends in such year. In addition,
distributions of cash dividends in any year are made (i) first, to the holders
of Preferred Shares, up to the amount of the Preferred Dividend of the
Preferred Shares for such year, (ii) then, to the holders of Common Shares,
until the amount distributed in respect of each Common Share is equal to the
amount distributed in respect of each Preferred Share, and (iii) thereafter,
to the Common Shares and Preferred Shares on a pro rata basis. If the
Mandatory Dividend in any year is less than or equal to the Preferred
Dividends payable to the holders of Preferred Shares in such year, the holders
of Common Shares will not be entitled to receive any cash dividends from the
Registrant in such year, unless the holders of Common Shares approve dividends
in excess of the Preferred Dividend. In such circumstances, however, holders
of Preferred Shares will be entitled to the amount available for payment of
dividends up to an aggregate amount equal to the Preferred Dividends plus, in
65
<PAGE>
the event the Preferred Dividend is higher than the amount available for
payment of dividends for such year, any retained earnings from previous years
may be used to make up for such shortfall. If the minimum dividend is not paid
for a period of three years, holders of Preferred Shares shall be entitled to
full voting rights until such time as the minimum dividend is paid in full for
any year.
Payment of Dividends
The Registrant is required by law and its By-laws to hold an annual
shareholders' meeting by April 30 of each year at which, among other things,
an annual dividend may be declared by decision of the shareholders on the
recommendation of the Executive Officers, as approved by the Board of
Directors. The payment of annual dividends is based on the Consolidated
Financial Statements prepared for the fiscal year ending December 31. Under
the Brazilian Corporation Law, dividends are required to be paid within 60
days following the date the
dividend is declared to shareholders of record on such declaration date,
unless a shareholders' resolution sets forth another date of payment, which
must occur prior to the end of the fiscal year in which such dividend was
declared. A shareholder has a three-year period from the dividend payment date
to claim dividends in respect of its shares, after which the Registrant has no
liability for such payment. Because the Registrant's shares are issued in
book-entry form, dividends with respect to any share are automatically
credited to the account holding such share and no action is required on the
part of the shareholder. The Registrant is not required to adjust the amount
of paid-in capital for inflation. Annual dividends may be paid to shareholders
on a pro rata basis according to the date when the subscription price is paid
to the Registrant.
Shareholders who are not residents of Brazil must register with the Central
Bank of Brazil in order for dividends, sales proceeds or other amounts with
respect to their shares to be eligible to be remitted outside of Brazil.The
Preferred Shares underlying the ADSs are held in Brazil by the Custodian, as
agent for the Depositary, which is the registered owner of the Registrant's
shares. See " --Description of American Depositary Receipts in respect of
Preferred Shares."
Payments of cash dividends and distributions, if any, will be made in
Brazilian currency to the Custodian on behalf of the Depositary, which will
then convert such proceeds into U.S. dollars and will cause such U.S. dollars
to be delivered to the Depositary for distribution to holders of ADRs. In the
event that the Custodian is unable to convert immediately the Brazilian
currency received as dividends into U.S. dollars, the amount of U.S. dollars
payable to holders of ADRs may be adversely affected by devaluations of the
Brazilian currency that occur before such dividends are converted and
remitted. Dividends in respect of the Preferred Shares paid to resident and
non-resident shareholders, including holders of ADSs, are not currently
subject to Brazilian withholding tax. See "Taxation--Brazilian Tax
Considerations."
Voting Rights
Each Common Share entitles the holder thereof to one vote at meetings of
shareholders of the Registrant. Preferred Shares do not entitle the holder to
vote except as set forth below. Holders of Preferred Shares are entitled to
attend or to address meetings of shareholders.
One of the three members of the permanent Audit Committee of the Registrant
and his or her alternate are elected by majority vote of the holders of
Preferred Shares present at the annual meeting of shareholders at which
members of the Audit Committee are elected.
Brazilian Corporation Law provides that certain non-voting shares, such as
the Preferred Shares, acquire voting rights in the event the Registrant fails
for three consecutive fiscal years to pay the Preferred Dividend to which such
shares are entitled until such payment is made.
The Preferred Shares are entitled to full voting rights with respect to (i)
the approval of any long-term contract between the Company and its affiliates,
on the one hand, and any controlling shareholder of the Company, such
shareholder's affiliates and related parties, on the other hand and (ii)
resolutions modifying
66
<PAGE>
certain provisions of the By-laws. The Preferred Shares are entitled to full
voting rights with respect to any resolution submitted to the shareholders'
meetings for the delisting ("going private") or during liquidation of the
Registrant.
Any change in the preference, benefits, conditions of redemption and
amortization of the Preferred Shares, or the creation of a class of shares
having priority or preference over the Preferred Shares, would require the
approval of holders of a majority of the outstanding Preferred Shares at a
special meeting of holders of Preferred Shares. Such a meeting would be called
by publication of a notice in the Gazeta Mercantil and the Diario Oficial da
Uniao at least thirty days prior to the meeting but would not generally
require any other form of notice.
In any circumstances in which holders of Preferred Shares are entitled to
vote, each Preferred Share will entitle the holder thereof to one vote.
Preemptive Rights
Each shareholder of the Registrant has a general preemptive right to
subscribe for shares in any capital increase, in proportion to its
shareholding. A period of 30 days following the publication of notice of the
capital increase is allowed for exercise of the right, and the right is
negotiable. However, a shareholders' meeting is authorized to eliminate
preemptive rights with respect to the issuance of new shares, debentures,
warrants and founders' shares convertible into new shares up to the limit of
the authorized share capital, provided that the distribution of these
securities is effected (i) on a stock exchange or in a public offering, (ii)
through an exchange of shares in a public offering the purpose of which is to
acquire control of another company or (iii) through the use of certain tax
incentives.
In the event of a capital increase which would maintain or increase the
proportion of capital represented by Preferred Shares, holders of ADSs, or of
Preferred Shares, would have preemptive rights to subscribe only to newly
issued Preferred Shares. In the event of a capital increase which would reduce
the proportion of capital represented by Preferred Shares, holders of ADSs, or
of Preferred Shares, would have preemptive rights to subscribe to Preferred
Shares, in proportion to their shareholdings and to Common Shares only to the
extent necessary to prevent dilution of their interest in the Registrant.
Preemptive rights to purchase shares may not be offered to U.S. holders of
ADSs unless a registration statement under the Securities Act is effective
with respect to the shares underlying such rights, or an exemption from the
registration requirements of the Securities Act is available. Consequently,
holders of ADSs who are U.S. persons or are located in the United States may
be restricted in their ability to participate in the exercise of preemptive
rights. See "--Description of American Depositary Receipts in respect of
Preferred Shares--Dividends, Other Distributions and Rights."
Right of Redemption
Neither the Common Shares nor the Preferred Shares are redeemable, subject
to the right of a dissenting shareholder to seek redemption upon a decision
made at a shareholders' meeting by shareholders representing over 50% of the
voting shares (i) to change the preference of the Preferred Shares or to
create a class of shares having priority or preference over the Preferred
Shares, (ii) to modify the mandatory distribution of dividends, (iii) to
change the corporate purposes of the Registrant, (iv) to dissolve or liquidate
the Registrant, (v) to transfer all of the shares of the Registrant to another
company in order to make the Registrant a wholly-owned subsidiary of such
company (incorporacao de acoes), (vi) to approve the acquisition of another
company, the price of which exceeds certain limits set forth in the Brazilian
Corporation Law and (vii) to merge or consolidate the Registrant with another
company, if certain liquidity standards provided in the Brazilian Corporation
Law are not met. The right to redemption lapses 30 days after publication of
the minutes of the relevant shareholders' meeting or, whenever the resolution
requires the approval of the holders of Preferred Shares by vote taken in a
special meeting of a majority of the holders of Preferred Shares affected by
the resolution, within 30 days from the publication of the minutes of such
special meeting. The Registrant would be entitled to reconsider any action
67
<PAGE>
giving rise to redemption rights within 10 days following the expiration of
such rights if the redemption of shares of dissenting shareholders would
jeopardize the financial stability of the Registrant.
Unless otherwise provided in the By-laws (which is not the case with the
Registrant), shares are redeemable at their book value, determined on the
basis of the last annual balance sheet approved by the shareholders. If the
shareholders' meeting giving rise to redemption rights occurs more that 60
days after the date of the last annual balance sheet, a shareholder may demand
that its shares be valued on the basis of a new balance sheet that is as of a
date within 60 days of such shareholders' meeting.
Form and Transfer
Shares of the Registrant are maintained in book-entry form with a transfer
agent (the "Transfer Agent") and the transfer of such shares is made in
accordance with the applicable provisions of the Brazilian Corporation Law,
which provides that a transfer of shares is effected by an entry made by the
Transfer Agent on its books, debiting the share account of the seller and
crediting the share account of the purchaser, against presentation of a
written order of the seller, or judicial authorization or order, in an
appropriate document which remains in the
possession of the Transfer Agent. The Preferred Shares underlying the ADS will
be registered on the Transfer Agent's records in the name of the Depositary.
Transfers of shares by a foreign investor are made in the same way and
executed by such investor's local agent on the investor's behalf except that,
if the original investment was registered with the Central Bank of Brazil
pursuant to the Annex IV Regulations, the foreign investor should also seek
amendment, if necessary, through its local agent, of the certificate of
registration to reflect the new ownership.
Each of the Sao Paulo Stock Exchange and the Rio de Janeiro Stock Exchange
operates a central clearing system. A holder of shares of the Registrant may
choose, at its discretion, to participate in these systems and all shares
elected to be put into the system will be deposited in custody with the
relevant stock exchange (through a Brazilian institution duly authorized to
operate by the Central Bank of Brazil having a clearing account with the
relevant stock exchange) and the fact that such shares are subject to custody
with the relevant stock exchange will be reflected in the Registrant's
register of shareholders. Each participating shareholder will, in turn, be
registered in the register of beneficial shareholders of the Registrant
maintained by the relevant stock exchange and will be treated in the same way
as registered shareholders.
Description of American Depositary Receipts in respect of Preferred Shares
The following is a summary of the material provisions of the deposit
agreement (the "Deposit Agreement"), dated as of July 27, 1998 among the
Registrant, the Depositary, and the registered holders (the "Owners") and
beneficial owners from time to time of ADSs (the "Beneficial Owners"),
pursuant to which the ADSs representing Preferred Shares are to be issued.
This summary is subject to and qualified in its entirety by reference to the
Deposit Agreement, including the form of ADRs. Terms used in this description
and not otherwise defined shall have the meanings set forth in the Deposit
Agreement. A copy of the Deposit Agreement has been filed as an exhibit to
this Registration Statement. Copies of the Deposit Agreement are available for
inspection at the Corporate Trust Office of the Depositary, currently located
at 101 Barclay Street, New York, NY 10286, and at the office of the agent of
the Custodian, currently located at the principal Sao Paulo, Brazil office of
Banco Itau. The Depositary's principal executive office is located at 1 Wall
Street, New York, NY 10015.
American Depositary Receipts
ADRs evidencing ADSs are issuable by the Depositary pursuant to the Deposit
Agreement. Each ADR is in registered form and evidences a specified number of
ADSs, each ADS representing 1,000 Preferred Shares, or evidence of the right
to receive 1,000 Preferred Shares deposited with the Custodian and registered
in the name of the Depositary or its nominee (together with any additional
Preferred Shares at any time deposited or deemed
68
<PAGE>
deposited under the Deposit Agreement and any and all other securities, cash
and other property received by the Depositary or the Custodian in respect of
such Preferred Shares and at such time held under the Deposit Agreement, the
"Deposited Securities"). Only persons in whose names ADRs are registered on
the books of the Depositary are treated by the Depositary and the Registrant
as Owners.
Deposit, Transfer and Withdrawal
The By-laws provide that ownership of capital generally must be evidenced
only by a record of ownership maintained by the Registrant or an accredited
intermediary, such as a bank, acting as a registrar for the shares. Currently,
such function is performed by the Registrant as registrar (the "Registrar").
Accordingly, all references to the deposit, surrender and delivery of the
Preferred Shares refer only to book-entry transfers of the Preferred Shares in
Brazil. See "--Capital Stock" for a description of the characteristics and
rights of the Preferred Shares. All references to the deposit, surrender and
delivery of the ADS or the ADRs refer not only to the physical transfer of any
certificates representing such ADRs but also to any book-entry transfers.
The Preferred Shares represented by ADSs were deposited pursuant to the
Deposit Agreement by book-entry transfer to an account of the Custodian and
registered in the name of the Custodian. The Depositary is the holder of
record on the books of the Custodian of all such Preferred Shares.
The Depositary has agreed, subject to the terms and conditions of the
Deposit Agreement, that upon delivery (including by book-entry credit) to the
Custodian of the Preferred Shares (or evidence of rights to receive Preferred
Shares) and pursuant to appropriate instruments of transfer in a form
satisfactory to the Custodian, the Depositary will, upon payment of the fees,
charges and taxes provided in the Deposit Agreement, execute and deliver at
its Corporate Trust Office to, or upon the written order of, the person or
persons named in the notice of the Custodian delivered to the Depositary or
requested by the person depositing such Preferred Shares with the Depositary,
an ADR or ADRs, registered in the name or names of such person or persons, and
evidencing any authorized number of ADSs requested by such person or persons.
The Depositary will refuse to accept Preferred Shares for deposit whenever
it is notified in writing that such deposit would result in any violation of
applicable laws.
Upon surrender at the Corporate Trust Office of the Depositary of an ADR for
the purpose of withdrawal of the Deposited Securities represented by the ADSs
evidenced by such ADR, and upon payment of the fees of the Depositary,
governmental charges and taxes provided in the Deposit Agreement, and subject
to the terms and conditions of the Deposit Agreement, the By-laws, the
Deposited Securities and applicable law, the Owner of such ADR will be
entitled to book-entry credit with the Registrar together with physical
delivery (if physical delivery is permitted under the By-laws), to him or upon
his order, as permitted by applicable law, of the amount of Deposited
Securities at the time represented by the ADS or ADSs evidenced by such ADR.
Any forwarding of share certificates (if any), other securities, property,
cash and other documents of title for such delivery will be at the risk and
expense of the Owner.
Subject to the terms and conditions of the Deposit Agreement and any
limitations that may be established by the Depositary and unless requested by
the Registrant to cease doing so, the Depositary may execute and deliver ADRs
prior to the receipt of Preferred Shares (a "Pre-Release"), may deliver
Preferred Shares upon the receipt, and cancellation of ADRs which have been
Pre-Released, whether or not such cancellation is prior to the termination of
such Pre-Release or the Depositary knows that such ADR has been Pre-Released,
and may receive ADRs in lieu of Preferred Shares in satisfaction of a Pre-
Release.
Each Pre-Release must be (a) preceded or accompanied by a written
representation and agreement from the person to whom the ADRs are to be
delivered (the "Pre-Release") that the Pre-Release or its customer (i) owns
the Preferred Shares or ADRs to be remitted, as the case may be, (ii) assigns
all beneficial right, title and interest in such Preferred Shares or ADRs, as
the case may be, to the Depositary for the benefit of the Owners and (iii)
agrees in effect to hold such Preferred Shares or ADRs, as the case may be,
for the account of the Depositary
69
<PAGE>
until delivery of the same upon Depositary's request, represented by ADSs
outstanding (without giving effect to ADSs evidenced by ADRs outstanding as a
result of the Pre-Release) (b) at all times fully collateralized with cash or
U.S. government securities, (c) terminable by the Depositary on not more than
five business days' notice and (d) subject to such further indemnities and
credit regulations as the Depositary deems appropriate. The Depositary will
set limits with respect to Pre-Release transactions to be entered into
hereunder with any particular Pre-Releasee on a case by case basis as the
Depositary deems appropriate. The collateral referred to in clause (b) above
shall be held by the Depositary for the benefit of the Owners as security for
the performance of the Pre-Releasee's obligations to the Depositary in
connection with a Pre-Release transaction, including the Pre-Releasee's
obligation to deliver Preferred Shares or ADRs upon termination of a Pre-
Release transaction.
The Depositary will also limit the number of ADRs involved in such Pre-
Release transactions so that Preferred Shares not deposited but represented by
ADSs outstanding at any time as a result of Pre-Releases will not normally
exceed thirty percent (30%) of the ADSs outstanding (without giving effect to
ADSs evidenced by ADRs outstanding as a result of the Pre-Release), but the
Depositary reserves the right to disregard such limit from time to time as it
deems appropriate and may, with the prior written consent of the Registrant,
change such limit for purposes of general application. The Depositary may
retain for its own account any compensation received by it in connection with
the foregoing. Neither the Registrant nor the Custodian shall incur any
liability to Owners of ADRs as a result of such transactions.
Dividends, Other Distributions and Rights
The Depositary is required to convert, as promptly as practicable and, in
any event, within one business day of its receipt thereof, into U.S. dollars,
all cash dividends or other distributions, net proceeds from the sale of
securities, property or rights, denominated in any currency other than U.S.
dollars that it receives in respect of the deposited Preferred Shares if
permitted under applicable laws and the Depositary determines that such
conversion into U.S. dollars and transfer to the United States can be effected
on a reasonable basis. If at the time of conversion, the resulting U.S.
dollars can, pursuant to applicable law, be transferred out of Brazil for
distribution, the Depositary will as promptly as practicable distribute the
amount received to the Owner entitled thereto in proportion to the number of
ADSs evidenced by such Owner's ADRs without regard to any distinctions among
Owners on account of exchange restrictions or otherwise. The amount
distributed will be reduced by any amounts to be withheld by the Registrant,
the Depositary or the Custodian, including amounts on account of any
applicable taxes and certain other expenses. For further details about
applicable taxes, see "Taxation."
If such conversion, transfer or distribution can be effected only with the
approval or license of any government or agency thereof, the Depositary will
file as promptly as practicable such application for approval or license;
however, the Depositary will be entitled to rely upon Brazilian local counsel
in such matters, which counsel will be instructed to act as promptly as
possible. If, pursuant to applicable law, any foreign currency received by the
Depositary or the Custodian cannot be converted to U.S. dollars, or if any
approval or license of any government or agency thereof that is required for
such conversion is denied or, in the opinion of the Depositary, cannot be
promptly obtained at a reasonable cost, the Depositary will, (a) as to the
portion of the foreign currency that is convertible into U.S. dollars, make
such conversion and (i) if permitted by applicable law, transfer such U.S.
dollars to the United States and distribute them to the Owners entitled
thereto or (ii) to the extent that such transfer is not permitted, hold such
U.S. dollars for the benefit of the Owners entitled thereto, uninvested and
without liability for interest thereon and (b) as to the nonconvertible
balance, if any, (i) if requested in writing by an Owner, distribute or cause
the Custodian to distribute the foreign currency (or an appropriate document
evidencing the right to receive such foreign currency) received by the
Depositary or the Custodian to such Owner and (ii) the Depositary shall hold
or will cause the Custodian to hold any amounts of nonconvertible foreign
currency not distributed pursuant to the immediately preceding subclause (i)
uninvested and without liability for the interest thereon for the respective
accounts of the Owners entitled to receive the same.
If the Registrant declares a dividend in, or free distribution of,
additional Preferred Shares with respect to the Preferred Shares represented
by the ADSs, the Depositary may, or will if the Registrant so requests,
distribute
70
<PAGE>
as promptly as practicable to the Owners of outstanding ADRs entitled thereto,
in proportion to the number of ADSs evidenced by their respective ADRs,
additional ADRs evidencing an aggregate number of ADSs that represents the
number of Preferred Shares received as such dividend or free distribution,
subject to the terms and conditions of the Deposit Agreement with respect to
the deposit of Preferred Shares and the issuance of ADSs evidenced by ADRs,
including the withholding of any tax or other governmental charge and the
payment of fees of the Depositary.
The Depositary may withhold any such distribution of ADRs if it has not
received satisfactory assurances from the Registrant that such distribution
does not require registration under the Securities Act or is exempt from
registration under the provisions of such Act. In lieu of delivering ADRs for
fractional ADSs in the event of any such dividend or free distribution, the
Depositary will sell the amount of Preferred Shares represented by the
aggregate of such fractions and distribute the net proceeds in accordance with
the Deposit Agreement. If additional ADRs are not so distributed, each ADS
will thereafter also represent the additional Preferred Shares distributed
upon the Deposited Securities represented thereby.
If the Registrant offers, or causes to be offered, to the holders of
Preferred Shares any rights to subscribe for additional Preferred Shares or
any rights of any other nature, the Depositary, after consultation with the
Registrant, will have discretion as to the procedure to be followed in making
such rights available to Owners or in disposing of such rights for the benefit
of such Owners and making the net proceeds available to such Owners. If, by
the terms of such rights offering or for any other reason, it would be
unlawful for, the Depositary to either make such rights available to any
Owners or dispose of such rights and make the net proceeds available to such
Owners, then the Depositary will allow the rights to lapse. If at the time of
the offering any rights, the Depositary determines in its discretion that it
is lawful and feasible to make such rights available to all or certain Owners,
the Depositary may, and at the request of the Company will, distribute to any
Owners to whom it determines the distribution to be lawful and feasible, in
proportion to the number of ADSs held by such Owner, warrants or other
instruments therefor in such form as it deems appropriate.
If the Depositary determines that it is not lawful or feasible to make such
rights available to all or certain Owners, it may, and at the request of the
Registrant, will use its best efforts that are reasonable under the
circumstances to, sell the rights, warrants or other instruments in proportion
to the number of ADSs held by the Owners to whom it has determined it may not
lawfully or feasibly make such rights available, and allocate net proceeds of
such sales for the account of such Owners otherwise entitled to such rights,
warrants or other instruments, upon an averaged or other practical basis
without regard to any distinctions among such Owners because of exchange
restrictions or the date of delivery of any ADR or ADRs or otherwise. The
Depositary will not be responsible for any failure to determine that it may be
lawful or feasible to make such rights available to Owners in general or any
Owner or Owners in particular.
In circumstances in which rights would not otherwise be distributed, if an
Owner requests the distribution of warrants or other instruments in order to
exercise the rights allocable to the ADSs of such Owner, the Depositary will
promptly make such rights available to such Owner upon written notice from the
Registrant to the Depositary that (a) the Registrant has elected in its sole
discretion to permit such rights to be exercised and (b) such Owner has
executed such documents as the Registrant has determined in its sole
discretion are reasonably required under applicable law. Upon instruction
pursuant to such warrants or other instruments to the Depositary from such
Owner to exercise such rights, upon payment by such Owner to the Depositary
for the account of such Owner of an amount equal to the purchase price of the
Preferred Shares to be received in exercise of the rights, and upon payment of
the fees of the Depositary as set forth in such warrants or other instruments,
the Depositary will, on behalf of such Owner, exercise the rights and purchase
the Preferred Shares, and the Registrant will cause the Preferred Shares so
purchased to be delivered to the Depositary on behalf of such Owner. As agent
for such Owner, the Depositary will cause the Preferred Shares so purchased to
be deposited, and will execute and deliver ADRs to such Owner, pursuant to the
Deposit Agreement. Such a disposal of rights may reduce the Owners'
proportionate equity interest in the Registrant.
71
<PAGE>
The Depositary will not offer rights to Owners having an address of record
in the United States unless a registration statement under the Securities Act
is in effect with respect to such rights and the Securities to which such
rights relate or unless the offering and sale thereof to such Owners are
exempt from registration under the Securities Act; however, the Registrant
will have no obligation to file a registration statement under the Securities
Act to make available to Owners any rights to subscribe for or to purchase any
of the Securities.
Whenever the Depositary receives any distribution other than cash, Preferred
Shares of rights in respect of the Deposited Securities, the Depositary will,
as promptly and practicable, cause the securities or property received by it
to be distributed to the Owners entitled thereto, after deduction or upon
payment of any fees and expenses of the Depositary or any taxes or other
governmental charges, in proportion to their holdings, respectively, in any
manner that the Depositary may deem equitable and practicable for
accomplishing such distribution; provided, however, that if in the opinion of
the Depositary such distribution cannot be made proportionately among the
Owners entitled thereto, or if for any other reason (including, but not
limited to, any requirement that the Registrant or the Depositary withhold an
amount on account of taxes or other governmental charges or that such
securities must be registered under the Securities Act, in order to be
distributed to Owners) the Depositary deems such distribution not to be
feasible, the Depositary may, after consultation with the Registrant, adopt
such method as it may deem equitable and practicable for the purpose of
effecting such distribution, including, but not limited to, the public or
private sale of the securities or property thus received, or any part thereof,
and the net proceeds of any such sale (net of the fees and expenses of the
Depositary) will be distributed by the Depositary to the Owners entitled
thereto as in the case of a distribution received in cash.
In connection with any distribution to Owners, the Registrant will remit to
the appropriate governmental authority or agency all amounts (if any) required
to be withheld by the Registrant and owing to such authority or agency by the
Registrant; and the Depositary and the Custodian will remit to the appropriate
governmental authority or agency all amounts (if any) required to be withheld
and owing to such authority or agency by the Depositary or Custodian. If the
Depositary determines that any distribution of property other than cash
(including Preferred Shares and rights to subscribe therefor) is subject to
any tax or governmental charge that the Depositary is obligated to withhold,
the Depositary may, by public or private sale, dispose of all or a portion of
such property in such amounts and in such manner as the Depositary deems
necessary and practicable to pay such taxes or governmental charges, and the
Depositary will distribute the net proceeds of any such sale or the balance of
any such property after deduction of such taxes or governmental charges to the
Owners entitled thereto in proportion to the number of ADSs held by them,
respectively.
Upon any change in nominal or par value, or split-up, consolidation or any
other reclassification of Deposited Securities, or upon any recapitalization,
reorganization, merger or consolidation or sale of assets affecting the
Registrant or to which it is a party, any Preferred Shares or other securities
that will be received by the Depositary or the Custodian in exchange for, in
conversion of, or in respect of Deposited Securities will be treated as new
Deposited Securities under the Deposit Agreement, and ADSs will thenceforth
represent, in addition to the existing Deposited Securities, the right to
receive the new Deposited Securities so received in exchange or conversion,
unless additional ADRs are delivered pursuant to the following sentence. In
any such case the Depositary may, and will if the Company so requests, execute
and deliver additional ADRs as in the case of a distribution in Preferred
Shares, or call for the surrender of outstanding ADRs to be exchanged for new
ADRs specifically describing such new Deposited Securities.
Record Dates
Whenever any cash dividend or other cash distribution shall become payable,
or whenever any distribution other than cash shall be made, or whenever rights
shall be issued with respect to the Deposited Securities, or whenever for any
reason the Depositary causes a change in the number of Preferred Shares that
are represented by each ADS or whenever the Depositary shall receive notice of
any meeting of holders of Preferred Shares or other Deposited Securities, or
whenever the Depositary shall find it necessary or convenient, the Depositary
will fix a record date, which date shall, to the extent practicable, be either
the same date as the record date fixed by the Registrant or, if different from
the record date fixed by the Registrant, fixed after consultation with the
72
<PAGE>
Registrant, (a) for the determination of the Owners who will be (i) entitled
to receive such dividend, distribution of rights, or the net proceeds of the
sale thereof, or (ii) entitled to give instructions for the exercise of voting
rights at any such meeting, or (b) on or after which such ADS will represent
the changed number of Preferred Shares, all subject to the provisions of the
Deposit Agreement.
Voting of the Deposited Securities
Preferred Shares do not entitle the holders thereof to vote on any matter
presented to a vote of shareholders of the Registrant except as set forth
under "--Capital Stock--Voting Rights." With respect to the circumstances set
forth thereunder and if, in the future, the terms of the Preferred Shares
should be revised or amended so as to provide for voting rights, or should the
Preferred Shares obtain voting rights pursuant to the Brazilian Corporation
Law or through any change in the laws, rules, or regulations applicable to
such shares or through any change in interpretation of such laws, the
following shall apply.
As soon as practicable after receipt of notice of any meeting or
solicitation of consents or proxies of holders of Preferred Shares or other
Deposited Securities, if requested in writing by the Registrant, the
Depositary will, as soon as practicable thereafter, mail to all Owners a
notice, the form of which notice will be in the sole
discretion of the Depositary, containing (a) the information included in such
notice of meeting received by the Depositary from the Registrant (or a summary
in English of the notice of such meeting), (b) a statement that the Owners as
of the close of business on a specified record date will be entitled, subject
to any applicable provision of Brazilian law, the By-laws and the provisions
of the Deposited Securities, to instruct the Depositary as to the exercise of
the voting rights, if any, pertaining to the Preferred Shares or other
Deposited Securities represented by their respective ADSs and (c) a statement
as to the manner in which such instructions may be given, including an express
indication that instructions may be given or deemed given in accordance with
the last sentence of this paragraph if no instruction is received, to the
Depositary to give a discretionary proxy to a person designated by the
Registrant. Upon the written request of an Owner on such record date, received
on or before the date established by the Depositary for such purpose, the
Depositary will endeavor, insofar as practicable, to vote or cause to be voted
the amount of Preferred Shares or other Deposited Securities represented by
the ADSs evidenced by such ADRs in accordance with the instructions set forth
in such request. The Depositary may not itself exercise any voting discretion
over any Preferred Shares. If the Depositary does not receive instructions
from an Owner on or before the date established by the Depositary for such
purpose, the Depositary will deem such Owner to have instructed the Depositary
to give a discretionary proxy to a person designated by the Registrant to vote
the underlying Preferred Shares, provided that no such discretionary proxy
will be given with respect to any matter as to which the Registrant informs
the Depositary that (i) the Registrant does not wish such proxy given, (ii)
substantial opposition exists or (iii) the rights of holders of Preferred
Shares will be materially and adversely affected. Under Brazilian law the
Depositary may vote the Preferred Shares or other Deposited Securities
represented by ADSs and evidenced by ADRs in accordance with the instructions
of the Owners even if those instructions differ among such Owners.
Owners are not entitled to attend meetings of shareholders. An Owner wishing
to do so must cancel its ADRs and obtain delivery of the underlying shares,
registered in the name of such Owner, prior to the record date for attendance
at such meeting.
Reports and Other Communications
The Depositary will make available for inspection by Owners at its Corporate
Trust Office any reports and communications, including any proxy soliciting
material, received from the Registrant, which are both (a) received by the
Depositary as the holder of the Deposited Securities and (b) made generally
available to holders of such Deposited Securities by the Registrant. The
Depositary will also send to Owners copies of such reports when furnished by
the Registrant pursuant to the Deposit Agreement. Any such reports and
communications furnished to the Depositary by the Registrant will be furnished
in English, to the extent that such materials are required to be translated
into English pursuant to any regulations of the Commission.
73
<PAGE>
Amendment and Termination of the Deposit Agreement
The form of the ADRs and any provision of the Deposit Agreement may at any
time and from time to time be amended by agreement between the Registrant and
the Depositary in any respect which they may deem necessary or desirable. Any
amendment that imposes or increases any fees or charges (other than taxes and
other governmental charges, registration fees, cable, telex or facsimile
transmission costs, delivery costs or other such expenses), or which otherwise
prejudices any substantial existing rights of Owners, will not take effect as
to the outstanding ADRs until the expiration of 30 days after notice of such
amendment has been given to the Owners of outstanding ADRs. Every Owner and
Beneficial Owner at the time such amendment becomes effective will be deemed,
by continuing to hold such ADR, to consent and agree to such amendment and to
be bound by the Deposit Agreement as amended thereby. In no event will any
amendment impair the right of any Owner to surrender his ADR and receive
therefor the Preferred Shares and other property represented thereby, except
to comply with mandatory provisions of applicable law.
The Depositary will at any time at the direction of the Registrant terminate
the Deposit Agreement by mailing notice of such termination to the Owners then
outstanding at least 30 days prior to the date fixed in such notice for such
termination. The Depositary may likewise terminate the Deposit Agreement by
mailing notice of such termination to the Registrant and the Owners, if at any
time after 60 days have expired after the Depositary shall have delivered
written notice of its election to resign to the Registrant, a successor
depositary shall not have been appointed and accepted its appointment, in
accordance with the terms of the Deposit Agreement. If any ADRs remain
outstanding after the date of termination, the Depositary thereafter will
discontinue the registration of transfer of ADRs, will suspend the
distribution of dividends to the holders thereof and will not give any further
notices or perform any further acts under the Deposit Agreement, except for
(1) the collection of dividends and other distributions pertaining to the
Deposited Securities, (2) the sale of rights and other property and (3) the
delivery of Preferred Shares, together with any dividends or other
distributions received with respect thereto and the net proceeds of the sale
of any rights or other property, in exchange for surrendered ADRs (after
deducting, in each case, the fees of the Depositary for the surrender of an
ADR and other expenses set forth in the Deposit Agreement and any applicable
taxes or governmental charges).
At any time after the expiration of one year from the date of termination,
the Depositary may sell the Deposited Securities then held thereunder and hold
uninvested the net proceeds of such sale, together with any other cash,
unsegregated and without liability for interest, for the pro rata benefit of
the Owners that have not theretofore surrendered their ADRs, such Owners
thereupon becoming general creditors of the Depositary with respect to such
net proceeds. After making such sale, the Depositary will be discharged from
all obligations under the Deposit Agreement, except to account for net
proceeds and other cash (after deducting, in each case, the fee of the
Depositary and other expenses set forth in the Deposit Agreement for the
surrender of an ADR and any applicable taxes or other governmental charges)
and certain indemnification obligations. Upon termination of the Deposit
Agreement, the Registrant will also be discharged from all obligations
thereunder, except for certain obligations to the Depositary.
Charges of Depositary
The Depositary will charge (to the extent permitted by applicable law) any
party depositing or withdrawing Preferred Shares or any party surrendering
ADRs or to whom ADRs are issued (including, without limitation, issuance
pursuant to a stock dividend or stock split declared by the Company or an
exchange of stock regarding the ADRs or Deposited Securities or a distribution
of ADRs pursuant to the Deposit Agreement), whichever is applicable: (1) taxes
and other governmental charges, (2) such registration fees as may from time to
time be in effect for the registration of transfers of Preferred Shares
generally on the register of the Registrant or the Registrar and applicable to
transfers of Preferred Shares to the name of the Depositary or its nominee or
the Custodian or its nominee on the making of deposits or withdrawals under
the Deposit Agreement, (3) such cable, telex and facsimile transmission
expenses as are expressly provided in the Deposit Agreement to be at the
expense of persons depositing Preferred Shares or Owners, (4) such expenses as
are incurred by the Depositary in the conversion of foreign currency pursuant
to the Deposit Agreement, (5) a fee not in excess of $5.00 per
74
<PAGE>
100 ADSs (or portion thereof) for the execution and delivery of ADRs pursuant
to the Deposit Agreement and the surrender of ADRs pursuant to the Deposit
Agreement, and (6) a fee for the distribution of proceeds of sales of
securities or rights pursuant to the Deposit Agreement, such fee (which may be
deducted from such proceeds) being in an amount equal to the lesser of (i) the
fee for issuance of ADSs referred to above which would have been charged as a
result of the deposit of such securities (for purposes of this clause treating
all such securities as if they were Preferred Shares) or Preferred Shares
received in exercise of rights distributed to them pursuant to the Deposit
Agreement, but which securities or rights are instead sold by the Depositary
and the net proceeds distributed and (ii) the amount of such proceeds.
The Depositary, pursuant to the Deposit Agreement, may own and deal in any
class of securities of the Company and its affiliates and in ADRs.
Liability of Owners or Beneficial Owners for Taxes or Other Charges
If any tax or other governmental charge shall become payable by the
Custodian, the Depositary or its nominee with respect to any ADR or any
Deposited Securities represented by the ADSs evidenced by such ADR, such tax
or other governmental charge will be payable by the Owner or Beneficial Owner
of such ADR. The Depositary may refuse to effect registration of transfer of
such ADR or any split-up or combination thereof or any withdrawal of Deposited
Securities underlying such ADR until such payment is made, and may withhold
any dividends or other distributions or may sell for the account of such Owner
or Beneficial Owner any part or all of the Deposited Securities underlying
such ADR and may apply such dividends or distributions or the proceeds of any
such sale in payment of any such tax or other governmental charge (and any
taxes or expenses arising out of such sale) and the Owner or Beneficial Owner
of such ADR will remain liable for any deficiency.
Limitation on Execution, Delivery, Transfer and Surrender of ADRs
The ADRs are transferable on the books of the Depositary, provided that the
Depositary may close the transfer books after consultation with the Registrant
to the extent practicable at any time or from time to time when deemed
expedient by it in connection with the performance of its duties or at the
request of the Registrant.
As a condition precedent to the execution and delivery, registration of
transfer, split-up, combination or surrender of any ADR, the delivery of any
distribution thereon or the withdrawal of Deposited Securities, the
Depositary, the Registrant, the Custodian or the Registrar may require payment
from the depositor of Preferred Shares or the presenter of the ADR of a sum
sufficient to reimburse it for any tax or other governmental charge and any
stock transfer or registration fee with respect thereto (including any such
tax, charge or fee with respect to Preferred Shares being deposited or
withdrawn) and payment of any other applicable fees provided for in the
Deposit Agreement. The Depositary may refuse to deliver ADRs, register the
transfer of any ADR or make any distribution of, or related to, the Preferred
Shares until it has received such proof of citizenship, residence, exchange
control approval, compliance with all applicable laws or regulations, or other
information as it may reasonably deem necessary or proper. The delivery,
transfer, registration of transfer, split-up, combination and surrender of
ADRs generally may be suspended or refused during any period when the transfer
books of the Depositary, the Registrant or the Registrar are closed or if any
such action is deemed necessary or advisable by the Depositary or the
Registrant, at any time or from time to time.
The Depositary will keep books, at its Corporate Trust Office, for the
registration and transfer of ADRs, which at all reasonable times will be open
for inspection by the Owners, provided that such inspection will not be for
the purpose of communicating with Owners in the interest of a business or
object other than the business of the Registrant or a matter related to the
Deposit Agreement or the ADRs.
The Depositary may upon notice to the Registrant appoint one or more co-
transfer agents reasonably acceptable to the Registrant for the purpose of
effecting transfers, combinations and split-ups of ADRs at designated transfer
offices on behalf of the Depositary. In carrying out its functions, a co-
transfer agent may require evidence of authority and compliance with
applicable laws and other requirements by Owners or persons entitled to ADRs
and will be entitled to protection and indemnity to the same extent as the
Depositary.
75
<PAGE>
Limitation of Liability
Neither the Depositary nor the Registrant nor any of their respective
directors, employees, agents or affiliates will be liable to any Owners or
Beneficial Owners of ADRs if by reason of any provision of any present or
future law or regulation of the United States, Brazil or any other country, or
of any other governmental or regulatory authority or stock exchange, or by
reason of any provision, present or future, of the By-laws, or by reason of
any act of God or war or other circumstance beyond its control, the Depositary
or the Registrant or any of their respective directors, employees, agents, or
affiliates shall be prevented, delayed or forbidden from, or be subject to any
civil or criminal penalty on account of, doing or performing any act or thing
which by terms of the Deposit Agreement it is provided will be done or
performed; nor will the Depositary or the Registrant incur any liability to
any Owner or Beneficial Owner of any ADR by reason of any nonperformance or
delay, caused as aforesaid, in the performance of any act or thing which by
the terms of the Deposit Agreement it is provided will or may be done or
performed, or by reason of any exercise of, or failure to exercise, any
discretion provided for under the Deposit Agreement. Where, by the terms of a
distribution pursuant to the Deposit Agreement, or an offering or distribution
pursuant to the Deposit Agreement, or for any other reason, the Depositary is
prevented or prohibited from making such distribution or offering available to
Owners, and the Depositary is prevented or prohibited from making such
distribution or offering on behalf of such Owners and making the net proceeds
available to such Owners, then the Depositary, after consultation with the
Registrant, will not make such distribution or offering, and will allow the
rights, if applicable, to lapse.
The Registrant and the Depositary assume no obligation nor will they be
subject to any liability under the Deposit Agreement to Owners or Beneficial
Owners of ADRs, except that they agree to perform their respective obligations
specifically set forth under the Deposit Agreement without negligence or bad
faith.
Governing Law
The Deposit Agreement is governed by the laws of the State of New York.
76
<PAGE>
PART III
Item 15: Defaults upon Senior Securities
The Company is party to certain credit agreements that contain covenants
restricting, among other things, (i) the ability of Telebras to dispose of all
or a substantial part of its assets or to cease to control a company that was
an operating subsidiary of the Telebras System and (ii) the ability of the
Federal Government to dispose of its controlling interest in the Telebras
System. The Breakup of Telebras on May 22, 1998, the privatization of the New
Holding Companies on July 29, 1998 and the announced liquidation of Telebras
constitute events of default under such credit agreements. In addition, most
of the Company's other credit agreements include cross-default provisions and
cross-acceleration provisions that would permit the holders of such
indebtedness to declare the indebtedness to be in default and to accelerate
the maturity thereof if a significant portion of the principal amount of the
Company's debt is in default or accelerated. The total amount of the Company's
outstanding debt as of December 31, 1997, which is currently, or is expected
to be in default is R$462.2 million. The Company is currently in negotiations
with the appropriate creditors with respect to this indebtedness. Although
none of the Company's creditors have notified the Company that they intend to
pursue their rights and remedies with respect to these defaults, there can be
no assurance that the Company will be able to obtain waivers or that the
creditors will not exercise their rights and remedies under the credit
agreements.
Item 16: Changes in Securities and Changes in Security for Registered
Securities
Not applicable.
PART IV
Item 17: Consolidated Financial Statements
The Registrant has responded to Item 18 in lieu of responding to this Item.
Item 18: Consolidated Financial Statements
Reference is made to pages F-1 through F-47.
Item 19: Consolidated Financial Statements and Exhibits
(a) The following Consolidated Financial Statements are filed as part of
this Form 20-F:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 1996 and 1997
Consolidated Statements of Income for the Years Ended December 31, 1995,
1996 and 1997
Consolidated Statements of Cash Flows for the Years Ended December 31,
1995, 1996 and 1997
Consolidated Statements of Changes in Shareholders' Equity for the Years
Ended December 31, 1995, 1996 and 1997
Notes to the Consolidated Financial Statements
(b) The following Unaudited Consolidated Condensed Financial Statements are
filed as part of this Form 20-F:
Unaudited Consolidated Condensed Balance Sheets as of December 31, 1997
and September 30, 1998
Unaudited Consolidated Condensed Statements of Operations for the Nine
Months Ended September 30, 1997 and 1998
Unaudited Consolidated Condensed Statements of Cash Flows for the Nine
Months Ended September 30, 1997 and 1998
Notes to the Unaudited Consolidated Condensed Financial Statements
(c) Exhibits
1.1* Charter of the Registrant
1.2* Charter of the Registrant (English translation)
2.1* Deposit Agreement dated as of July 27, 1998 among the Registrant,
The Bank of New York, as Depositary, and Owners and Beneficial
Owners of American Depositary Receipts issued thereunder
77
<PAGE>
10.1* Standard Concession Agreement for Domestic Long-Distance,
Switched, Fixed-Line Telephone Service (Embratel)
10.2* Standard Concession Agreement for Domestic Long-Distance,
Switched, Fixed-Line Telephone Service (Embratel) (English
translation)
10.3* Standard Concession Agreement for International Long-Distance,
Switched, Fixed-Line Telephone Service (Embratel)
10.4* Standard Concession Agreement for International Long-Distance,
Switched, Fixed-Line Telephone Service (Embratel) (English
translation)
10.5** Management Agreement between MCI WORLDCOM and the Company.
23.1** Consent of KPMG Peat Marwick.
- --------
* Previously filed
** Filed herewith
78
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of
1934, the Registrant certifies that it meets all of the requirements for
filing on Form 20-F and has duly caused this amendment to its registration
statement on Form 20-F, Commission File No. 001-14499, to be signed on its
behalf by the undersigned, thereunto duly authorized.
Embratel Participacoes S.A.
/s/ Daniel Eldon Crawford
By: _________________________________
Name: Daniel Eldon Crawford
Title:President
/s/ Dilio Sergio Penedo
By: _________________________________
Name: Dilio Sergio Penedo
Title:Vice-President and Investor
Relations Director
Dated: March 16, 1999
79
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1995, 1996 and 1997
CONTENTS
<TABLE>
<S> <C>
Independent Auditors' Report.................................. F-2
Consolidated Balance Sheets................................... F-3
Consolidated Statements of Income............................. F-4
Consolidated Statements of Cash Flows......................... F-5
Consolidated Statements of Changes in Shareholders' Equity.... F-6
Notes to the Consolidated Financial Statements................ F-7 through F-48
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
Embratel Participacoes S.A.
We have audited the accompanying consolidated balance sheets of Embratel
Participacoes S.A. as of December 31, 1996 and 1997, and the related
consolidated statements of income, cash flows and changes in shareholders'
equity for each of the years in the three-year period ended December 31, 1997.
These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards in Brazil, which do not differ in any material respects from
generally accepted auditing standards in the United States of America. Those
standards require that we plan and perform the audit to obtain reasonable
assurance about whether the consolidated financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting amounts and disclosures in the consolidated financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Embratel
Participacoes S.A. as of December 31, 1996 and 1997, and the results of its
operations and its cash flows for each of the years in the three-year period
ended December 31, 1997, in conformity with accounting principles generally
accepted in Brazil, including continued recognition of the effects of changes
in the purchasing power of the Brazilian currency as discussed in Note 2.
Generally accepted accounting principles in Brazil vary in certain respects
from generally accepted accounting principles in the United States of America.
Application of generally accepted accounting principles in the United States
of America would have affected results of operations for each of the years in
the three-year period ended December 31, 1997 and shareholders' equity as of
December 31, 1996 and 1997 to the extent summarized in Note 29 of the
consolidated financial statements.
July 17, 1998
Brasilia, Brazil
KPMG Peat Marwick
F-2
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
CONSOLIDATED BALANCE SHEETS
December 31, 1996 and 1997
(In thousands of constant Brazilian Reais--R$ of
December 31, 1997 and thousands of US dollars--US$)
<TABLE>
<CAPTION>
December 31
-----------------------------
1996 1997 1997
Note R$ R$ US$
---- --------- --------- ---------
Unaudited
(Note 2b)
<S> <C> <C> <C> <C>
Current assets:
Other cash and cash equivalents:
Deposits with Banco do Brasil............. 24 647,006 694,699 353,752
Other cash and cash equivalents........... 10 58,260 60,037 30,572
Accounts receivable:
Trade, net................................ 11 303,765 235,504 119,923
Trade receivables from related parties.... 24 139,861 222,271 113,184
Deferred and recoverable taxes............ 12 150,794 249,261 126,928
Other assets:
Other accounts receivable from related
parties.................................. 24 4,710 7,062 3,596
Loans and financing receivable from
related parties.......................... 24 12,795 4,994 2,543
Other..................................... 13 64,725 79,944 40,709
--------- --------- ---------
Total current assets..................... 1,381,916 1,553,772 791,207
--------- --------- ---------
Noncurrent assets:
Other assets.............................. 13 57,021 47,798 24,339
--------- --------- ---------
Permanent assets:
Investments............................... 14 50,983 71,156 36,234
Property, plant and equipment, net........ 15 6,319,963 6,326,208 3,221,411
--------- --------- ---------
Total permanent assets................... 6,370,946 6,397,364 3,257,645
--------- --------- ---------
Total assets............................... 7,809,883 7,998,934 4,073,191
========= ========= =========
Current liabilities:
Payroll and related accruals.............. 16 106,759 113,574 57,834
Accounts payable and accrued expenses..... 17 450,247 430,158 219,044
Taxes other than income taxes............. 18 23,164 44,864 22,845
Proposed dividends:
Dividends and interest on own capital
payable to Telebras...................... 24 231,300 292,191 148,789
Dividends payable to others............... 2,928 3,890 1,981
Income taxes.............................. 8 6,203 22,577 11,497
Loans and financing....................... 19 150,692 108,406 55,202
Provisions for contingencies.............. 20 15,373 11,019 5,611
Other liabilities:
Payable to related parties................ 24 10,090 10,760 5,479
Other..................................... 41,147 38,598 19,655
--------- --------- ---------
Total current liabilities................ 1,037,903 1,076,037 547,937
--------- --------- ---------
Noncurrent liabilities:
Income taxes.............................. 8 240,423 314,786 160,294
Loans and financing....................... 19 448,578 471,468 240,079
Deferred income........................... 84,412 97,211 49,501
Other liabilities......................... 44,964 56,597 28,820
--------- --------- ---------
Total noncurrent liabilities............. 818,377 940,062 478,694
--------- --------- ---------
Minority interests......................... 2 74,420 74,791 38,085
--------- --------- ---------
Shareholders' equity:
Capital and reserves...................... 4,257,623 4,229,635 2,153,801
Retained earnings......................... 1,621,560 1,678,409 854,674
--------- --------- ---------
Total shareholders' equity............... 22 5,879,183 5,908,044 3,008,475
--------- --------- ---------
Total liabilities and shareholders'
equity.................................... 7,809,883 7,998,934 4,073,191
========= ========= =========
</TABLE>
See the accompanying notes to the consolidated financial statements
F-3
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 1995, 1996 and 1997
(In thousands of constant Brazilian Reais--R$ of
December 31, 1997 and thousands of US dollars--US$)
<TABLE>
<CAPTION>
Years ended December 31
---------------------------------------------
1995 1996 1997 1997
Note R$ R$ R$ US$
----- ---------- ---------- ---------- ---------
Unaudited
(Note 2b)
<S> <C> <C> <C> <C> <C>
Net operating revenue
from telecommunication
services:
Services provided to
third parties......... 4 981,172 1,290,061 1,089,464 554,773
Services provided to
the Telebras operating
companies............. 4, 24 740,024 797,569 1,123,492 572,101
---------- ---------- ---------- ---------
1,721,196 2,087,630 2,212,956 1,126,874
---------- ---------- ---------- ---------
Cost of services:
Provided by third
parties .............. 5 (1,131,137) (1,135,944) (1,093,413) (556,784)
Provided by the
Telebras operating
companies ............ 5, 24 (11,583) (9,669) (4,150) (2,113)
---------- ---------- ---------- ---------
(1,142,720) (1,145,613) (1,097,563) (558,897)
---------- ---------- ---------- ---------
Gross profit............. 578,476 942,017 1,115,393 567,977
Operating expenses:
Selling expense........ (147,556) (160,243) (230,808) (117,531)
General and
administrative
expense............... (245,372) (237,216) (213,617) (108,777)
Other net operating
income (expense)...... 6 36,400 (47,812) (84,621) (43,090)
---------- ---------- ---------- ---------
Operating income before
interest................ 221,948 496,746 586,347 298,579
Interest income.......... 54,992 86,622 97,809 49,806
Interest expense......... -- (30,723) (40,110) (20,425)
---------- ---------- ---------- ---------
Operating income......... 276,940 552,645 644,046 327,960
Write-off of property and
equipment from physical
inventory............... 15 (94,298) -- -- --
Net other nonoperating
expense................. 7 (53,221) (95,962) (284,179) (144,709)
---------- ---------- ---------- ---------
Income before taxes and
other charges........... 129,421 456,683 359,867 183,251
Income and social
contribution taxes...... 8 54,661 (13,861) 52,018 26,488
---------- ---------- ---------- ---------
Income before employees'
profit share and
minority interests...... 184,082 442,822 411,885 209,739
Employees' profit share.. (21,766) (22,642) (30,622) (15,593)
---------- ---------- ---------- ---------
Income before minority
interests............... 162,316 420,180 381,263 194,146
Minority interests....... 2 (2,041) (5,253) (4,766) (2,427)
---------- ---------- ---------- ---------
Net income............... 160,275 414,927 376,497 191,719
========== ========== ========== =========
</TABLE>
See the accompanying notes to the consolidated financial statements.
F-4
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1995, 1996 and 1997
(In thousands of constant Brazilian Reais--R$ of December 31, 1997 and
thousands of US dollars--US$)
<TABLE>
<CAPTION>
Years ended December 31
-----------------------------------------
1995 1996 1997 1997
R$ R$ R$ US$
-------- --------- --------- ---------
Unaudited
(Note 2b)
<S> <C> <C> <C> <C>
Cash provided by operations:
Net income.......................... 160,275 414,927 376,497 191,719
Adjustments to reconcile net income
to cash provided by operating
activities:
Depreciation and amortization...... 676,195 640,067 673,305 342,858
Minority interests................. 2,041 5,253 4,766 2,427
Losses on disposal and write-offs
of permanent assets............... 165,686 112,981 312,682 159,223
Allowance for doubtful accounts.... (2,222) - 10,163 5,175
Decrease in income tax rate........ 159,752 34,233 2,917 1,485
(Increase) decrease in trade
accounts receivables.............. 25,847 5,142 (24,312) (12,380)
(Increase) decrease in other
accounts receivable from related
parties........................... (1,179) 3,081 (2,352) (1,198)
Decrease in loans and financing
receivable from related parties... 37,998 10,698 7,801 3,972
(Increase) decrease in other
current assets.................... (136,910) 36,306 (15,219) (7,750)
(Increase) decrease in other
noncurrent assets................. (15,812) (941) 9,223 4,697
Increase (decrease) in payroll and
related accruals.................. (5,860) 25,002 6,815 3,470
Increase (decrease) in accounts
payable and accrued expenses...... 135,012 85,386 (20,089) (10,230)
Increase (decrease) in taxes other
than income taxes................. (4,497) 2,620 21,700 11,050
Increase (decrease) in payable to
related parties................... 259 (969) 670 341
Increase (decrease) in other
current liabilities............... (13,399) 303 (2,549) (1,298)
Increase (decrease) in accrued
interest.......................... 2,822 (1,207) (724) (369)
Decrease in income taxes........... (263,393) (51,310) (169,660) (86,394)
Decrease in provisions for
contingencies..................... (9,852) (13,952) (4,354) (2,217)
Increase in deferred income........ 20,942 63,470 12,799 6,517
Increase in other noncurrent
liabilities....................... 4,556 7,209 11,633 5,927
-------- --------- --------- --------
938,261 1,378,299 1,211,712 617,025
-------- --------- --------- --------
Cash flow from investing activities:
Additions to investments............ (6,130) (1,260) (20,173) (10,272)
Additions to property, plant and
equipment.......................... (704,327) (941,864) (918,054) (467,489)
Capitalized interest................ (27,075) (13,341) (7,998) (4,073)
Proceeds from asset disposals....... 11,303 9,079 36,883 18,781
-------- --------- --------- --------
(726,229) (947,386) (909,342) (463,053)
-------- --------- --------- --------
Cash flow from financing activities:
Loans repaid........................ (72,168) (76,982) (105,955) (53,954)
New loans obtained.................. 78,563 140,026 87,283 44,446
Dividends paid:
Dividends paid to Telebras......... (162,990) (85,921) (231,300) (117,782)
Dividends paid to others........... (2,168) (1,143) (2,928) (1,491)
-------- --------- --------- --------
(158,763) (24,020) (252,900) (128,781)
-------- --------- --------- --------
Increase in cash and cash
equivalents......................... 53,269 406,893 49,470 25,191
Cash and cash equivalents at
beginning of year................... 245,104 298,373 705,266 359,133
-------- --------- --------- --------
Cash and cash equivalents at end of
year................................ 298,373 705,266 754,736 384,324
======== ========= ========= ========
</TABLE>
See the accompanying notes to the consolidated financial statements.
F-5
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years ended December 31, 1995, 1996 and 1997
(In thousands of constant Brazilian Reais--R$ of December 31, 1997)
<TABLE>
<CAPTION>
Capital
and Retained
reserves earnings Total
--------- --------- ---------
<S> <C> <C> <C>
Balances at December 31, 1994................. 4,120,432 1,371,614 5,492,046
Fiscal incentive investments.................. 13,508 -- 13,508
Interest on construction in progress.......... 122,840 -- 122,840
Change in tax rates........................... 128,440 31,312 159,752
Net income.................................... -- 160,275 160,275
Realization of reserves....................... (124,464) 124,464 --
Appropriations:
Transfers to reserves........................ 123,629 (123,629) --
Dividends.................................... -- (87,064) (87,064)
Minority interest movements.................. (1,120) 1,383 263
--------- --------- ---------
Balances at December 31, 1995................. 4,383,265 1,478,355 5,861,620
Fiscal incentive investments.................. 47 -- 47
Interest on construction in progress.......... 142,823 -- 142,823
Change in tax rates........................... (52,278) 86,511 34,233
Reversal of revaluation of permanent assets:
Permanent assets............................. (262,867) -- (262,867)
Tax effects of reversal...................... 80,319 80,319
Net income.................................... -- 414,927 414,927
Realization of unrealized income.............. (57,490) 57,490 --
Deferred tax on full indexation............... -- (163,203) (163,203)
Appropriations:
Transfers to reserves........................ 21,884 (21,884) --
Dividends.................................... -- (234,228) (234,228)
Minority interest movements.................. 1,920 3,592 5,512
--------- --------- ---------
Balances at December 31, 1996................. 4,257,623 1,621,560 5,879,183
Fiscal incentive investments.................. 904 -- 904
Interest on construction in progress.......... 102,160 -- 102,160
Change in tax rates........................... -- 2,917 2,917
Net income.................................... -- 376,497 376,497
Realization of unrealized income.............. (156,810) 156,810 --
Deferred tax on full indexation............... -- (138,120) (138,120)
Appropriations:
Transfers to reserves........................ 25,408 (25,408) --
Interest on own capital...................... -- (160,000) (160,000)
Dividends.................................... -- (159,891) (159,891)
Minority interest movements.................. 350 4,044 4,394
--------- --------- ---------
Balances at December 31, 1997................. 4,229,635 1,678,409 5,908,044
========= ========= =========
</TABLE>
See the accompanying notes to the consolidated financial statements.
F-6
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
1. Operations and background
Beginning in 1995, the Federal Government of Brazil (the "Federal
Government") undertook a comprehensive reform of the Brazilian regulation
of the telecommunications industry. In July 1995, the Federal Congress
adopted a General Telecommunications Law providing for the privatization of
Telecomunicacoes Brasileiras S.A. ("Telebras") which, through its 28
operating subsidiaries, was the primary supplier of public
telecommunications services in Brazil.
In preparation of the privatization of the Telebras system, the operating
companies have been divided into twelve separate groups, (a) three regional
fixed line operators, (b) eight regional cellular operators and (c) one
national long-distance operator, Empresa Brasileira de Telecomunicacoes
S.A.--Embratel, using a procedure under Brazilian corporate law called a
cisao or spin-off. As part of this process, Embratel Participacoes S.A.
(the "Holding Company") was formed.
Embratel Participacoes S.A. was formed on May 22, 1998, through the spin-
off of certain assets and liabilities of Telebras, including 98.7% of the
share capital of Empresa Brasileira de Telecomunicacoes S.A.--Embratel
("Embratel"). Until August 4, 1998, the Company was controlled by the
Federal Government (see Note 28).
The Company provides international and domestic long-distance
telecommunications services in Brazil. These services include data
communication, text and sound and image transmission and are performed
under the terms of a concession to be granted by the Federal Government
which will expire on December 31, 2005 and may be renewed for a further
term of 20 years.
The Company's business, including the services it may provide and the rates
it charges, is regulated by the Agencia Nacional de Telecomunicacoes
("Anatel"), the regulatory authority for the Brazilian telecommunications
industry pursuant to Law No. 9,472 of July 16, 1997 and the related
regulations, decrees, orders and plans.
2. Presentation of the consolidated financial statements
The consolidated financial statements present the consolidated financial
condition and results of operations of Embratel Participacoes and its
subsidiary, Embratel (the "Company"). The formation of the Holding Company
has been accounted for as a reorganization of entities under common control
in a manner similar to a pooling of interests. The portion of equity and
net income attributable to shareholders other than Telebras at December 31,
1996 and 1997, and for each of the years in the three year period ended
December 31, 1997 is reflected as "minority interests" in the consolidated
financial statements. At December 31, 1997, such minority shareholders
owned 1.7% of the share capital of Embratel.
The consolidated financial statements were prepared on a fully indexed
basis to recognize the effects of changes in the purchasing power of the
Brazilian currency during the periods presented.
a. Full indexation to December 31, 1997
The principal criteria adopted to prepare the fully indexed consolidated
financial statements, which are restated from amounts recorded in
Embratel's statutory accounting records maintained in accordance with the
practices described in Note 3, are as follows:
i. Inflation restatement index
The consolidated financial statements were indexed and expressed in
currency of constant purchasing power of December 31, 1997 by using the
monthly average values of the Fiscal Reference Unit ("UFIR') through
December 31, 1995 and the retail price index ("IGP-M') of the Getulio
Vargas Foundation in 1996 and 1997 following the cessation of the
widespread use of the UFIR which resulted from the change in Brazil's
corporate law.
F-7
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Inflation for the three year period ended December 31, 1997, as measured by
the UFIR and the IGP-M, was as follows:
<TABLE>
<CAPTION>
Annual inflation
Period Index %
------ ----- ----------------
<S> <C> <C>
Year ended December 31, 1995.......................... UFIR 22.5
Year ended December 31, 1996.......................... IGP-M 9.2
Year ended December 31, 1997.......................... IGP-M 7.7
</TABLE>
Management believes that these indices are appropriate indications of
general price level inflation to be used under Brazilian and US GAAP for
the years indicated.
In July 1997, the three-year cumulative inflation rate for Brazil fell
below 100%. However, for accounting purposes, the constant currency method
continued to be applied through December 31, 1997. The Brazilian Institute
of Accountants has not yet published definitive rules regarding when the
constant currency method of accounting may no longer be used to prepare
consolidated financial statements. If the Brazilian Institute of
Accountants determines that the constant currency method may no longer be
used to prepare consolidated financial statements beginning January 1,
1998, the restated balances of nonmonetary assets and liabilities of the
Company as of December 31, 1997 will become the new basis for accounting,
and consolidated statement of income items will no longer be restated for
inflation.
ii. Consolidated statements of income
Items in the consolidated statements of income are adjusted to the balance
sheet date by:
. allocating inflationary holding gains or losses on interest bearing
monetary assets and liabilities to their corresponding interest income
and expense captions; and,
. allocating inflationary holding gains and losses from other monetary
items to their corresponding income or expense captions. Amounts without
a corresponding income or expense caption were allocated "other net
operating income."
iii. Deferred income tax effects of indexation adjustments in 1996 and 1997
As a result of legislation mandating the discontinuation of the indexation
system for Brazilian corporate law and most fiscal purposes as from January
1, 1996, the indexation of assets and liabilities for financial reporting
purposes herein is not permitted for tax purposes. Accordingly, a deferred
tax liability arises for the excess of net assets shown for financial
reporting purposes over the tax basis of these net assets. The charge
relating to the additional deferred tax liabilities of R$163,203 and
R$138,120 in 1996 and 1997, respectively, was recorded directly against
retained earnings.
b. Translation of constant Brazilian Real amounts into U.S. dollar amounts
The translation of Brazilian Real amounts into U.S. dollar amounts is
unaudited and included solely for the convenience of readers outside of
Brazil and has been performed using the closing selling exchange rate
published by the Central Bank of Brazil of R$1.9638 to US$1.00 as of
February 1, 1999. This translation should not be construed as a
representation that Brazilian Real amounts could be converted to U.S.
dollars at this or any other rate.
c. Principles of Consolidation
These consolidated financial statements include the financial records of
the Holding Company and its subsidiary, Embratel. All material intercompany
accounts and transactions have been eliminated.
F-8
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
3. Summary of the principal accounting practices
a. Cash equivalents
Cash equivalents are considered to be all highly liquid temporary cash
investments with original maturity dates of three months or less.
b. Trade accounts receivable
Accounts receivable from affiliate operating companies and other customers
are calculated at the tariff rate on the date the services were rendered
and discounted to their present value at the balance sheet date by applying
the interest rate published by the National Association of Investment
Bankers ("ANBID'). Trade accounts receivable also include services provided
to customers up to the balance sheet date but not yet invoiced.
c. Allowance for doubtful accounts
Provision is made for Trade accounts receivable for which recoverability is
considered improbable.
d. Foreign currency transactions
Transactions in foreign currency are recorded at the prevailing exchange
rate at the time of the related transactions. Foreign currency denominated
assets and liabilities are translated using the exchange rate at the
balance sheet date. Exchange differences are recognized in the statement of
income as they occur.
e. Inventories
Inventories are stated at the lower of indexed cost or replacement value
and are included within other assets on the Balance Sheet. Cost of
inventories is determined principally on the average cost basis.
f. Investments
Shares in the Intelsat and Inmarsat communication satellites are recorded
under the equity method.
Other investments are recorded at indexed cost less a provision for losses
when considered necessary.
g. Property, plant and equipment
Property, plant and equipment is stated at indexed cost. Improvements to
existing property are capitalized while maintenance and repair costs are
charged to expense as incurred. Materials allocated to specific projects
are added to construction-in-progress. The residual value of old or
obsolete equipment is written off at the time the equipment is retired from
service, substantially all of which retirement occurs in the year in which
such equipment is identified as requiring replacement. Where early
identification of a need for replacement occurs, accelerated depreciation
is charged through to the date of expected replacement. Depreciation is
provided using the straight-line method based on the estimated useful lives
of the underlying assets as determined by the public telecommunications
service regulators. The principal depreciation rates are shown in Note
15(b).
Interest, calculated monthly at a rate of 12% per annum on construction-in-
progress, is capitalized as part of property, plant and equipment until the
asset is placed in service.
h. Accounts payable
Accounts payable to suppliers are discounted to their present value using
the ANBID interest rate.
i. Vacation pay accrual
Cumulative vacation pay due to employees is accrued as earned.
F-9
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
j. Income and social contribution taxes
Income and social contribution taxes comprise federal income tax and social
contribution tax. Deferred taxes are provided on temporary differences.
k. Loans and financing
Loans and financing include accrued interest to the balance sheet date.
l. Provisions for contingencies
Provisions for contingencies are based on legal advice and management's
opinion as to the likely outcome of the outstanding matters at the balance
sheet date.
m. Revenue recognition
Revenues for all services are recognized when the service is provided.
Revenues from international and domestic long-distance services consist
mainly of charges to the state operating companies, whose customer is
billed for the call, in accordance with the revenues sharing system as well
as charges to major governmental and private customers for its other
services.
Revenues from international services also include revenues earned under
bilateral agreements between Embratel and foreign telecommunications
administrations or private operators, which are influenced by the
guidelines of the International Tariff and Trade Regulations and cover
virtually all international calls to and from Brazil. These agreements
govern the ratio of payment by Embratel to the foreign entities for the use
of their facilities in connecting international calls billed in Brazil and
by the foreign entity to Embratel for the use of its facilities in
connecting international calls billed abroad (see Note 24).
n. Interest income (expense)
Interest income represents interest earned and gains and losses on
investments after adjusting for the effects of inflation as measured by the
variation in the inflation index and exchange gains and losses.
Interest expense represents interest incurred and gains and losses on loans
and financing after adjusting for the effects of inflation as measured by
the variation in the inflation index and net exchange gains of R$1,935,
R$13,449 and R$49,315 in 1995, 1996 and 1997, respectively.
o. Voluntary resignation incentive program
The R$62,493 cost of the 1996 voluntary resignation incentive program
relating to all employees of Embratel who exercised an option to resign or
to take early retirement by the deadline of December 31, 1996, was expensed
in 1996. At December 31, 1997, amounts of R$3,816 classified within other
current liabilities and R$4,429 classified within other noncurrent
liabilities were still outstanding, relating to the Company's commitment to
continue making monthly payments to the Telos pension fund and to the
Company health care plan to up to a maximum of 60 and 18 months,
respectively, from the date the employee left the Company.
p. Research and development
Research and development costs are charged to expense as incurred. Total
research and development costs were R$19,950, R$17,987 and R$15,978 in
1995, 1996 and 1997, respectively.
F-10
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
q. Retirement benefits
Embratel sponsors a separate entity that provides pensions and other post-
retirement benefits for its employees. Current costs are determined
actuarially and are recorded on the accrual basis.
r. Employee's profit share
Embratel has made a provision for granting employees the right to a share
of the profits in accordance with the requirements of regulations
applicable to companies owned by the Federal Government.
s. Segment information
Embratel operates in the segment of long-distance and international
telecommunications, data transmission and other services. All of the
company's revenue originates from services provided within Brazil.
t. Earnings per thousand shares
Earnings per thousand shares information has not been presented as the
capital structure of Embratel Participacoes S.A. was not in place at
December 31, 1997.
u. Use of estimates
The preparation of consolidated financial statements in conformity with
Brazilian and US GAAP requires management to make estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the consolidated financial
statements, and the reported amounts of revenues and expenses during the
period reported. Actual results could differ from those estimates.
v. Minority interests
Minority interests reflected in the balance sheets at December 31, 1996 and
1997 and in the consolidated statements of income for the years ended
December 31, 1995, 1996 and 1997 relate to the interests of shareholders
other than Telebras in the Company.
4. Net operating revenue from telecommunications services
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Gross operating revenue:
Voice................................... 1,127,294 1,239,927 1,366,622
Data.................................... 451,070 644,022 608,913
Text.................................... 86,393 69,041 34,176
Other................................... 93,589 174,703 204,308
--------- --------- ---------
Total domestic............................ 1,758,346 2,127,693 2,214,019
--------- --------- ---------
Voice................................... 367,943 405,317 443,987
Data.................................... 53,207 65,812 56,794
Text.................................... 12,442 10,804 5,699
Other................................... 17,513 19,230 21,893
--------- --------- ---------
Total international....................... 451,105 501,163 528,373
--------- --------- ---------
Total gross operating revenue............. 2,209,451 2,628,856 2,742,392
Value added and other indirect taxes...... (488,255) (541,226) (529,436)
--------- --------- ---------
Net operating revenue..................... 1,721,196 2,087,630 2,212,956
========= ========= =========
Revenue from telecommunications services
provided to the Telebras operating
companies................................ 740,024 797,569 1,123,492
Revenue from telecommunications services
provided to third parties................ 981,172 1,290,061 1,089,464
</TABLE>
The only customer who contributed more than 10% of gross operating revenues
was Telecomunicacoes de Sao Paulo S.A. ("Telesp"), specifically in relation
to its fixed-line operations. Gross operating revenues derived from Telesp
amounted to R$299,984, R$308,591 and R$410,542 in 1995, 1996 and 1997,
respectively (see Notes 24 and 28b).
F-11
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Net operating revenues from other domestic and international
telecommunications services include a number of ancillary services,
including telex and dedicated line telegraph, radio signal and television
signal satellite retransmission, mobile satellite communications, mobile
maritime telecommunications and certain data communications services. The
Company has generated losses from the provision of these services.
Management does not consider the services described above to constitute a
separate line or lines of business and historically has not accounted for
them separately. Management estimates that these activities generated gross
losses (net operating revenues less cost of services) of approximately R$78
million in each of 1995 and 1996 and R$45 million in 1997. No provision has
been made for future losses due to uncertainty as to the level of the
future losses and length of time during which they will be sustained.
5. Cost of services
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Depreciation and amortization............. 637,517 618,512 659,233
Personnel................................. 392,312 413,478 313,506
Third party services...................... 77,285 81,030 101,526
Other..................................... 35,606 32,593 23,298
--------- --------- ---------
1,142,720 1,145,613 1,097,563
========= ========= =========
6. Other net operating income (expense)
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Taxes other than income taxes............. -- -- (58,904)
Provision for contingencies (Note 20)..... -- -- (18,776)
Fines and expenses recovered.............. 51,822 5,459 6,002
Municipal and State taxes on property and
vehicles................................. (2,200) (2,564) (13,086)
Provision for losses with tax incentives.. (6,582) -- --
Voluntary resignation incentive program... -- (62,493) --
Other..................................... (6,640) 11,786 143
--------- --------- ---------
36,400 (47,812) (84,621)
========= ========= =========
7. Net other non operating income (expense)
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Net book value of permanent asset
disposals, write-offs and provisions:
Telex equipment.......................... (67,918) (45,990) (108,568)
Transdata equipment...................... -- -- (98,686)
Analog submarine cables.................. -- (20,623) (44,369)
Other.................................... (3,470) (32,982) (43,813)
--------- --------- ---------
(71,388) (99,595) (295,436)
Physical inventory shortages (Note
15(e)).................................. -- (13,386) (17,246)
Proceeds from asset disposals............ 11,303 9,079 36,883
Other.................................... 6,864 7,940 (8,380)
--------- --------- ---------
(53,221) (95,962) (284,179)
========= ========= =========
</TABLE>
The telex equipment write-offs in 1995 and 1996 were the result of
declining customer demand for telex services which allowed the Company to
concentrate its telex switching operations in its more modern equipment
and, consequently, remove from service a substantial portion of its older
equipment. The telex equipment write-offs in 1997 were the result of a
steep increase at the end of 1996 in the cost of leasing the dedicated
lines required for the provision of telex services. As a result of this
increase the Company determined that the telex business had become
unprofitable and accordingly decided to write off the entire remaining book
value of this equipment.
F-12
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The Transdata low speed data transfer service was profitable in 1996 and
previously. However as a result of a steep decline in revenues in 1997,
this service incurred a loss in 1997 and was generating negative cash
flows. As a result of these factors and a continued decline in revenues at
the beginning of 1998, the net book value of the equipment specifically
dedicated to this service line was written off as of December 31, 1997.
The net book values of the analog submarine cables were written off as they
were removed from service before the end of their estimated useful lives
due to declining demand for international analog transmission equipment and
the existence of alternative digital satellite transmission capacity.
Other net other non operating income (expense) includes income from
Embratel's interest in two international partnerships that own and operate
satellites (Intelsat and Inmarsat). The partnerships are owned by the users
of the services and allocate revenues over expenses to their members, based
on their rates of utilization of the services, with the objective of
meeting a target rate of return. At December 31, 1997, the Company's
ownership percentages in the Intelsat and Inmarsat partnerships were
1.357999% and 1.997990%, respectively. The interests are denominated in US
dollars.
Intelsat historically has allocated undistributed earnings to a reserve
account that was not included in shareholders' equity. Amounts were
transferred from this reserve account to shareholder's equity, as
necessary, in order to ensure that targeted rates of return were met. In
1997, the entire amount of this reserve account was transferred to
shareholders' equity.
Although the matter is not free from doubt, the Company believes that under
the terms of the Intelsat partnership agreement amounts included in the
reserve account described above are not available for distribution until
transferred to shareholders' equity. This matter is not free from doubt
because the partnership agreement does not clearly establish the rights of
the partners upon withdrawal with respect to undistributed earnings that
are not allocated to shareholders' equity. Embratel has been informed by
Intelsat that as of July 17, 1998 no partner had withdrawn from Intelsat.
Accordingly Embratel has recognized its equity interest in these
partnerships based on its share of shareholders' equity, excluding any
earnings allocated to the reserve account, so that the year in which income
is recognized by Embratel may differ from the year in which it is earned by
the partnership. The equity in earnings of the partnerships recorded in
each of the periods as other net non operating income (expense) was as
follows:
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------
1995 1996 1997
------- ------- --------
<S> <C> <C> <C>
Intelsat......................................... R$5,433 R$4,151 R$11,999
Inmarsat......................................... 1,544 3,386 6,000
</TABLE>
Of these amounts, approximately R$726, R$336, and R$4,232, were related
to amounts which were transferred by Intelsat from the reserve account
described above to stockholders' equity in 1995, 1996 and 1997,
respectively.
8. Income and social contribution taxes
Brazilian income taxes are comprised of Federal income tax and the social
contribution tax. In 1995, 1996 and 1997 the rates for income tax were 43%,
25% and 25%, respectively, and social contribution tax were 9.09%, 7.41%
and 8.00%, respectively. As a result of legislation enacted in 1996 the
social contribution tax was no longer deductible for its own computation
basis, nor was it deductible for income tax purposes. The changes produced
a combined statutory rate of 48.18%, 30.56% and 33.00% in 1995, 1996 and
1997, respectively.
Deferred taxes are provided on temporary differences which include the
effects of indexation adjustments that will not give rise to deductions
when subsequently depreciated, amortized or disposed of.
F-13
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
In prior years, the indexation adjustments to permanent assets and
shareholders' equity in accordance with the tax law gave rise to a tax
deductible expense if the indexation of equity exceeded the indexation of
permanent assets, and to taxable income called inflationary profit, if the
indexation of permanent assets exceeded that of equity. In the latter case,
payment of the related tax liability could be deferred until it had been
deemed to have been realized either through depreciation or disposal of the
permanent assets in existence at the time the liability was recorded
subject to a minimum realization rate of 10% per annum (5% per annum prior
to 1995).
In 1997, Embratel elected to prepay income taxes on inflationary profit
that it had previously deferred. Brazilian companies making such a
prepayment in relation to 1997 were entitled to a 50% discount on the
payment of income tax. The result for Embratel was a gain of R$ 3,152 in
1997 from the reduction of its deferred tax liabilities.
At December 31, 1997 Embratel had tax loss carryforwards totaling R$
410,228 for income tax purposes, to offset against future taxable income,
for which the future benefits have been fully recognized as deferred tax
assets. The offset of accumulated tax losses is restricted to 30% of
taxable profits of subsequent periods, but the losses have no expiration
date.
The following is an analysis of income tax (charge) credit:
<TABLE>
<CAPTION>
1995 1996 1997
-------- ------- ------
<S> <C> <C> <C>
Social contribution (charge) credit................ (11,912) (28,760) 9,135
Federal income tax credit.......................... 180,220 14,237 41,800
-------- ------- ------
168,308 (14,523) 50,935
Effect of rate changes on deferred tax............. (113,647) 662 --
Early payment incentives........................... -- -- 1,083
-------- ------- ------
Total tax (charge) credit.......................... 54,661 (13,861) 52,018
======== ======= ======
</TABLE>
The following is a reconciliation of the amount calculated by applying the
combined statutory tax rates to the reported income before taxes and the
reported income tax expense:
<TABLE>
<CAPTION>
1995 1996 1997
------- -------- --------
<S> <C> <C> <C>
Income before taxes and other charges as
reported in the accompanying consolidated
financial statements......................... 129,421 456,683 359,867
======= ======== ========
Tax charge at the combined statutory rate..... (62,355) (139,562) (118,756)
Permanent additions:
Non-deductible expenses..................... (17,706) (4,718) (8,343)
Permanent exclusions:
Foreign income.............................. 208,948 117,064 109,929
Capitalized interest........................ 9,439 3,180 1,927
Other....................................... 13,865 8,574 11,309
Other items:
Effect of rate changes on deferred tax...... (97,530) 1,153 --
Early payment incentives.................... -- -- 3,152
Interest on own capital..................... -- -- 52,800
Other....................................... -- 448 --
------- -------- --------
Income tax (charge) credit as reported in the
accompanying consolidated financial
statements................................... 54,661 (13,861) 52,018
======= ======== ========
Effective tax rate............................ 42.2% (3.0)% 14.5%
======= ======== ========
</TABLE>
F-14
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The composition of deferred tax assets and liabilities, based on temporary
differences is as follows:
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Deferred tax assets:
Provisions for contingencies............................... 26,437 31,099
Tax loss carry forwards.................................... 104,507 102,557
Provisions for permanent asset write-offs.................. -- 47,208
Additional indexation expense from 1990.................... 3,043 1,412
Other...................................................... 3,511 9,897
------- -------
Total (Note 12)............................................ 137,498 192,173
======= =======
Deferred tax liabilities:
Total ....................................................... 246,626 337,363
======= =======
Current.................................................... 6,203 22,577
Non current................................................ 240,423 314,786
</TABLE>
All of the deferred tax liabilities relate to the difference between the
tax basis of permanent assets, which was not indexed for inflation
subsequent to December 31, 1995, and the reporting basis, which includes
indexation through December 31, 1997.
9. Cash flow information
<TABLE>
<CAPTION>
1995 1996 1997
------ ------ ------
<S> <C> <C> <C>
Income and social contribution tax paid................ 26,375 46,109 70,078
Interest paid.......................................... 48,894 49,621 50,320
Cash paid against provisions for contingencies......... -- 13,952 23,130
Non cash transactions:
Fiscal incentive investments......................... 13,508 47 904
</TABLE>
10. Cash and cash equivalents
<TABLE>
<CAPTION>
1996 1997
------ ------
<S> <C> <C>
Cash........................................................... 627 528
Bank accounts.................................................. 57,633 59,509
------ ------
58,260 60,037
====== ======
</TABLE>
11. Trade receivables, net
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Accrued amounts............................................ 264,862 186,473
Billed amounts............................................. 40,240 60,531
Allowance for doubtful accounts............................ (1,337) (11,500)
------- -------
303,765 235,504
======= =======
</TABLE>
12. Deferred and recoverable taxes
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Tax deducted at source....................................... 8,963 24,232
Social contribution tax recoverable.......................... 2,256 9,948
Deferred tax assets.......................................... 137,498 192,173
Sales and other taxes........................................ 2,077 22,908
------- -------
150,794 249,261
======= =======
</TABLE>
F-15
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
13. Other assets
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Other debtors............................................... 96,803 88,673
Maintenance inventories..................................... 6,433 9,790
Prepayments................................................. 1,534 10,696
Other....................................................... 16,976 18,583
------- -------
121,746 127,742
======= =======
Current..................................................... 64,725 79,944
Noncurrent.................................................. 57,021 47,798
The majority of other debtors in both 1996 and 1997 relate to tax
incentives, legal deposits and advances made to employees and suppliers.
14. Investments
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Shares in Intelsat and Inmarsat communication satellites.... 49,180 58,895
Other investments........................................... 1,803 12,261
------- -------
50,983 71,156
======= =======
</TABLE>
15. Property, plant and equipment, net
a. Composition:
<TABLE>
<CAPTION>
1996 1997
---------- ----------
<S> <C> <C>
Indexed cost:
Construction-in-progress........................... 863,205 1,073,261
Automatic switching equipment...................... 1,621,745 1,648,399
Transmission and other equipment................... 4,466,554 4,252,347
Buildings and underground ducts.................... 1,256,828 1,350,017
Other.............................................. 2,142,751 2,110,401
---------- ----------
Total............................................ 10,351,083 10,434,425
---------- ----------
Accumulated depreciation:
Automatic switching equipment...................... (730,638) (844,907)
Transmission and other equipment................... (1,845,658) (1,777,397)
Buildings and underground ducts.................... (540,268) (585,362)
Other.............................................. (914,556) (900,551)
---------- ----------
Total............................................ (4,031,120) (4,108,217)
---------- ----------
Property, plant and equipment, net................... 6,319,963 6,326,208
========== ==========
</TABLE>
Transmission and other equipment include: aerial, underground and
building cables, private automatic exchanges, generating equipment and
furniture.
Other property, plant and equipment include: underground cables,
submarine cables, computer equipment, vehicles, land and other assets.
Within "Other property, plant and equipment' the book value of land is
R$166,490 and R$175,732 in 1996 and 1997, respectively.
F-16
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
b. Depreciation rates
The annual depreciation rates applied to property, plant and equipment are as
follows:
<TABLE>
<CAPTION>
%
<S> <C>
Automatic switching equipment.................................. 7.69
Transmission and other equipment............................... 10.00
Buildings and underground ducts ............................... 4.00
Other.......................................................... 5.00-20.00
</TABLE>
c. Rentals
Embratel rents equipment and premises through a number of operating
agreements that expire at different dates. The value of the total annual
rental expenses under these agreements and the future commitments under
non-cancelable rental agreements are minimal.
d. Revaluation
On December 31, 1990 Embratel recorded an appraisal write-up of part of its
property, plant and equipment. The corresponding credit was shown as a
capital reserve which was amortized on the same basis as the revalued
assets. The unamortized balance of the revaluation reserve, together with
the related provision for deferred taxes, were reversed during 1996
following the recommendations of the Comissao de Valores Mobiliarios
("CVM"- a public organization that sets accounting and disclosure standards
for Brazilian listed companies). This reversal had no impact on net income.
e. Physical inventory adjustments
Physical inventories of property and equipment performed in 1995, 1996 and
1997 resulted in write-offs of R$94,298, R$13,386 and R$17,246,
respectively, in relation to equipment which had been removed from service
before it was fully depreciated. The inventory counts disclosed the need
for the write-offs by identifying differences between equipment in service
as physically identified and that which was recorded in the accounting
records.
The physical inventory in 1995 resulted in a write-off of R$94,298 of
equipment that had been taken out of service since the Company's previous
physical inventory was conducted in 1978. Accordingly, the 1995 write-off
has been presented separately on the consolidated statements of income. The
equipment write-off relating to the 1996 and 1997 physical inventories are
reflected as a component of net other nonoperating expense (see Note 7).
With respect to equipment removed from service in any year prior to 1995,
the write-off should have been accounted for as the correction of an error
requiring restatement of the financial statements for such earlier year.
The Company was not able, however, to determine the years in which
equipment was removed from service and, accordingly, it recognized the
entire amount of the write-off in 1995 and did not restate earlier years.
If it had been able to do so, the restatement would have resulted in (a) in
each affected earlier year, a charge under "net other nonoperating
expense", a related reduction in tax expense and a corresponding reduction
in net income and (b) in 1995, a smaller charge under "write-off of
property and equipment from physical inventory", a related increase in tax
expense and correspondingly higher net income.
F-17
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
16. Payroll and related accruals
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Wages and salaries........................................... 28,531 37,871
Accrued social security charges.............................. 72,464 67,971
Accrued benefits............................................. 5,764 7,732
------- -------
106,759 113,574
======= =======
17. Accounts payable and accrued expenses
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Suppliers.................................................... 162,094 155,743
Payable to international operators........................... 209,491 190,789
Customer deposits............................................ 27,891 69,051
Other accrued expenses....................................... 50,771 14,575
------- -------
450,247 430,158
======= =======
18. Taxes other than income taxes
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Value added taxes............................................ 18,627 12,599
Taxes on operating revenues.................................. 4,537 32,265
------- -------
23,164 44,864
======= =======
19. Loans and financing
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Loans and financing.......................................... 585,687 567,015
Accrued interest............................................. 13,583 12,859
------- -------
599,270 579,874
======= =======
</TABLE>
<TABLE>
<CAPTION>
Lenders Interest Maturity 1996 1997
------- ------------ -------- ------- -------
<S> <C> <C> <C> <C>
Banco Real............................. 6.49% 2003 19,863 16,754
BBL.................................... 9.65% 2005 19,144 16,774
Credit Lyonnais........................ 7.00% 2008 129,437 121,503
EDC.................................... 6.00% 2006 17,730 16,780
Eximbank............................... 7.79% 2007 177,053 185,191
Lloyds Bank PLC........................ 6.93% 2005 21,839 27,786
NEC do Brasil S.A. .................... 8.00% 2003 68,717 77,041
Nissho Iwai............................ 8.75% 2005 20,380 22,063
PEFCO.................................. 10.14% 2005 6,677 5,874
------- -------
480,840 489,766
Other.................................. 5.71 to 6.5% Various 118,430 90,108
------- -------
599,270 579,874
======= =======
</TABLE>
<TABLE>
<S> <C> <C>
Current...................................................... 150,692 108,406
Noncurrent................................................... 448,578 471,468
</TABLE>
Unused commitments for long-term financing amounted to R$50,000 as of
December 31, 1997.
F-18
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
a. Loans and financing
Loans and financing comprise credits from various banks and suppliers of
telecommunications equipment, to be repaid in periodic installments.
Foreign currency denominated debt bears fixed interest rates varying from
5.71% per annum to 10.14% per annum and variable interest rates varying
from 0.25% to 3.30% per annum over LIBOR. The LIBOR rate at December 31,
1997 was 5.84% per annum.
Of the total loans and financing, R$350,039 and R$253,999 in 1996 and 1997,
respectively, have been guaranteed by the Federal Government and R$11,911
and R$7,799 in 1996 and 1997, respectively, by Telebras. In addition,
R$23,643 and R$16,279 in 1996 and 1997, respectively, of amounts payable
(classified within other liabilities) were secured by future income arising
in the United States of America.
b. Repayment schedule
Noncurrent debt is scheduled to be repaid as follows:
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
1998......................................................... 67,947 --
1999......................................................... 68,455 80,002
2000......................................................... 64,504 76,061
2001......................................................... 60,696 72,264
2002......................................................... 56,162 70,286
2003 and after............................................... 130,814 172,855
------- -------
448,578 471,468
======= =======
</TABLE>
c. Currency analysis
Total debt is denominated in the following currencies:
<TABLE>
<CAPTION>
Exchange rate at
December 31, 1997 1996 1997
----------------- ------- -------
(Units of one
Brazilian real)
<S> <C> <C> <C>
U.S. dollar................................ 1.116400 548,062 518,522
Japanese yen............................... 0.008574 4,648 3,291
German mark................................ 0.623235 824 9,884
French franc............................... 0.186284 45,736 48,177
------- -------
599,270 579,874
======= =======
</TABLE>
In addition to loans and financing, Embratel has accounts payable in
foreign currency totaling R$209,491 and R$190,289 at December 31, 1996 and
1997, respectively. Embratel does not hedge its foreign currency
liabilities.
F-19
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
d. Credit agreement defaults
The Company is party to certain credit agreements that contain covenants
restricting, among other things, (i) the ability of Telebras to dispose of
all or a substantial part of its assets or to cease to control a company
that was an operating subsidiary of the Telebras System and (ii) the
ability of the Federal Government to dispose of its controlling interest in
the Telebras System. The Breakup of Telebras on May 22, 1998 and the
privatization of the Company constituted, an event of default under such
credit agreements. In addition, most of the Company's other credit
agreements include cross-default provisions and cross-acceleration
provisions that would permit the holders of such indebtedness to declare
the indebtedness to be in default and to accelerate the maturity thereof if
a significant portion of the principal amount of the Company's debt is in
default or accelerated. A substantial portion (R$462,161) of the Company's
outstanding debt is currently in default or expected to be in default as a
result of the privatization. The Company is currently in negotiations with
the appropriate creditors with respect to this indebtedness.
The consolidated financial statements do not include any adjustments
relating to the recoverability of assets and classification of liabilities
that might be necessary should the Company be unable to renegotiate its
credit agreements. The Company believes that once the privatization is
finalized, the Company's creditors will renegotiate the terms of these
credit agreements and/or provide appropriate waivers regarding such
defaults.
20. Contingencies
The Company is a party to certain legal proceedings arising in the normal
course of business, including civil, administrative, tax, social security
and labor proceedings. The Company has provided for amounts to cover its
estimated losses due to adverse legal judgments. In the opinion of
management, such actions, if decided adversely to the Company, would not
have a material adverse effect on the Company's business, consolidated
financial condition or results of operations.
Telebras, the legal predecessors of the Company, is a defendant in a number
of legal proceedings and subject to other claims and contingencies. Any
claims against Telebras which are not satisfied by Telebras could result in
claims against the Company or the Holding Company. Management of the
Company believes that the chances of any such claims materializing and
having a material adverse financial effect on the Company are remote.
Labor claims
The provision for labor claims amounted to R$15,373 and R$11,019 at
December 31, 1996 and 1997, respectively. These amounts represent
management's estimate of the most probable loss in relation to numerous
suits filed by current and former employees. An analysis of the movement on
the provision is as follows:
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Beginning balance......................................... 29,325 15,373
Provision charged to other operating expenses (Note 6).... -- 18,776
Payments.................................................. (13,952) (23,130)
------- -------
15,373 11,019
======= =======
</TABLE>
F-20
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Tax contingencies
FINSOCIAL and COFINS taxes
A predecessor tax to COFINS, called FINSOCIAL, was originally introduced
at a rate of 0.5% and was subsequently increased in stages to a rate of
2.0% on gross operating revenues. The timing of these increases was
successfully challenged in court by a number of Brazilian companies, giving
rise to tax credits on account of past overpayments which could be
compensated against current payments of the similar tax, COFINS. The
Company recorded a credit for the overpaid FINSOCIAL tax in 1995 after a
High Court ruling had been published decreeing the unconstitutionality of
the FINSOCIAL rate increases. The Company realized this credit by
offsetting overpaid FINSOCIAL taxes against current liabilities to COFINS.
Embratel recognized a gain of R$42.9 million in 1995.
In 1997 Embratel was questioned by the COFINS authorities alleging that
it had underpaid the COFINS tax in prior years as a result of taking the
FINSOCIAL credit. Embratel and its lawyers are defending this claim, but,
because the existence of this dispute was making it difficult for Embratel
to obtain tax clearance certificates it required (in order to be able to
participate in public bids as a supplier to government entities, import
equipment which is tax exempt and record real estate transactions in the
public registry), management decided to pay the offset tax in 48 monthly
installments. This gave rise to an additional charge of R$58.9 million in
1997. In April, 1998, as a result of obtaining an initial favorable
decision in legal proceedings initiated by the Company to prove the
unconstitutionality of charging COFINS for telecommunications services,
Embratel suspended its payment of installments under the aforementioned
agreement.
Withholding tax on remittances to foreign communications companies
The Company regularly makes payments to foreign communications companies to
complete international calls that originate in Brazil and terminate in a
foreign country. Brazilian income tax law generally requires Brazilian
recipients of services from foreign companies to withhold 15% from payments
to such foreign companies for such services. However, based on decisions in
1952 of both the Brazilian Finance Ministry and the Taxpayers' Council, the
Company has never withheld Brazilian income tax from such payments.
Brazil is a signatory to the International Telecommunications Agreement of
1989, known as the Melbourne Treaty, in which the members agreed, amongst
other things, not to tax payments of this nature. For this treaty to have
legal effect in Brazil, presidential approval is required. Although there
has been no indication that such presidential approval will not be granted,
it has not been granted to date.
Should a retroactive presidential decree not be signed, the income tax
authorities may reconsider their earlier decisions exempting payments to
foreign communications companies from Brazilian income tax. If the
authorities were to challenge this exemption and determine that their
earlier decisions are no longer applicable to the Company, then they may
claim unpaid taxes together with interest and penalties of approximately
R$530 million through 1997 and additional amounts in 1998. Based on the
decisions in 1952 of both the Brazilian Finance Ministry and the Taxpayers'
Council to exempt the withholding of Brazilian income tax from payments to
foreign communications companies, the Company has never withheld Brazilian
income tax from such payments. Accordingly, the accompanying consolidated
financial statements do not include any provision for such taxes.
Management continually monitors and is evaluating its position with respect
to this tax contingency to determine if there have been changes, which
could result in an unfavorable outcome to the Company.
F-21
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Income tax on net foreign source operating income
On January 1, 1996 a new Brazilian law came into effect requiring that any
income from abroad is subject to corporate income tax. The Company believes
that the foreign source operating income of Embratel is not subject to tax
because the new law does not cover income from telecommunications services.
Additionally, the Company believes that it is exempt in accordance with a
specific exemption granted to foreign source telecommunications income
before the advent of the new law. If the Company should be challenged by
the fiscal authorities, it may be liable to additional income tax which,
together with interest and penalties for late payment, would have amounted
to a liability of approximately R$300 million at December 31, 1997, for
which no provision has been made in the accompanying financial statements.
Management continually monitors and is evaluating its position with respect
to this tax contingency to determine if there have been changes, which
could result in an unfavorable outcome to the Company.
Other taxes
The determination of the manner in which federal, state and municipal taxes
apply to the operations of Embratel is subject to varying interpretations
due to the unique nature of its operations. Management believes that its
interpretation of Embratel's tax obligations is substantially in compliance
with current legislation. Accordingly, any changes in the tax treatment of
its operations will be the result of new legislation or interpretive
rulings of the tax authorities which will not have any retroactive impact.
Other litigation
Management believes it has meritorious defenses to all lawsuits and legal
proceedings in which Embratel is a defendant. Based on its evaluation of
such matters, and after consideration of reserves established, management
believes that the resolution of such matters will not have a material
adverse effect on the Company's consolidated financial position or results
of its operations.
21. Provision for pensions
Embratel sponsors a defined benefit pension plan and a post retirement
benefit plan, both managed by the Fundacao Embratel de Seguridade Social
("Telos'). Approximately 97% of Embratel's employees are covered by these
plans.
The pension benefit is generally defined as the difference between (i) 90%
of the retiree's average salary during the last 36 months indexed to the
date of retirement and (ii) the value of the retirement pension paid by the
Brazilian social security system. For retired employees the initial pension
payment is subsequently adjusted upwards to recognize cost of living
increases and productivity awards granted to active employees. In addition
to the pension supplements, post retirement health care and life insurance
benefits are provided to eligible pensioners and their dependents.
F-22
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Contributions to the plans are based on actuarial studies prepared by
independent actuaries under Brazilian regulations. The actuarial studies
are revised periodically to identify whether adjustments to the
contributions are necessary. A summary of the plans, in compliance with
accounting principles generally accepted in Brazil, is as follows:
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Accumulated pension and other post retirement
benefit obligations.............................. 412,003 496,104 592,307
Other obligations................................. 50,602 65,606 78,810
------- ------- -------
Total obligations................................. 462,605 561,710 671,117
======= ======= =======
Combined plan assets:
Interest bearing deposits....................... 237,411 311,266 362,613
Stocks and shares............................... 200,650 224,088 296,619
Investment properties........................... 104,350 82,880 75,110
Loans to beneficiaries.......................... 27,898 31,764 33,055
Other investments............................... 13,140 21,480 31,311
------- ------- -------
Total plan assets............................... 583,449 671,478 798,708
======= ======= =======
Employer's contributions for the plans during the
year............................................. 42,350 62,229 61,687
======= ======= =======
</TABLE>
The Company is negotiating with the Brazilian pensions regulators
(Secretaria de Previdencia Complementar) and the government state companies
secretariat to increase the funding of the Telos pension fund. An actuarial
study has determined that an additional contribution of R$213,000 is
required including R$106,000 relating to an income tax dispute of the
pension fund. If the tax dispute is decided in favor of Telos, then only an
additional R$107,000 will be required. It is management's intention to pay
the additional amount over 20 years. There can be no assurance that these
negotiations will continue or result in payment to Telos under the
aforementioned terms. This potential additional payment has not been
recognized as a liability at December 31, 1997.
22. Shareholders' equity
The consolidated financial statements reflect the shareholders' equity of
the Company, after segregating as minority interests the participation of
minority shareholders in the Company at the historical percentages
applicable to shareholders other than Telebras. The shareholders' equity
has been segregated between capital, reserves and retained earnings.
23. Allocation of inflationary gains and losses
For the purposes of presenting the accompanying consolidated financial
statements in the fully indexed form, realized inflationary gains and
losses on non-interest-bearing assets and liabilities have been allocated
to the following statement of income captions:
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Gross operating revenue (21,412) (17,550) (19,804)
Taxes on operating revenues....................... 3,838 1,801 1,616
Cost of services ................................. 21,266 6,717 5,952
Selling expense................................... 2,196 823 2,097
General and administrative expense................ 10,781 3,290 6,762
Other net operating income (expense).............. (9,340) 4,229 (5,590)
------- ------- -------
Total............................................ 7,329 (690) (8,967)
======= ======= =======
</TABLE>
F-23
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The above gains and losses were generated from the following balance sheet
accounts or sub-accounts:
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Cash and cash equivalents......................... (3,511) (920) (1,119)
Accounts receivable............................... (21,006) (17,400) (19,804)
Other receivables................................. (8,240) (3,173) (1,767)
Indexation adjustments............................ (9,965) 2,761 (8,561)
Other assets...................................... (4,251) (1,451) (3,030)
Payroll and related accruals...................... 15,658 6,524 6,400
Accounts payable and accrued expenses............. 22,408 6,781 10,691
Income and other taxes payable.................... 3,885 1,837 1,745
Other liabilities................................. 12,351 4,351 6,478
------- ------- -------
7,329 (690) (8,967)
======= ======= =======
</TABLE>
24. Transactions with related parties
The principal related party transactions take place with the operating
subsidiaries of Telebras. Embratel provides domestic and international
long-distance telecommunications services to the customers of the local
operating companies. However, all charges to customers are billed by the
local operating companies, who transfer part of the charges to Embratel. As
a result Embratel normally has a receivable position with each of the local
operating companies.
Before the Breakup and privatization, the Company was the exclusive
provider of interstate long-distance service under Brazilian law. Under the
regulatory regime in effect before the Breakup and privatization, each
cellular and fixed-line company generally operated within one of the 26
states of Brazil or the Federal District and Embratel had the exclusive
right to carry calls between any two cellular or fixed-line companies. As
such, Embratel's exclusive interstate long-distance telephone service
accounted for 47.2% and 49.8% of the Company's total operating revenues
during 1996 and 1997, respectively.
Embratel must pay a network usage fee if it accesses end customers via the
network of a fixed-line telecommunications company. In practical terms,
even though the network usage fee includes the costs of a variety of
network elements and services, the network usage fee primarily reflects the
use of certain facilities of the fixed-line company for which Embratel does
not have adequate substitutes, particularly the local loop between local
exchanges and end customers.
Until April 1, 1998, revenues for domestic and international long-distance
calls were divided between the Company and the regional fixed-line
companies. Under this system, each regional fixed-line company billed its
customers for all domestic and international long-distance telephone calls
and retained a fixed percentage of the revenue, transferring the remainder
of the revenue to the Company. The fixed percentage varied by regional
fixed-line company. As of March 31, 1997, the regional fixed-line companies
transferred an average of 33% of the total revenue for such calls to
Embratel.
As part of the liberalization of the Brazilian telecommunications sector,
this system was eliminated as of April 1, 1998. Under the new system, the
Company receives 100% of the revenues from domestic and international long-
distance calls and pays certain per-minute interconnection charges to the
regional fixed-line companies for connection to and use of their networks.
In addition, until June 30, 2001, the Company must pay a supplemental per-
minute charge for such interconnection, the Parcela Adicional Temporaria
(the "PAT"). The Company does not expect that implementation of this new
system will have a material impact on its net income. However, it is
expected that the allocation to the Company of 100% of the revenues
F-24
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
generated by long distance calls will cause operating revenues to increase
substantially. This increase is expected to be offset by increased cost of
services resulting from the network usage charges and PAT paid to the
fixed-line companies.
Following the privatization of the telecommunications sector, the Company,
currently the exclusive provider of domestic and international long-
distance services in Brazil, will face increased competition from new
entrants. However, the Company will be authorized to provide full intra-
regional long-distance service as a competitor of the regional fixed-line
companies. The Company anticipates that, as a consequence of the
competition, prices for long-distance service will decline and its
operating margins may diminish. The exact identity of new entrants, the
scope of increased competition and any adverse effects on the Company's
results and market share will depend on a variety of factors that cannot
now be assessed with precision and that are beyond the Company's control
(see Note 28b).
The Company offers a number of ancillary telecommunication services
pursuant to licenses. Under the terms of the licenses, the Company is
required to offer telex and telegraph, radio signal satellite
retransmission and television signal satellite retransmission services
through August 2001 ("Collective Interest Obligations") (or such later
date, in the case of telex, as is required for another service provider to
offer the same service). The Company is required to continue to provide
mobile marine telecommunication services for an indefinite period, although
the long-term profitability of these services is uncertain. The Company is
effectively prohibited from increasing the fees charged for the above
described services (except, in some cases, for increases up to the rate of
inflation). The Company has generated losses from the provision of these
services and expects to continue to do so in the future.
Management does not consider the services described above to constitute a
separate line or lines of business and historically has not accounted for
them separately. Management estimates that these activities generated gross
losses (net operating revenues less cost of services) of approximately R$78
million in each of 1995 and 1996 and R$45 million in 1997.
Additionally, as a result of telephone calls to and from the service areas
of other telephone operators, Embratel has receivable and payable positions
with other telecommunications service providers in Brazil within the
Telebras group of companies relating to charges for the use of the networks
belonging to those telecommunications service providers.
The balances at December 31, 1996 and 1997 with related parties were as
follows:
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Cash and cash equivalents:
Deposits with Banco do Brasil S.A........................ 647,006 694,699
Accounts receivable:
Trade accounts receivable from local operating
companies............................................... 139,861 222,271
Other accounts receivable................................ 4,710 7,062
Loans and financing receivable........................... 12,795 4,994
Accounts payable:
Dividends and interest on own capital payable to
Telebras................................................ 231,300 292,191
Other.................................................... 10,090 10,760
</TABLE>
F-25
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- ---------
<S> <C> <C> <C>
Revenues earned:
Services provided to the operating companies.... 740,024 797,569 1,123,492
Cost of services:
Provided by the Telebras operating companies.... 11,583 9,669 4,150
</TABLE>
The principal other related parties are the Federal Government, both
through its holding company, Telebras, and through Banco do Brasil S.A.,
and the state operating companies.
Deposits with Banco do Brasil S.A. are overnight interest bearing deposits.
There are no restrictions on withdrawal of funds.
Revenues from telephone calls made by government bodies and related
organizations have not been provided because details of the type of
telephone user are not maintained by Embratel.
Until the breakup of Telebras, Embratel and the other companies of the
Telebras system each contributed to the research and development center
operated by Telebras (Centro de Pesquisa e Desenvolvimento da Telebras) and
also conducted their own independent research and development operations.
Embratel contributed 1.14%, 0.85% and 0.67% in 1995, 1996 and 1997,
respectively, of its net revenues to the research and development center
operated by Telebras. The total costs charged to Embratel by Telebras as
described above for the years ended December 31, 1995, 1996, and 1997 were
R$19,617, R$17,743 and R$15,042, respectively, out of total research and
development expenditures of R$19,950, R$17,987 and R$15,978, respectively.
Following the spin-off from Telebras, a private independently administered
research and development center was established. Pursuant to a three year
contract signed in May 1998 between Embratel and Telebras, Embratel is
obligated to contribute up to R$57 million during the three years ending
May 2001 on research and development to this center.
The Company believes that all the costs of doing business are reflected in
the consolidated financial statements and that no additional expenditures
will be incurred as a result of the cessation of the activities previously
performed by Telebras.
25. Commitments
At December 31, 1997, the Company had the following capital expenditure
commitments, which are related primarily to optical fiber, satellite and
telephone cables:
<TABLE>
<CAPTION>
Contracted
Expected year of expenditure ----------
<S> <C>
1998......................................................... 693,000
1999......................................................... 358,000
2000......................................................... 97,000
2001......................................................... 72,000
2002......................................................... 72,000
</TABLE>
F-26
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
26. Insurance
At December 31, 1997, in the opinion of the Company's management, all
significant and high risk assets and obligations were insured.
27. Fair values of financial assets and liabilities
Estimated fair values of Embratel's financial assets and liabilities have
been determined using available market information and appropriate
valuation methodologies. However, considerable judgement was required in
interpreting market data to produce the estimated fair values. Accordingly,
the estimates presented below are not necessarily indicative of the amounts
that could be realized in a current market exchange. The use of different
market assumptions and/or estimation methodologies may have a material
effect on the estimated fair values.
The fair value information as of December 31, 1996 and 1997 presented below
is based on pertinent information available to management as of those
dates. Although management is not aware of any factors that would
significantly affect the estimated fair value amounts at December 31, 1996,
such amounts have been indexed to December 31, 1997 and current estimates
of fair values may differ significantly from the amounts shown.
Where no comparison of book versus fair value is presented for a financial
asset or liability line item in the schedule below, no significant
difference in value is believed to exist.
<TABLE>
<CAPTION>
1996 1996 1997 1997
Book Fair Book Fair
value value value value
------- ------- ------- -------
<S> <C> <C> <C> <C>
Assets:
Deferred and recoverable taxes............. 150,794 114,164 249,261 202,127
Liabilities:
Income and other taxes..................... 276,596 221,373 382,227 377,154
Loans and financing........................ 599,270 547,155 579,874 597,861
</TABLE>
Cash, cash equivalents, accounts receivable, other current assets, accounts
payable and accrued expenses
The carrying value of cash, cash equivalents, accounts receivable, other
current assets, accounts payable and accrued expenses are a reasonable
estimate of their fair value. Cash equivalents are represented principally
by short-term investments, their fair values, and that of other short-term
investments and bank deposits not meeting the definition of cash
equivalents, were estimated using rates currently offered for deposits of
similar maturities.
Loans and financing
Interest rates that are currently available to Embratel for issuance of
debt with similar terms and maturities were used to estimate fair value.
Taxes recoverable and payable
Market value was calculated by discounting future expected cash flows
according to the TJLP interest rate (a Brazilian benchmark long-term
interest rate).
F-27
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
28. Events Subsequent to December 31, 1997
a. Incorporation of Embratel Participacoes S.A. (Registrant)
On May 22, 1998 the shareholders of Telebras approved Telebras division
into twelve new holding companies using a procedure under Brazilian
corporate law called a cisao ("spin-off'), whereby existing shareholders
received shares in the new companies in proportion to their holdings in
Telebras. The new companies contain the assets and liabilities previously
recorded in the accounts of Telebras, except for the following, which will
remain on the books of Telebras and not be allocated to the new holding
companies:
. approximately R$98,000 of net assets which have been attributed to a
newly constituted research foundation that will take over the activities
previously performed by the Telebras Campinas Research and Development
Center; and
. R$370,000 of net assets that will provide the funds required to
liquidate Telebras, including approximately R$132,000 of retroactive
dividends to be paid to the holders of new shares issued in April 1998,
as a result of the resolution of the disputed capital increase of 1990,
approximately R$50,000 of indemnity payments to employees and
approximately R$87,000 of expenses arising out of the privatization
process.
In addition to approving the allocation of assets and liabilities to the
new holding companies at the May 22, 1998 meeting, the shareholders also
approved a specific structure for the shareholders' equity of each new
holding company, which included an allocation of a portion of the retained
earnings of Telebras. Consequently, the amounts of the balances of capital,
reserves and retained earnings, together with the corresponding assets and
liabilities for the formation of Embratel Participacoes S.A. were
established. After Telebras retained within its own shareholders' equity
sufficient retained earnings from which to pay dividends on its 1997
earnings and in settlement of dividends as a result of settlement of the
1990 disputed share increase, Telebras allocated to each New Holding
Company the balance of its retained earnings in proportion to the allocated
total net assets. This value of allocated retained earnings does not
represent the historical retained earnings of the Holding Companies and
resulted in a decrease of R$210,432 in relation to the Company's historical
retained earnings. These values are shown in the "Spin-off from Telebras"
column in the following table. The first column summarizes the December 31,
1997 consolidated historical balances of the Company, and the "Holding
Company Consolidated Statement" column summarizes the consolidated balance
sheet of Embratel Participacoes S.A. after the spin-off.
As a result of the legal structure of the spin-off and as allowed under
Brazilian GAAP, a company formed as a result of a cisao will have such
retained earnings in its balance sheet as the parent company shareholders'
resolution adopting the cisao allocates from the parent company to the new
company. Accordingly, upon formation, Embratel Participacoes S.A.'s legal
capital structure was defined by the resolutions approved by the Telebras
shareholders' meeting of May 22, 1998 so that its shareholders' equity of
R$5,939,392 includes retained earnings of R$1,467,977 The allocated
retained earnings and future retained earnings will be the basis from which
future dividends will be payable.
The "Adjustments and Elimination" column presents the elimination of the
Holding Company's investment in the operating company.
F-28
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
<TABLE>
<CAPTION>
December Holding
31, 1997 Adjustments Company
Historical Spin-off and Consolidated
Balances from Telebras Eliminations Statement
---------- ------------- ------------ ------------
<S> <C> <C> <C> <C>
Assets:
Cash and cash equiva-
lents................. 754,736 32,263 -- 786,999
Intercompany receiv-
ables................. 222,271 -- -- 222,271
Other intercompany re-
ceivables............. 12,056 -- -- 12,056
Other current assets... 564,709 -- -- 564,709
--------- --------- ---------- ---------
Total current assets.. 1,553,772 32,263 -- 1,586,035
Other noncurrent as-
sets.................. 47,798 -- -- 47,798
Investment in subsidi-
ary................... 71,156 5,908,044 (5,908,044) 71,156
Property, Plant and
Equipment, net........ 6,326,208 -- -- 6,326,208
--------- --------- ---------- ---------
Total Permanent As-
sets................. 6,397,364 5,908,044 (5,908,044) 6,397,364
--------- --------- ---------- ---------
Total Assets........... 7,998,934 5,940,307 (5,908,044) 8,031,197
========= ========= ========== =========
Liabilities:
Loans and financing.... 108,406 -- -- 108,406
Dividends payable to
Telebras.............. 292,191 -- -- 292,191
Other.................. 675,440 -- -- 675,440
--------- --------- ---------- ---------
Total current liabili-
ties................. 1,076,037 -- -- 1,076,037
Loans and financing.... 471,468 -- -- 471,468
Other.................. 468,594 -- -- 468,594
--------- --------- ---------- ---------
Total noncurrent lia-
bilities............. 940,062 -- -- 940,062
Minority interests..... 74,791 -- -- 74,791
--------- --------- ---------- ---------
Share capital.......... -- 2,134,427 -- 2,134,427
Capital and reserves... 4,229,635 -- (4,229,635) --
Income reserves........ -- 2,336,988 -- 2,336,988
Retained earnings...... 1,678,409 1,467,977 (1,678,409) 1,467,977
--------- --------- ---------- ---------
Total Shareholders'
equity............... 5,908,044 5,939,392 (5,908,044) 5,939,392
Funds for capitaliza-
tion.................. -- 915 -- 915
--------- --------- ---------- ---------
Total liabilities and
shareholders' equity.. 7,998,934 5,940,307 (5,908,044) 8,031,197
========= ========= ========== =========
</TABLE>
The formation of the Holding Company has been accounted for as a
reorganization of entities under common control in a manner similar to a
pooling of interests. Brazilian corporate and tax law allows state-
controlled companies that are participating in the government's
privatization program a three-month delay between the accounting base date
for a spin-off and the date on which the shareholders' meeting approves the
spin-off, including the related accounting basis for the net assets to be
spun off. Furthermore, as allowed by Brazilian corporate law, the amount
shown in the "Spin-off from Telebras" column as "Investment in subsidiary"
was determined based on the balance sheet of that subsidiary as of
December 31, 1997. As a result, the consolidated financial statements of
the Holding Company for 1998 will include the results of operations and
changes in financial condition of the subsidiary from January 1, 1998 and
the effects of the cash allocated from Telebras as of March 1, 1998.
F-29
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The capital stock of the Holding Company is comprised of preferred shares
and common shares, all without par value. At May 22, 1998, there were
210,029,997 thousand outstanding preferred shares (inclusive of 13,718,350
thousand preferred shares resulting from the settlement in April 1998 with
Telebras as discussed below) and 124,351,903 thousand outstanding common
shares (net of 17,128 thousand common shares in treasury). The capital may
be increased only by a decision taken at a shareholders' meeting or by the
Board of Directors in connection with the capitalization of profits or
reserves previously allocated to capital increases at a shareholders'
meeting.
The preferred shares are non-voting except under limited circumstances and
are entitled to a preferential, noncumulative dividend and to priority over
the common shares in the case of liquidation of the Holding Company.
Under the Brazilian Corporation Law, the number of non-voting shares, such
as the preferred shares, may not exceed two-thirds of the total number of
shares.
Dividends
Pursuant to its By-laws, the Registrant is required to distribute as
dividends in respect of each fiscal year ending on December 31, to the
extent amounts are available for distribution, an aggregate amount equal to
at least 25% of Adjusted Net Income (as defined) on such date (the
"Mandatory Dividend"). The annual dividend distributed to holders of
preferred shares (the "Preferred Dividend") has priority in the allocation
of Adjusted Net Income. Remaining amounts to be distributed are allocated
first to the payment of a dividend to holders of Common Shares in an amount
equal to the Preferred Dividend and the remainder is distributed equally
among holders of preferred shares and common shares.
For purposes of Brazilian Corporation Law, and in accordance with Embratel
Participacoes S.A.'s By-laws, the "Adjusted Net Income" is an amount equal
to Embratel Participacoes S.A.'s net profits adjusted to reflect
allocations to or from (i) the statutory reserve, (ii) a contingency
reserve for anticipated losses, if any, and (iii) an unrealized revenue
reserve, if any.
On June 7, 1990 the Board of Directors of Telebras authorized an increase
in the Company's share capital by public offer. During the offer period the
CVM initiated an investigation as to whether Brazilian securities law and
regulations regarding the correct pricing of the new shares issued had been
violated because the shares were issued at a discount to equity value per
share. After its investigation the CVM notified the Federal Prosecutor's
Office that it believed no violation occurred since the price was
established in line with market prices for Telebras shares traded on the
Brazilian stock exchanges. The Federal Prosecutor decided to pursue the
issue through judicial channels, in spite of the CVM's conclusions, because
of its concern that the value of the Federal Government's shareholding may
have been adversely affected. A high court ruling was favorable to
Telebras, but the Federal Prosecutor had appealed the decision to the
Supreme Court. During 1998, this investigation was concluded resulting in
Telebras issuing 13,718,350 thousand shares of preferred stock and
transfering the $R68 million in other funds to share capital.
b. Regulatory Environment
As of April 1, 1998 the Revenue Sharing System used to divide interstate
and international long-distance revenues between Embratel and the local
fixed telephone operators was replaced with a network usage fee for the
interconnection based on the terms of an interconnection agreement with the
Company which became effective in April 1998.
F-30
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The terms of this interconnection agreement, particularly pricing and
technical requirements, will affect the Company's results of operations,
its competitive environment and its capital expenditure policies. The
Company does not expect the terms of the interconnection agreement to have
a material impact on net income initially as increased revenues under the
new structure are expected to be offset by a supplemental per-minute charge
called Parcela Adicional de Transicao ("PAT") that supplements the network
useage charge. The PAT is to be charged at rates which will vary between
regions and is intended to neutralize the impact of the new structure on
the combined net income of the operating companies within each of the new
fixed-line regions. Under the current regulatory framework, all
telecommunications service providers must provide interconnection services
on a non-discriminatory basis. Subject to certain requirements, providers
are free to negotiate the terms of interconnection but, in the event the
parties fail to reach an agreement, Anatel will establish the terms of
interconnection.
Under the General Plan on Concessions and Licenses, the fixed-line
companies and the Company are prohibited from offering certain basic fixed-
line telecommunications services until they fulfill certain specified
obligations. The Company is prohibited from offering local or cellular
services and the regional fixed-line companies are prohibited from offering
cellular, interregional long-distance and international long-distance
services. After the privatization is effected, the Company will be allowed
to enter the market for full intra-regional long-distance service within
their regions, including any calls between local calling areas, as a
competitor to the regional fixed-line companies once the privatization of
Telebras is completed.
c. Change in Control (Unaudited)
On July 29, 1998, the Federal Government sold to twelve buyers (the "New
Controlling Shareholders") its rights to receive shares of the twelve New
Holding Companies upon the distribution of such shares. In connection with
this sale, the Federal Government assigned to the New Controlling
Shareholders substantially all its economic and voting rights with respect
to the New Holding Companies and, as a consequence, effective August 4,
1998, the New Controlling Shareholders control the New Holding Companies.
d. Devaluation of the Brazilian real (unaudited)
On January 13, 1999, the Central Bank of Brazil effectively devalued the
Brazilian real by 8% by resetting the band within which the currency was
permitted to trade. On January 18, 1999, the band was suspended and the
currency allowed to float freely. Since that time, the exchange rate has
been very volatile and at February 24, 1999 the market rate was R$2.0033 to
each U.S. dollar. At December 31, 1997, all of the Company's R$579,874 of
debt and R$190,289 of its accounts payable are denominated in foreign
currency.
29. Summary of the differences between Brazilian and U.S. GAAP
Embratel's accounting policies comply with generally accepted accounting
principles in Brazil ("Brazilian GAAP"). Accounting policies which differ
significantly from generally accepted accounting principles in the United
States of America ("US GAAP") are described below:
a. Different criteria for capitalizing and amortizing capitalized interest
Until December 31, 1993, capitalized interest was not added to the
individual assets in property, plant and equipment, instead it was
capitalized separately and amortized over a time period different from the
useful lives of the related assets. Under US GAAP, capitalized interest is
added to the individual assets and is amortized over their useful lives.
Also, under Brazilian GAAP as applied to companies in the
telecommunications industry, interest attributable to construction-in-
progress is computed at the rate of 12% per annum of the balance of
construction-in-progress and that part which relates to interest on third
party loans is credited to interest expense based on actual interest costs
with the balance relating to its own capital being credited to capital
reserves.
F-31
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Under US GAAP, in accordance with the provisions of SFAS No. 34,
("Capitalization of Interest Costs") interest incurred on borrowings is
capitalized to the extent that borrowings do not exceed construction-in-
progress. The credit is a reduction of interest expense. Under US GAAP, the
amount of interest capitalized excludes the monetary gain associated with
the borrowings and the foreign exchange gains and losses on foreign
currency borrowings. The US GAAP differences between the accumulated
capitalized interest on disposals and in accumulated amortization on
disposals relate to the differences between capitalized interest and
related accumulated amortization under Brazilian GAAP and US GAAP which is
included in the net book value of disposed property, plant and equipment.
Although these amounts have been determined to be the same, they are
presented individually in both the determination of the capitalized
interest difference and in the determination of the amortization of the
capitalized interest difference in order to demonstrate the origin of the
reconciling items for capitalized interest and amortization of capitalized
interest which are disclosed in the net income reconciliation of the
differences between US and Brazilian GAAP.
The effects of these different criteria for capitalizing and amortizing
capitalized interest are presented below:
<TABLE>
<CAPTION>
1996 1997
-------- --------
<S> <C> <C>
Capitalized Interest difference
US GAAP Capitalized Interest:
Interest which would have been capitalized and credited to income under US GAAP.. 35,387 48,472
(Being interest incurred on loans from the Company's parent and from third
parties, except in years where total loans exceeded total construction in
progress, when capitalized interest is reduced proportionately)
Add US GAAP difference in accumulated capitalized interest on disposals........... 101,415 76,098
-------- --------
136,802 124,570
-------- --------
Less Brazilian GAAP Capitalized Interest:
Interest capitalized and credited to income under Brazilian GAAP................. (12,357) (4,529)
(Up to the limit of interest incurred on loans obtained for financing capital
investments)
Interest capitalized and credited to reserves under Brazilian GAAP (Difference
between total capitalized interest and interest capitalized and credited to
income)......................................................................... (142,823) (102,160)
-------- --------
Total capitalized interest under Brazilian GAAP (12% per annum, applied monthly
to the balance of construction-in-progress)..................................... (155,180) (106,689)
-------- --------
US GAAP Difference............................................................... (18,378) 17,881
======== ========
<CAPTION>
1996 1997
-------- --------
<S> <C> <C>
Amortization of Capitalized Interest difference
Amortization under Brazilian GAAP................................................. 119,533 137,322
-------- --------
Amortization under US GAAP........................................................ (39,087) (41,109)
US GAAP difference in accumulated amortization on disposals....................... (101,415) (76,098)
-------- --------
(140,502) (117,207)
-------- --------
US GAAP Difference................................................................ (20,969) 20,115
======== ========
</TABLE>
F-32
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
b. Reversal of fixed asset revaluation
Brazilian GAAP permits appraisal write-ups on fixed assets under certain
circumstances; US-GAAP requires fixed assets to be carried at fully indexed
historical cost less accumulated depreciation and amortization.
Accordingly, the portion of depreciation and amortization expense related
to such write-ups must be adjusted in calculating US GAAP income.
During the year ended December 31, 1996, Embratel wrote-off the appraisal
write-ups on fixed assets against the revaluation reserve and the related
deferred taxes.
c. Reversal of proposed dividends and interest on capital
Under Brazilian GAAP, proposed dividends and proposed interest on capital,
net of income taxes are accrued for in the consolidated financial
statements in anticipation of their approval at the shareholders' meeting.
Under US GAAP, dividends are not accrued until they are formally declared.
d. Assets presented at net realizable value
Non interest bearing investments with fixed maturities are not discounted
to their present value under Brazilian GAAP. Such discounting is required
under US GAAP to eliminate the effects of implicit interest rates.
e. Pension and other post-retirement benefits
Embratel provides for the costs of pensions and other post-retirement
benefits based on a fixed percentage of remuneration, as recommended
annually by Telos' actuaries and certified by independent actuaries. For
purposes of the US GAAP reconciliations, the provisions of SFAS 87--
Employers' accounting for pensions--and SFAS 106--Employers' accounting for
post retirement benefits other than pensions have been applied. The
provisions of SFAS 87 were applied with effect from January 1, 1991 because
it was not feasible to apply them from the effective date specified in the
standard. As a result, R$73,743 of the transition liability was transferred
directly to shareholders' equity at the implementation date.
f. Items posted directly to shareholders' equity accounts
Under Brazilian GAAP various items are posted directly to shareholders'
equity accounts, which under US GAAP would be posted to the income
statement. Examples include capitalized interest, the effects of
adjustments to tax rates and fiscal incentive investment credits received.
The posting of such items to shareholders' equity in the subsidiary
companies gives rise to consolidation adjustments in the consolidated
statements of changes in shareholders' equity. Since the original postings
by the subsidiaries to their equity accounts would, under US GAAP, be made
directly to the income statement, these consolidation adjustments must be
included in the reconciliation of net income in accordance with US GAAP.
The effects of changes in income tax rates posted directly to shareholders'
equity accounts arises from applying increases or decreases in tax rates to
the deferred tax liability relating to the special reserve described in
Note 22.
g. Earnings per share
Under Brazilian GAAP, net income per share is calculated on the number of
shares outstanding at the balance sheet date. Since the Capital structure
of the new Holding Company was not in place at December 31, 1997, earnings
per share is not presented under Brazilian GAAP.
F-33
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
In these consolidated financial statements, information is disclosed per
lot of one thousand shares, because this is the minimum number of shares
that can be traded on the Brazilian stock exchanges. Each American
Depositary Share ("ADS") is equivalent to one thousand shares.
As discussed in Note 1, the Company was not formed until subsequent to
December 31, 1997. For US GAAP purposes, the equity structure utilized for
earnings per share computations is that of the new entity formed in May
1998. The New Holding Company's equity structure has been used for all
years presented. At the date of formation, the Company had 124,351,903
thousand common shares (net of 17,128 thousand common shares in treasury)
and 196,311,647 thousand preferred shares outstanding (exclusive of the
13,718,350 thousand preferred shares resulting from the settlement in April
1998 with Telebras).
In February 1997, the Financial Accounting Standards Board issued SFAS No.
128 "Earnings Per Share". This statement is effective for 1997, and
provides computation, presentation and disclosure requirements for US GAAP
basic and diluted earnings per share.
Since the preferred and common stockholders have different dividend, voting
and liquidation rights, Basic earnings per share has been calculated using
the "two-class" method for US GAAP purposes. The "two-class" method is an
earnings allocation formula that determines earnings per share for
preferred and common stock according to the dividends to be paid as
required by the Company's by-laws and participation rights in undistributed
earnings.
Basic earnings per common share is computed by reducing net income by
distributable and undistributable net income available to preferred
shareholders and dividing net income available to common shareholders by
the weighted-average number of common shares outstanding during the period.
Net income available to preferred shareholders is the sum of the preferred
stock dividends up to a minimum of 6% of adjusted net income (as defined in
the Company's by-laws) (distributable net income) and the preferred
shareholders' portion of undistributed net income. Undistributed net income
is computed by deducting preferred stock dividends and common stock
dividends from net income. Undistributed net income is shared equally by
the preferred and common shareholders on a pro rata basis. Common stock
dividends are calculated as up to 25% of adjusted net income or an amount
equal to the preferred stock dividend, whichever is less.
The Company's preferred shares are non-voting except under certain limited
circumstances and are entitled to a preferential, noncumulative dividend
and to priority over the common shares in the event of liquidation of the
Company. The preferred shareholders were entitled to a non-cumulative
dividend of R$0.27, R$0.73 and R$0.50 per preferred share on 1995, 1996 and
1997 net income from continuing operations, respectively. The preferred
shareholders would share equally in the undistributed earnings of the
Company in the amount of R$0.19, R$0.37 and R$0.91 per preferred share on
1995, 1996 and 1997 net income from continuing operations, respectively.
The weighted-average number of common and preferred shares used in
computing basic earnings per share for 1997 was 124,351,903 thousand and
196,311,647 thousand, respectively. There were no common stock equivalents
outstanding under the new capital structure; accordingly diluted earnings
per share is not presented.
In April 1998, resolution was reached on the disputed capital increase of
1990 (see Note 28a). In connection with the resolution, the Company issued
13,718,350 thousand shares of preferred stock. For Brazilian GAAP and US
GAAP, such shares are considered outstanding when issued.
F-34
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
h. Impairment of long-lived assets
For US GAAP, effective January 1, 1996 the Company adopted SFAS 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of". In accordance with this standard, the Company
periodically evaluates the carrying value of long-lived assets to be held
and used, when events and circumstances warrant such a review. The carrying
value of long-lived assets is considered impaired when the anticipated
undiscounted cash flow from such assets is separately identifiable and is
less than their carrying value. In that event, a loss is recognized based
on the amount by which the carrying value exceeds the fair market value of
the assets.
Brazilian GAAP does not require cash flow computations in order to
determine potential asset impairment.
The following are the components of the US GAAP impairment charge in 1996
and 1997:
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Telex equipment......................................... 154,558 --
Transdata equipment..................................... -- 98,686
BRUS analog cable....................................... 20,623 --
Atlantis 1 analog cable................................. -- 44,369
Other, mainly analog switching and transmission
equipment.............................................. 48,168 30,057
------- -------
223,349 173,112
======= =======
</TABLE>
A reduction in demand for telex services, followed at the end of 1996 by a
steep increase in the charge from the local fixed-line companies for the
special dedicated lines required by Embratel for the performance of this
service resulted in the 1996 US GAAP impairment charge. A review of future
expected cash flows following this cost increase resulted in the need for
an impairment charge for US GAAP purposes equal to the residual value of
the equipment. Introduction of more modern switching equipment lead to the
impairment charge for older analog switching equipment. For Brazilian GAAP
purposes the equipment was written off in 1997 when the equipment
upgrade/replacement was approved by the Company.
Under US GAAP, impairment charges would be included as a charge in arriving
at operating income.
i. Disclosure requirements
US GAAP disclosure requirements differ from those required by Brazilian
GAAP. However, in these financial statements, the level of disclosure has
been expanded to comply with US GAAP.
j. Income taxes
Embratel fully accrues for deferred income taxes on temporary differences
between tax and accounting basis. The existing policies for providing for
deferred taxes are substantially in accordance with SFAS 109--Accounting
for income taxes, except in connection with the deferred income tax effects
of indexation adjustments in 1996 and 1997 (see note 2(a)(iii)). Under US
GAAP the deferred tax effects of the 1996 and 1997 indexation for financial
reporting purposes would be charged to income and social contribution taxes
in the statement of income. For purposes of cash flow statement
presentation, under US GAAP, the change in deferred income taxes would be
presented as a non cash item within operating activities.
k. Interest income (expense)
Brazilian GAAP requires interest to be shown as part of operating income.
Under US GAAP interest income (expense) would be shown after operating
income.
F-35
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
l. Employees' profit share
Brazilian GAAP requires employees' profit share to be shown as an
appropriation of net income for the year. Under US GAAP employee profit
sharing would be included as an expense in arriving at operating income.
m. Permanent assets
Brazilian GAAP has a class of assets called permanent assets. This is the
collective name for all assets on which indexation adjustments were
calculated in the corporate and fiscal law accounts of Brazilian companies.
Under US GAAP the assets in this classification would be non current
assets.
Losses on disposals of permanent assets were R$154,383, R$103,902 and
R$275,799 in 1995, 1996 and 1997, respectively. Such losses were included
in non-operating expenses for Brazilian GAAP. Under US GAAP, such losses
including physical inventory adjustments would have reduced operating
income (see notes 7 and 15(e)).
n. Price-level adjustments and the US GAAP presentation
The effects of price-level adjustments have not been eliminated in the
reconciliation to US GAAP nor has Embratel reflected monetary gains or
losses associated with the various US GAAP adjustments separately
identified, because the application of inflation restatement as measured by
the UFIR and the IGP-M represents a comprehensive measure of the effect of
price level changes in the Brazilian economy. As such, it is considered a
more meaningful presentation than historical cost-based reporting for both
Brazilian and US accounting purposes.
o. Deferred taxes
The deferred tax adjustments represent the tax effects of taxable US GAAP
pre-tax adjustments and include the negative effect of R$46,455 in 1996 and
R$0 in 1997 arising from enacted changes in the income tax rates.
Additionally, for US GAAP deferred tax assets and liabilities are
classified as current or non-current based on the classification of the
asset or liability attributing to the temporary difference.
p. COFINS tax accrual
In 1995 Embratel recognized a gain of R$42,900 in relation to the potential
offset of overpaid FINSOCIAL taxes against its COFINS liabilities (see Note
20). Under US GAAP, this gain does not meet the SFAS 5 "Accounting for
Contingencies" criteria for recognition and accordingly it has been
eliminated in the determination of US GAAP income. In 1997 Embratel agreed
to settle a dispute with the tax authorities in relation to their
allegation that the offset was improper and this agreement gave rise to an
additional charge for COFINS of R$58,904, which included the reversal of
the R$42,900 gain from 1995. Accordingly, in the determination of US GAAP
income for 1997 the R$42,900 adjustment has been eliminated.
q. Discontinued operations of Telebras
Under Brazilian law, Embratel is not the legal successor to Telebras.
Accordingly, under Brazilian GAAP, the Company has only presented the net
assets, results of operations and cash flows of Embratel. Under Brazilian
GAAP, the net assets, results of operations and cash flows of Telebras have
not been presented.
Under US GAAP, the Company and management of Telebras concluded that, due
to Embratel's position as the only long-distance carrier providing services
to all other Telebras subsidiaries, the significance of its revenues and
net assets, its low minority ownership and the lack of material effect of
the spin-off on Embratel, it is the appropriate entity to be considered as
the continuing entity within the Telebras group for US financial reporting
purposes. As a result, all operations of Telebras and its subsidiaries,
except for Embratel, are considered to be discontinued operations for US
reporting requirements.
F-36
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The following schedules present, in a US GAAP reporting format, the
Brazilian GAAP condensed financial position, results of operations and cash
flows of Embratel as the continuing entity with all other Telebras group
operations presented as discontinued operations:
CONDENSED CONSOLIDATED BALANCE SHEET INFORMATION
<TABLE>
<CAPTION>
December 31,
---------------------
1996 1997
R$ R$
---------- ----------
(In thousands of
constant Brazilian
Reais--R$ of December
31, 1997)
<S> <C> <C>
Current assets............................................ 1,381,916 1,553,772
Noncurrent assets......................................... 57,021 47,798
Permanent assets.......................................... 6,370,946 6,397,364
Net assets of discontinued operations..................... 25,575,173 28,119,430
---------- ----------
Total assets.............................................. 33,385,056 36,118,364
========== ==========
Current liabilities....................................... 1,037,903 1,076,037
Noncurrent liabilities.................................... 818,377 940,062
Minority interests........................................ 74,420 74,791
---------- ----------
Shareholders' equity
Capital and reserves.................................... 26,334,000 28,267,000
Retained earnings....................................... 5,120,356 5,760,474
---------- ----------
Total shareholders' equity (1) and (2).................. 31,454,356 34,027,474
---------- ----------
Total liabilities and shareholders' equity................ 33,385,056 36,118,364
========== ==========
</TABLE>
- --------
(1) As a result of the spin-off in 1998, shareholders' equity will be reduced
by an amount equal to the net assets of discontinued operations.
(2) The presentation of "Shareholders' equity" is consistent with the
presentation of the published consolidated financial statements of
Telebras, from which the accompanying financial information was extracted,
except for an additional provision for doubtful accounts of R$110,692 in
1997, additional provisions for the Telepar supplementary pension plan of
R$11,077 in 1997, additional depreciation in Embratel of R$34,529 in 1997,
the write-off of the BRUS submarine cable with a book value of R$20,623 in
1996 rather than 1997, the write-off of the Atlantis I submarine cable
with a book value of R$44,369 in 1997 rather than 1998, provision for
impairment of the Transdata equipment with a book value of R$98,686 in
1997 and the resulting offsetting effect of deferred income taxes and
minority interests of R$8,728 and R$106,827 in 1996 and 1997. The
additional provisions resulted from a reevaluation of the Company's
probable losses in relation to trade accounts receivable at December 31,
1997 and from a subsequent pension amendment provided to the Company by
its actuary to update information previously submitted to the Company.
These additional provisions are being reflected in the 1997 financial
statements of the Telebras subsidiaries because the adjustments represent
the correction of previously reported amounts. The additional depreciation
charge in 1997, the write-off of the Transdata equipment and the submarine
cables, and R$11,500 of the additional provision for doubtful accounts
were the correction of previously reported amounts relating to Embratel.
F-37
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant brazilian reais of December 31,
1997)
CONDENSED CONSOLIDATED INCOME STATEMENT INFORMATION
<TABLE>
<CAPTION>
Years ended December 31,
----------------------------------
1995 1996 1997
R$ R$ R$
---------- ---------- ----------
(In thousands of constant
Brazilian Reais--R$ of
December 31, 1997)
<S> <C> <C> <C>
Net operating revenue from
telecommunications services.............. 1,721,196 2,087,630 2,212,956
Cost of services.......................... (1,142,720) (1,145,613) (1,097,563)
---------- ---------- ----------
Gross profit.............................. 578,476 942,017 1,115,393
Operating expenses:
Selling expense......................... (147,556) (160,243) (230,808)
General and administrative expense...... (245,372) (237,216) (213,617)
Other net operating income.............. 36,400 (47,812) (84,621)
---------- ---------- ----------
Operating income from continuing
operations before interest............... 221,948 496,746 586,347
Interest income........................... 54,992 86,622 97,809
Interest expense.......................... -- (30,723) (40,110)
---------- ---------- ----------
Operating income from continuing
operations............................... 276,940 552,645 644,046
Write-off of property and equipment from
physical inventory....................... (94,298) -- --
Net nonoperating expense.................. (53,221) (95,962) (284,179)
---------- ---------- ----------
Income before taxes and other charges..... 129,421 456,683 359,867
Income and social contribution taxes...... 54,661 (13,861) 52,018
---------- ---------- ----------
Income from continuing operations before
employees' profit share.................. 184,082 442,822 411,885
Employees' profit share................... (21,766) (22,642) (30,622)
---------- ---------- ----------
Income from continuing operations before
minority interests....................... 162,316 420,180 381,263
Income attributable to minority
interests................................ (2,041) (5,253) (4,766)
---------- ---------- ----------
Net income from continuing operations..... 160,275 414,927 376,497
Income attributable to discontinued
operations............................... 792,725 2,529,428 3,062,600
---------- ---------- ----------
Net income (1)............................ 953,000 2,944,355 3,439,097
========== ========== ==========
</TABLE>
- --------
(1) The presentation of "Net income" is consistent with the presentation of
the published consolidated financial statements of Telebras, from which
the accompanying financial information was extracted, except for an
additional provision for doubtful accounts of R$110,692 in 1997,
additional provisions for the Telepar supplementary pension plan of
R$11,077 in 1997, additional depreciation in Embratel of R$34,529 in 1997,
the write-off of the BRUS submarine cable with a book value of R$20,623 in
1996 rather than 1997, the write-off of the Atlantis I submarine cable
with a book value of R$44,369 in 1997 rather than 1998, provision for
impairment of the Transdata equipment with a book value of R$98,686 in
1997 and the resulting offsetting effect of deferred income taxes and
minority interests of R$8,728 and R$106,827 in 1996 and 1997. The
additional provisions resulted from a reevaluation of the Company's
probable losses in relation to trade accounts receivable at December 31,
1997 and from a subsequent pension amendment provided to the Company by
its actuary to update information previously submitted to the Company.
These additional provisions are being reflected in the 1997 financial
statements of the Telebras subsidiaries because the adjustments represent
the correction of previously reported amounts. The additional depreciation
charge in 1997, the write-off of the Transdata equipment and the submarine
cables, and R$11,500 of the additional provision for doubtful accounts
were the correction of previously reported amounts relating to Embratel.
F-38
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
CONDENSED CONSOLIDATED CASH FLOW INFORMATION
<TABLE>
<CAPTION>
Years ended December 31,
----------------------------------
1995 1996 1997
R$ R$ R$
---------- ---------- ----------
(In thousands of constant
Brazilian Reais--R$ of
December 31, 1997)
<S> <C> <C> <C>
Cash provided by operations:
Income from continuing operations......... 160,275 414,927 376,497
Adjustments to reconcile net income from
continuing operations to cash provided by
continuing operating activities.......... 777,986 963,372 835,215
---------- ---------- ----------
Net cash provided by continuing
operations................................ 938,261 1,378,299 1,211,712
Net cash provided by discontinued
operations................................ 4,151,739 5,692,701 6,996,288
---------- ---------- ----------
Net cash provided by operations--Telebras.. 5,090,000 7,071,000 8,208,000
---------- ---------- ----------
Net cash flow from investing activities--
continuing operations..................... (726,229) (947,386) (909,342)
Net cash flow from investing activities--
discontinued operations................... (4,311,771) (5,569,614) (6,811,658)
---------- ---------- ----------
Net cash flow from investing activities--
Telebras.................................. (5,038,000) (6,517,000) (7,721,000)
---------- ---------- ----------
Net cash flow from financing activities--
continuing operations..................... (158,763) (24,020) (252,900)
Net cash flow from financing activities--
discontinued operations................... 404,763 2,297,020 128,900
---------- ---------- ----------
Net cash flow from financing activities--
Telebras.................................. 246,000 2,273,000 (124,000)
---------- ---------- ----------
Net cash flows--Telebras................... 298,000 2,827,000 363,000
Less: Net cash flows from discontinued
operations................................ (244,731) (2,420,107) (313,530)
---------- ---------- ----------
Increase in cash and cash equivalents from
continuing operations..................... 53,269 406,893 49,470
Cash and cash equivalents at beginning of
year...................................... 245,104 298,373 705,266
---------- ---------- ----------
Cash and cash equivalents at end of year... 298,373 705,266 754,736
========== ========== ==========
</TABLE>
The principal elements of the discontinued operations, in accordance with
Brazilian GAAP, are presented below:
<TABLE>
<CAPTION>
1995 1996 1997
--------- ---------- ----------
<S> <C> <C> <C>
Net operating revenues........................ 8,417,804 11,675,370 13,982,044
Net income.................................... 792,725 2,529,428 3,062,600
Current assets................................ -- 5,608,084 6,374,321
Property, plant and equipment................. -- 34,644,414 38,106,208
Total assets.................................. -- 40,685,494 45,081,575
Current liabilities........................... -- 4,412,291 4,430,040
Total liabilities (including funds for
capitalization).............................. -- 10,153,914 9,150,978
Minority interests............................ -- 4,956,407 7,811,167
Net assets of discontinued operations......... -- 25,575,173 28,119,430
</TABLE>
r. Loans and Financing
For US GAAP, loans and financing balances in default or expected to be in
default within a year of the balance sheet date would be classified as
current obligations unless creditors had provided the Company waivers for
such defaults. For Brazilian GAAP, loans and financing balances in
technical default are not
F-39
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
always classified as current liabilities. A substantial portion (R$462,161)
of the Company's outstanding debt at December 31, 1997 is currently in
default as a result of the privatization and accordingly, for US GAAP,
would be classified as current liabilities.
s. Retained earnings
For Brazilian GAAP, a company formed as a result of a cisao may have
retained earnings in its balance sheet if the parent company shareholders'
resolution adopting the cisao allocates retained earnings from the parent
company to the new company. Under US GAAP, "retained earnings" allocated in
the cisao would not be considered historical retained earnings as such
amount would represent capital allocated from the parent company and would
be described as "distributable capital." As a result of the May 22, 1998
spin off, the Company will have US GAAP distributable capital of
R$1,467,977.
F-40
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
The following reconciliations have been segregated between continuing and
discontinued operations to disclose the discontinued operation with more
prominence.
Net income reconciliation of the differences between US and Brazilian GAAP
<TABLE>
<CAPTION>
1995 1996 1997
-------- --------- ---------
<S> <C> <C> <C>
Income as reported......................... 160,275 414,927 376,497
Add (deduct):
Different criteria for:
Capitalized interest................... (33,940) (18,378) 17,881
Amortization of capitalized interest... 48,129 (20,969) 20,115
Impairment of long lived assets:
SFAS 121 impairment adjustment......... -- (119,447) 119,447
Pension and other post retirement
benefits:
SFAS 87 adjustment..................... (69,080) (56,154) (24,233)
SFAS 106 adjustment.................... (13,372) (13,897) (14,458)
Reversal of COFINS tax credit............ (42,900) -- 42,900
Items posted directly to shareholders'
equity accounts:
Deferred tax effect of the non
deductibility of the indexation
increments to shareholders' equity ... -- (163,203) (138,120)
Effects of changes in income tax
rates................................. 64,574 83,081 2,917
Fiscal incentive investments........... 13,508 47 904
Interest on construction in progress... 122,840 142,823 102,160
Reversal of depreciation of asset
revaluation............................. 37,000 -- --
Deferred tax effect of the above
adjustments............................. (139,119) 101,299 (53,346)
Effect of minority interest in the above
adjustments............................. 314 810 (1,114)
-------- --------- ---------
US GAAP income from continuing operations.. 148,229 350,939 451,550
======== ========= =========
<CAPTION>
1995 1996 1997
-------- --------- ---------
<S> <C> <C> <C>
Income from discontinued operations
(Telebras and all subsidiaries except
Embratel)................................. 792,725 2,529,428 3,062,600
Add (deduct):
Different criteria for:
Capitalized interest................... (186,060) (472,622) (512,979)
Amortization of capitalized interest... 165,871 237,969 246,983
Amortization of contribution to plant
expansion............................. 56,000 96,000 121,000
Donations and subsidies for investment... -- -- (97,000)
Assets presented at net realizable value:
Investments discounted to present
value................................. 60,000 14,000 10,000
Compulsory loans....................... 17,000 -- --
Fiscal incentive investments........... 106,000 -- --
Pension and other post retirement
benefits:
SFAS 87 adjustment..................... (223,920) (225,846) (191,767)
SFAS 106 adjustment.................... (67,628) (121,103) (134,542)
Reversal of COFINS tax credit............ (77,647) (6,194) --
Items posted directly to shareholder's
equity accounts:
Fiscal incentive investments........... (13,508) (47) 16,096
Interest on construction in progress... 242,160 460,177 434,840
Effects of changes in income tax
rates................................. 150,426 (40,081) (2,917)
Other consolidation adjustments........ 73,000 40,000 84,000
Deferred tax on full indexation........ -- (708,797) (651,880)
Deferred tax effects of above
adjustments............................. (349,100) 227,940 447,984
Effect of minority interest on the above
adjustments............................. (28,516) (54,395) 295,523
-------- --------- ---------
US GAAP income from discontinued
operations................................ 716,803 1,976,429 3,127,941
======== ========= =========
</TABLE>
F-41
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
<TABLE>
<CAPTION>
1995 1996 1997
-------- --------- ---------
<S> <C> <C> <C>
Total net income (Telebras--consolidated).. 953,000 2,944,355 3,439,097
Add (deduct):
Different criteria for:
Capitalized interest................... (220,000) (491,000) (495,098)
Amortization of capitalized interest... 214,000 217,000 267,098
Amortization of contribution to plant
expansion............................. 56,000 96,000 121,000
Reversal of fixed assets revaluation..... 37,000 -- --
Donations and subsidies for investment... -- -- (97,000)
Assets presented at net realizable value:
Investments discounted to present
value................................. 60,000 14,000 10,000
Compulsory loans....................... 17,000 -- --
Fiscal incentive investments........... 106,000 -- --
SFAS 121 adjustment.................... -- (119,447) 119,447
Pension and other post retirement
benefits:
SFAS 87 adjustment..................... (293,000) (282,000) (216,000)
SFAS 106 adjustment.................... (81,000) (135,000) (149,000)
Reversal of COFINS tax credit............ (120,547) (6,194) 42,900
Items posted directly to shareholder's
equity accounts:
Fiscal incentive investments........... -- -- 17,000
Interest on construction in progress... 365,000 603,000 537,000
Effects of changes in income tax
rates................................. 215,000 43,000 --
Other consolidation adjustments........ 73,000 40,000 84,000
Deferred tax on full indexation........ -- (872,000) (790,000)
Deferred tax effects of above
adjustments............................. (488,219) 329,239 394,638
Effect of minority interest on the above
adjustments............................. (28,202) (53,585) 294,409
-------- --------- ---------
US GAAP total net income(1)................ 865,032 2,327,368 3,579,491
======== ========= =========
</TABLE>
- --------
(1) The presentation of the U.S. GAAP adjustments to the total net income of
the Company, including discontinued operations, is consistent with the
presentation in the published consolidated financial statements of
Telebras except for (1) reversal of COFINS tax credits of R$120,547 and
R$6,194 recorded in 1995 and 1996 under Brazilian GAAP relating to a tax
dispute which for U.S. GAAP purposes do not meet the SFAS 5 criteria for
gain recognition and (2) reversal in 1997 of the R$42,900 COFINS gain
recognition adjustment in respect of the continuing operations of the
Company when Embratel again recognized a liability for COFINS (see Note
20).
Net income per thousand shares in accordance with US GAAP
<TABLE>
<CAPTION>
1995 1996 1997
----------- ----------- -----------
Basic:
<S> <C> <C> <C>
Common shares:
Continuing operations................ .46 1.10 1.41
Discontinued operations.............. 2.24 6.16 9.75
----------- ----------- -----------
Total................................ 2.70 7.26 11.16
=========== =========== ===========
Weighted average (thousand) common
shares outstanding.................... 124,351,903 124,351,903 124,351,903
Preferred shares:
Continuing operations................ .46 1.10 1.41
Discontinued operations.............. 2.24 6.16 9.75
----------- ----------- -----------
Total................................ 2.70 7.26 11.16
=========== =========== ===========
Weighted average (thousand) preferred
shares outstanding.................... 196,311,647 196,311,647 196,311,647
</TABLE>
F-42
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Net equity reconciliation of the differences between US and Brazilian GAAP
<TABLE>
<CAPTION>
1996 1997
---------- ----------
<S> <C> <C>
Total shareholders' equity as reported............. 5,879,183 5,908,044
Add (deduct):
Different criteria for:
Capitalized interest........................... (943,276) (925,395)
Amortization of capitalized interest........... 412,587 432,702
Reversal of proposed dividends and net interest
on capital...................................... 234,228 296,081
Reversal of dividend distribution tax............ -- 23,810
Impairment of long-lived assets:
SFAS 121 adjustment............................ (119,447) --
Pension and other post retirement benefits:
SFAS 87 adjustment............................. (483,705) (507,938)
SFAS 106 adjustment............................ (151,557) (166,015)
Reversal of COFINS tax credit.................... (42,900) --
Deferred tax effects of the above adjustments.... 438,338 384,993
Effect of minority interest on the above
adjustments..................................... 8,358 5,772
---------- ----------
5,231,809 5,452,054
US GAAP net assets of discontinued operations...... 25,064,131 26,591,377
---------- ----------
US GAAP shareholders equity (Telebras--
consolidated)(1).................................. 30,295,940 32,043,431
========== ==========
</TABLE>
- --------
(1) The presentation of the U.S. GAAP adjustments to the total net equity of
the Company, including discontinued operations, is consistent with the
presentation in the published consolidated financial statements of
Telebras except for (1) reversal of COFINS tax credits totalling R$
137,819 recorded in 1994, 1995 and 1996 under Brazilian GAAP relating to a
tax dispute which for U.S. GAAP purposes do not meet the SFAS 5 criteria
for gain recognition and (2) reversal in 1997 of the R$42,900 COFINS gain
recognition adjustment in respect of the continuing operations of the
Company when Embratel again recognized a liability for COFINS (see Note
20).
F-43
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Upon consummation of the spin-off in 1998, US GAAP shareholders equity will
be reduced by the net book value of the net assets of discontinued operations
(R$26,591,377 as of December 31, 1997).
<TABLE>
<CAPTION>
1995 1996 1997
------- ---------- ----------
<S> <C> <C> <C>
US GAAP Supplementary information (Continuing
Operations):
The reconciliation of operating income under
Brazilian GAAP to operating income under US
GAAP is as follows:
Brazilian GAAP operating income.............. 276,940 552,645 644,046
Exclusion from US GAAP operating income:
Net interest income........................ (54,992) (55,899) (57,699)
Inclusion in US GAAP operating income:
Employee profit share...................... (21,766) (22,642) (30,622)
Write off of property and equipment from
physical inventory........................ (94,298) (13,386) (17,246)
Losses on permanent asset write offs....... (60,085) (90,516) (258,553)
US GAAP adjustments:
SFAS 121 impairment adjustment............. -- (119,447) 119,447
SFAS 87 pension adjustment................. (69,080) (56,154) (24,233)
SFAS 106 other post-retirement benefits
adjustment (13,372) (13,897) (14,458)
Reversal of depreciation of asset
revaluation............................... 37,000 -- --
------- ---------- ----------
US GAAP operating income from continuing
operations.................................. $ 347 180,704 360,682
======= ========== ==========
Total assets ................................ 7,570,111 7,891,234
========== ==========
Property, plant and equipment................ 9,407,807 9,509,030
Accumulated depreciation..................... (3,758,603) (3,675,511)
---------- ----------
Net property, plant and equipment............ 5,649,204 5,833,519
========== ==========
</TABLE>
The deferred tax effect of the US GAAP adjustments relating to continuing
operations noted above of R$438,388 in 1996 and R$384,993 in 1997 would
principally be classified as non-current on the balance sheet.
F-44
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Statements of changes in total shareholders' equity (Telebras--consolidated) in
accordance with US GAAP
Years ended December 31, 1995, 1996 and 1997
<TABLE>
<CAPTION>
Capital
and Retained
reserves earnings Total
---------- ---------- ----------
<S> <C> <C> <C>
Balances at December 31, 1994.............. 22,722,000 2,397,540 25,119,540
Capital increase:
Other funds............................... 25,000 -- 25,000
Expansion plan contributions:
Received.................................. 1,192,000 -- 1,192,000
Deferred credits.......................... (501,000) -- (501,000)
Reversal of reserves....................... (250,000) 250,000 --
Purchase of treasury shares................ (1,000) -- (1,000)
Net income................................. -- 865,032 865,032
Transfers to reserves...................... 1,001,000 (1,001,000) --
Dividends paid............................. -- (109,000) (109,000)
---------- ---------- ----------
Balances at December 31, 1995.............. 24,188,000 2,402,572 26,590,572
Expansion plan contributions:
Received.................................. 2,074,000 -- 2,074,000
Deferred credits.......................... (301,000) -- (301,000)
Reversal of reserves....................... (243,000) 243,000 --
Sale of treasury shares.................... 1,000 -- 1,000
Net income................................. -- 2,327,368 2,327,368
Transfers to reserves...................... 1,134,000 (1,134,000) --
Dividends paid............................. -- (396,000) (396,000)
---------- ---------- ----------
Balances at December 31, 1996.............. 26,853,000 3,442,940 30,295,940
Expansion plan contributions
Received.................................. 1,188,000 -- 1,188,000
Transferred to minority shareholders...... (2,373,000) -- (2,373,000)
Reversal of reserves....................... (82,000) 82,000 --
Sale of treasury shares.................... 1,000 -- 1,000
Net income................................. -- 3,579,491 3,579,491
Transfers to reserves...................... 1,997,000 (1,997,000) --
Dividends paid............................. -- (648,000) (648,000)
---------- ---------- ----------
Balances at December 31, 1997.............. 27,584,000 4,459,431 32,043,431
========== ========== ==========
</TABLE>
F-45
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
30. Additional disclosures required by US GAAP
a. Pension and Post-retirement benefits
If Embratel had reported its net pension cost, net periodic post retirement
benefit cost, the funded status of its pension and other post retirement
benefits plans in accordance with accounting principles and actuarial
assumptions generally accepted in the United States of America, the
disclosures required would have been as follows:
Pension benefits
<TABLE>
<CAPTION>
1996 1997
--------- ---------
<S> <C> <C>
Components of net pension cost:
Service cost-benefits earned during the period..... 62,362 59,257
Interest on projected benefit obligation........... 73,554 75,354
Actual return on plan assets....................... (54,056) (46,507)
Unrecognized net (gain) loss....................... 25,066 (12,840)
Unrecognized net liability at transition........... 34,599 34,599
--------- ---------
Total pension cost................................. 141,525 109,863
Less: employee contributions....................... (30,831) (30,853)
--------- ---------
Net pension cost................................... 110,694 79,010
========= =========
Funded status:
Accumulated benefit obligation:
Vested........................................... 484,226 512,793
Non vested....................................... 557,286 590,164
--------- ---------
Total............................................ 1,041,512 1,102,957
========= =========
Projected benefit obligation....................... 1,274,997 1,371,407
Fair value of plan assets.......................... (557,790) (651,843)
--------- ---------
Projected obligation in excess of plan assets...... 717,207 719,564
Unrecognized net gain.............................. 154,694 141,971
Unrecognized net liability at transition........... (388,196) (353,597)
--------- ---------
Accrual required at December 31 under US GAAP...... 483,705 507,938
========= =========
The actuarial assumptions used were as follows:
Discount rate for determining projected benefit
obligations....................................... 6.00% 6.00%
Rate of increase in compensation levels............ 3.25% 3.25%
Expected long-term rate of return on plan assets... 6.00% 6.00%
</TABLE>
The above are real rates over inflation as measured by the Fiscal Reference
Unit (UFIR) through December 31, 1995 and the IGP-M subsequently.
F-46
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
Amortization of the unrecognized liability at transition: 17.22 years
commencing on January 1, 1991.
Other post-retirement benefits
<TABLE>
<CAPTION>
1996 1997
------- -------
<S> <C> <C>
Components of net periodic post-retirement benefit cost:
Service cost-benefits earned during the period......... 9,001 9,023
Interest on projected benefit obligation............... 12,372 13,349
Actual return on plan assets........................... (4,795) (2,997)
Amortization of:
Unrecognized net gain................................ 5,008 1,994
------- -------
Net post-retirement benefit cost....................... 21,586 21,369
======= =======
Funded status:
Accumulated post-retirement benefit obligations:
Retirees and dependents.............................. 55,062 54,976
Fully eligible active plan participants.............. 28,311 30,010
Other active plan participants....................... 131,233 148,670
------- -------
214,606 233,656
Fair value of plan assets.............................. (27,875) (34,461)
------- -------
Obligation in excess of plan assets.................... 186,731 199,195
Unrecognized net gain.................................. (35,174) (33,180)
------- -------
Accrual required at December 31 under US GAAP.......... 151,557 166,015
======= =======
</TABLE>
There was no unrecognized liability at transition.
Health care cost trend rates of increase were projected at annual rates
excluding inflation ranging from 6.48% in 1998 to 2.00% in 2047. The effect
of a one percent annual increase in the assumed health care cost trend
rates would increase the accumulated post-retirement benefit obligation at
December 31, 1997 by R$50,361 and the aggregate of service and interest
cost components by R$5,826. Measurement of the accumulated post-retirement
benefit obligation was based on the same assumptions as were used in the
pension calculations.
The funded status of the pension and post retirement plans under Brazilian
and US GAAP differ. Benefit obligations differ because they have been
prepared using different actuarial assumptions permitted under Brazilian
and US GAAP.
The net assets of the plans differ under Brazilian and US GAAP principally
due to the accrual of income tax contingencies of the pension fund for US
GAAP purposes in the amount of R$90,691 and R$106,205 in 1996 and 1997,
respectively. The contingency arises out of uncertainty as to the income
tax status of Brazilian pension funds in general because the tax law is
unclear as to whether these funds are exempt from tax on their investment
gains. Under Brazilian GAAP two methods of accounting for the income tax
contingency are currently permitted. The tax is either deducted from plan
assets for the purposes of determining the funded status of the plan or it
is not deducted, but is disclosed in a note as being a contingency.
Management of the pension fund have determined that the Brazilian GAAP
financial statements of the fund be prepared on the basis that the legal
arguments against assessment of the tax on the investment gains are
sufficiently strong as to avoid the need for the potential liability to be
recognized. However, for US GAAP purposes, management of the Company
believe that the assessment of this potential
F-47
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1, 2 and 28)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais of December 31,
1997)
income tax liability is probable. Accordingly, in determining the funded
status for US GAAP purposes, the potential income tax liability (calculated
in accordance with SFAS 109) has been deducted from the fair value of the
plan assets.
b. Concentrations of risks
Embratel is prohibited from investing its surplus cash balances in
financial instruments other than government securities controlled by the
Central Bank of Brazil or the Federally owned bank, Banco do Brasil S.A.
Embratel's main customers are the related party telephone operating
companies. During the years covered by the accompanying consolidated
financial statements there were 27 such operating companies, with each
usually covering a single Brazilian state. This resulted in Embratel's
credit risk with respect to customer accounts being diversified. Of the
operating companies only Telecomunicacoes de Sao Paulo S.A.--TELESP
accounted for more than 10% of Embratel's revenues during the year ended
December 31, 1997.
In conducting its business Embratel is fully dependent on its long-distance
and international telecommunications concession granted by the federal
government of Brazil.
Approximately 97% of Embratel's employees are members of state labor
unions, with whom it enters new collective agreements every year. The
collective agreements currently in force expire on November 30, 1998.
There is no concentration of available sources of labor, services,
concessions or rights, other than those mentioned above, that could, if
suddenly eliminated, severely impact Embratel operations.
c. New accounting pronouncements
SFAS No. 130, "Reporting Comprehensive Income"
SFAS No. 130 establishes the standards for reporting and displaying
comprehensive income and its components (revenues, expenses, gains and
losses) as part of a full set of financial statements. This statement
requires that all elements of comprehensive income be reported in a
financial statement that is displayed with the same prominence as other
financial statements.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information"
SFAS No. 131 establishes the standards for the manner in which public
enterprises are required to report financial and descriptive information
about their operating segments. The standard defines operating segments as
components of an enterprise for which separate financial information is
available and evaluated regularly as a means for assessing segment
performance and allocating resources to segments. A measure of profit or
loss, total assets and other related information are required to be
disclosed for each operating segment. In addition, this standard requires
the annual disclosure of: information concerning revenues derived from the
enterprise's products or services; countries in which it earns revenues or
holds assets, and major customers.
SFAS No. 132, "Employers' disclosures about pensions and other
postretirement benefits"
SFAS No. 132 revises and standardizes employers' disclosures about pension
and other postretirement benefit plans. It does not change the measurement
or recognition of those plans.
The Company will comply with the requirements of SFAS No. 130, 131 and 132
in 1998.
F-48
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
For the Nine Months Ended September 30, 1997 and 1998
CONTENTS
<TABLE>
<S> <C>
Unaudited Consolidated Condensed Balance Sheets as of
December 31, 1997 and September 30, 1998................... F-50
Unaudited Consolidated Condensed Statements of Operations
for the Nine Months
Ended September 30, 1997 and 1998.......................... F-51
Unaudited Consolidated Condensed Statements of Cash Flows
for the Nine Months
Ended September 30, 1997 and 1998.......................... F-52
Notes to the Unaudited Consolidated Condensed Financial
Statements................................................. F-53 through F-70
</TABLE>
F-49
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
UNAUDITED CONSOLIDATED CONDENSED BALANCE SHEETS
December 31, 1997 and September 30, 1998
(In thousands of constant Brazilian Reais--R$ of
December 31, 1997 and thousands of Brazilian Reais--R$ of September 30, 1998)
<TABLE>
<CAPTION>
December 31, 1997 September 30, 1998
Note R$ R$
---- ----------------- ------------------
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents:
Deposits with Banco do Brasil .... 694,699 735,575
Other cash and cash equivalents
................................. 60,037 18,368
Accounts receivable, net........... 8 457,775 646,908
Deferred and recoverable taxes .... 9 249,261 304,257
Other assets....................... 92,000 146,852
--------- ---------
Total current assets............. 1,553,772 1,851,960
--------- ---------
Noncurrent assets:
Other assets ...................... 47,798 157,612
--------- ---------
Permanent assets:
Investments ....................... 71,156 98,422
Property, plant and equipment, net
.................................. 10 6,326,208 6,512,796
--------- ---------
Total permanent assets........... 6,397,364 6,611,218
--------- ---------
Total assets........................ 7,998,934 8,620,790
========= =========
Current liabilities:
Payroll and related accruals ...... 113,574 156,308
Accounts payable and accrued ex-
penses ........................... 430,158 566,263
Taxes other than income taxes ..... 44,864 204,236
Proposed dividends................. 296,081 --
Income taxes ...................... 6 22,577 34,413
Loans and financing ............... 108,406 136,475
Provisions for contingencies ...... 12 11,019 17,090
Other liabilities.................. 49,358 210,913
--------- ---------
Total current liabilities ....... 1,076,037 1,325,698
--------- ---------
Noncurrent liabilities:
Income taxes ...................... 6 314,786 265,653
Loans and financing ............... 471,468 500,680
Deferred income ................... 97,211 110,526
Other liabilities ................. 56,597 417,262
--------- ---------
Total noncurrent liabilities .... 940,062 1,294,121
--------- ---------
Minority interests ................. 74,791 75,013
--------- ---------
Shareholders' equity:
Capital and reserves .............. 4,229,635 4,291,496
Retained earnings ................. 1,678,409 1,634,462
--------- ---------
Total shareholders' equity ...... 5,908,044 5,925,958
--------- ---------
Total liabilities and shareholders'
equity ............................ 7,998,934 8,620,790
========= =========
</TABLE>
See the accompanying notes to these unaudited consolidated condensed financial
statements.
F-50
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
Nine Months ended September 30, 1997 and 1998
(In thousands of constant Brazilian Reais--R$ of
December 31, 1997 and thousands of Brazilian Reais--R$ of September 30, 1998)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
------------------------
1997 1998
Note R$ R$
---- ----------- -----------
<S> <C> <C> <C>
Net operating revenue from telecommunication
services...................................... 1,679,355 2,794,150
Cost of services............................... (819,849) (1,993,463)
=========== ===========
Gross profit................................... 859,506 800,687
----------- -----------
Operating expenses:
Selling expense............................... (85,999) (130,214)
General and administrative expense............ (219,018) (298,584)
Other net operating expense................... 4 (77,348) (475,807)
----------- -----------
Operating income (loss) before interest........ 477,141 (103,918)
Interest income................................ 48,083 114,663
Interest expense............................... (29,834) (79,918)
----------- -----------
Operating income (loss)........................ 495,390 (69,173)
Net other nonoperating expense................. 5 (137,725) (77,560)
----------- -----------
Income (loss) before taxes and other charges... 357,665 (146,733)
Income and social contribution tax (expense)
benefit....................................... 6 (34,072) 119,022
----------- -----------
Income (loss) before employees' profit share
and minority interests........................ 323,593 (27,711)
Employees' profit share........................ (25,485) (18,000)
----------- -----------
Income (loss) before minority interests........ 298,108 (45,711)
Minority interests............................. (3,726) 571
----------- -----------
Net income (loss) ............................. 294,382 (45,140)
=========== ===========
Net income (loss) per thousand shares.......... 0.92 (0.14)
=========== ===========
Weighted average shares outstanding(in
thousands).................................... 320,663,550 329,809,117
=========== ===========
</TABLE>
See the accompanying notes to these unaudited consolidated condensed financial
statements.
F-51
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
Nine Months ended September 30, 1997 and 1998
(In thousands of constant Brazilian Reais--R$ of
December 31, 1997 and thousands of Brazilian Reais--R$ of September 30, 1998)
<TABLE>
<CAPTION>
Nine Months ended
September 30,
-------------------
1997 1998
R$ R$
-------- ---------
<S> <C> <C>
Cash provided by operations:
Net income (loss)........................................ 294,382 (45,140)
Adjustments to reconcile net income (loss) to cash
provided by operating activities:
Depreciation and amortization........................... 513,152 593,877
Minority interests...................................... 3,726 (571)
Losses on disposal and write-offs of permanent assets... 159,961 97,886
Provision for doubtful accounts (charge-offs)........... (80) 42,735
(Increase) in trade accounts receivables................ (88,183) (231,868)
(Increase) in taxes recoverable......................... (25,170) (54,996)
(Increase) in other current assets...................... (27,188) (54,852)
(Increase) decrease in other noncurrent assets.......... (1,558) (109,814)
Increase in payroll and related accruals................ 9,608 42,734
Increase (decrease) in accounts payable and accrued
expenses............................................... (30,260) 136,105
Increase in income taxes................................ 87,475 186,177
Increase in other current liabilities................... 4,154 161,555
Increase(decrease) in provisions for contingencies...... (6,933) 6,071
Increase in deferred income............................. 4,867 13,315
Increase (decrease) in other noncurrent liabilities..... (29,593) 297,871
-------- ---------
868,360 1,081,085
-------- ---------
Cash flows from investing activities:
Additions to investments................................. (6,681) (27,266)
Additions to property, plant and equipment............... (600,422) (819,434)
Capitalized interest..................................... (23,432) (2,846)
Proceeds from asset disposals............................ 13,075 6,468
-------- ---------
(617,460) (843,078)
-------- ---------
Cash flows from financing activities:
Loans repaid............................................. (97,135) (109,312)
New loans obtained....................................... 55,171 166,593
Dividends paid........................................... (234,229) (296,081)
-------- ---------
(276,193) (238,800)
-------- ---------
Increase in cash and cash equivalents..................... (25,293) (793)
Cash and cash equivalents at beginning of period.......... 705,265 754,736
-------- ---------
Cash and cash equivalents at end of period................ 679,972 753,943
======== =========
</TABLE>
See the accompanying notes to these unaudited consolidated condensed financial
statements.
F-52
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
1. Operations and background
Embratel Participacoes S.A. (the "Holding Company") was formed on May 22,
1998, through the spin-off of certain assets and liabilities of
Telecomunicacoes Brasileiras ("Telebras"). Although the Holding Company was
not formed until May 22, 1998, the spin-off was effective using balances as
of February 28, 1998, and including all income and expense for the period
from January 1, 1998 through February 28, 1998 except for the effect of
minor cash allocations from Telebras at February 28, 1998. Until August 4,
1998, the date of privatization, the Holding Company was controlled by the
Federal Government.
Embratel Participacoes S.A., through its subsidiary provides international
and domestic long-distance telecommunications services in Brazil. These
services include data communication, text, sound and image transmission and
are performed under the terms of a concession granted by the Federal
Government which will expire on December 31, 2005 and may be renewed for a
further term of 20 years.
The Company's business, including the services it may provide and the rates
it charges, is regulated by the Agencia Nacional de Telecomunicacoes
("Anatel"), the regulatory authority for the Brazilian telecommunications
industry pursuant to Law No. 9,472 of July 16, 1997 and the related
regulations, decrees, orders and plans.
2. Presentation of the consolidated financial statements
The consolidated financial statements included herein have been prepared by
the Company, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission (the "SEC") for interim information. In
the opinion of management, these unaudited consolidated condensed financial
statements contain all adjustments, which are of a normal recurring nature,
necessary to present fairly the Company's financial position as of
September 30, 1998 and the results of operations for the nine months ended
September 30, 1997 and September 30, 1998. Certain information and footnote
disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles in Brazil have
been condensed or omitted pursuant to the rules and regulations of the SEC.
These unaudited statements should be read in conjunction with the audited
financial statements and the notes thereto included elsewhere in this 20-F.
The Company has made no significant changes in accounting policies during
the nine months ended September 30, 1998 except as discussed in Note 3.
The consolidated financial statements present the consolidated financial
condition and results of operations of Embratel Participacoes and its
subsidiary, Embratel (the "Company").
a. Full indexation to December 31, 1997
The consolidated financial statements as of December 31, 1997 and for the
nine months ended September 30, 1997 were prepared on a fully indexed basis
to recognize the effects of changes in the purchasing power of the
Brazilian currency during the periods presented and are stated in constant
currency as of December 31, 1997.
In July 1997, the three-year cumulative inflation rate for Brazil fell
below 100%. However, for accounting purposes, the constant currency method
continued to be applied through December 31, 1997. Although the Brazilian
Institute of Accountants has not yet issued instructions to discontinue
restating financial
F-53
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
information to constant currency, the Company's management has concluded
that the effects of inflation for the nine months ended September 30, 1998
of 1% are not material. Accordingly, the restated balances of nonmonetary
assets and liabilities of the Company as of December 31, 1997 became the
new basis for accounting, and the consolidated statement of income for the
nine months ended September 30, 1998 has not been restated for inflation,
except for the effect of depreciation expense, and the related tax effect,
using balances for fixed assets restated to December 31, 1997.
b. Principles of Consolidation
These consolidated financial statements include the financial records of
the Holding Company and its subsidiary, Embratel. All material intercompany
accounts and transactions have been eliminated.
c. Reclassifications
These financial statements reflect certain classifications that differ from
those reflected in the Company's audited consolidated financial statements
at December 31, 1996 and 1997 and for the periods ended December 31, 1995,
1996 and 1997 (the "Consolidated Financial Statements"). The principal such
differences are: (A) certain expenses classified as selling expense in the
Consolidated Financial Statements are classified as cost of services in
these financial statements (R$76,451 in the 1997 interim period and
R$102,009 in the 1998 interim period) and (B) certain expenses classified
as cost of services in the Consolidated Financial Statements are classified
as general and administrative expense in these financial statements
(R$75,425 in the 1997 interim period and R$96,107 in the 1998 interim
period).
The major items reclassified from selling expense to cost of services were
certain labor costs. The major items reclassified from cost of services to
general and administrative were third party services and depreciation.
Prior to 1997, there was one "operational cost center". During 1997, three
cost centers were formed (Services, Engineering and Administration) to more
accurately allocate such costs as accounting services, purchasing,
treasury, security, etc.
3. Summary of the principal accounting practices
a. Allowance for doubtful accounts
The Company makes provisions for trade accounts receivable for which
recoverability is considered improbable.
b. Property, plant and equipment
Property, plant and equipment is stated at cost, restated for inflation as
of December 31, 1997, which became the new basis for accounting as more
fully described in Note 2a. Improvements to existing property are
capitalized while maintenance and repair costs are charged to expense as
incurred. Materials allocated to specific projects are added to
construction-in-progress. The residual value of old or obsolete equipment
is written off at the time the equipment is retired from service,
substantially all of which retirement occurs in the year in which such
equipment is identified as requiring replacement. Where early
identification of a need
F-54
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
for replacement occurs, accelerated depreciation is charged through to the
date of expected replacement. Depreciation is provided using the straight-
line method based on the estimated useful lives of the underlying assets as
determined by the public telecommunications service regulators.
Interest, calculated monthly at a rate of 12% per annum on construction-in-
progress, is capitalized as part of property, plant and equipment until the
asset is placed in service.
c. Shareholders' equity and earnings per share
The consolidated financial statements reflect the shareholders' equity of
the Holding Company, after segregating as minority interests the
participation of minority shareholders in the Holding Company's subsidiary,
Embratel, at the historical percentages applicable to shareholders other
than the Holding Company. The shareholders' equity has been segregated
between capital, reserves and retained earnings.
For US GAAP purposes, the equity structure utilized for earnings per share
computations for all periods presented is that of the new entity formed in
May 1998.
d. Use of estimates
The preparation of consolidated financial statements in conformity with
Brazilian and US GAAP requires management to make estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the consolidated financial
statements, and the reported amounts of revenues and expenses during the
period reported. Actual results could differ from those estimates.
e. Revenue
Revenues from all services are recognized when the service is provided. The
Company records as revenue the amount of communication services furnished,
as measured primarily by the minutes of traffic processed, after deducting
an estimate for billing errors or disputes. Some products are billed on a
fixed-price monthly fee basis. For these fixed-price products, bills are
generated on a monthly basis and the revenue is recognized in the month
billed.
Revenues from international services also include revenues earned under
bilateral agreements between Embratel and foreign telecommunications
administrations or private operators, which are influenced by the
guidelines of the International Tariff and Trade Regulations and cover
virtually all international calls to and from Brazil. These agreements
govern the ratio of payment by Embratel to the foreign entities for the use
of their facilities in connecting international calls billed in Brazil and
by the foreign entity to Embratel for the use of its facilities in
connecting international calls billed abroad.
4. Other net operating income (expense)
<TABLE>
<CAPTION>
Nine months
ended September
30,
-----------------
1997 1998
------- --------
<S> <C> <C>
Taxes other than income taxes............................. (58,904) (12,629)
Provision for contingencies (Note 12)..................... (13,530) (9,112)
Municipal and state taxes on property and vehicles........ (3,138) (3,809)
Voluntary resignation incentive program (Note 14)......... -- (56,804)
Pension plan (Notes 13 and 17)............................ -- (341,230)
Post-retirement healthcare plan (Note 13)................. -- (55,756)
Other..................................................... (1,776) 3,533
------- --------
(77,348) (475,807)
======= ========
</TABLE>
F-55
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
5. Net other nonoperating income (expense)
<TABLE>
<CAPTION>
Nine months ended
September 30,
------------------
1997 1998
-------- --------
<S> <C> <C>
Net book value of permanent asset disposals, write-
offs and provisions:
Proceeds from asset disposals........................ 13,075 6,468
Capitalized interest................................. 5,675 2,840
International Partnership............................ 6,751 23,518
Loss on disposals of permanent assets................ (64,436) (104,354)
Write off on asset impairments....................... (108,600) --
Other................................................ 9,810 (6,032)
-------- --------
(137,725) (77,560)
======== ========
</TABLE>
During the first nine months of 1997, the Company wrote-off telex equipment
in the amount of R$108.6 million, which comprised the entire remaining book
value of the Company's telex equipment. The write-off resulted from a 71%
increase in the cost of leasing the dedicated lines required for the
provision of telex services at the end of 1996. Management believed that
market conditions would not allow this additional cost to be passed on to
telex consumers and, as a result, expected the line of business to become
increasingly unprofitable. The amount of the 1997 telex write-off was
determined by providing in full against the remaining net book value of the
equipment at the time it was removed from service.
Losses on equipment disposals during the nine months ended September 30,
1998 totaled R$104.3 million which included sales of equipment and
scrapping of excess equipment. For the same period in 1997, R$64.4 million
in equipment was disposed of in the ordinary course of business.
The Company records its equity in the income of the international
partnership based on its percentage of ownership, which varies over time
depending on the utilization rates of the Company and the other partners.
The international partnerships correspond to Embratel's interest in two
partnerships which own and operate satellites (Intelsat and Inmarsat). At
September 30, 1998, the Company's percentages of ownership in the Intelsat
and Inmarsat partnerships were 2.104549% and 1.995980%, respectively. The
interests are denominated in US dollars. The partnerships are owned by the
users of the services and allocate benefits and operating expenses and
other costs and expenses to their members, with a targeted return on
capital currently set at 17-21%.
Intelsat historically has allocated undistributed earnings to a reserve
account that was not included in shareholders' equity. Amounts were
transferred from this reserve account to shareholders' equity, as
necessary, in order to ensure that targeted rates of return were met. In
1997, the entire amount of this reserve account was transferred to
shareholders' equity.
Although the matter is not free from doubt, the Company believes that under
the terms of the Intelsat partnership agreement amounts included in the
reserve account described above are not available for distribution until
transferred to shareholders' equity. This matter is not free from doubt
because the partnership agreement does not clearly establish the rights of
the partners upon withdrawal with respect to undistributed earnings that
are not allocated to shareholders' equity. Embratel has been informed by
Intelsat that as of March 12, 1999 no partner had withdrawn from Intelsat.
F-56
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
Accordingly Embratel has recognized its equity interest in these
partnerships based on its share of shareholders' equity, excluding any
earnings allocated to the reserve account, so that the year in which income
is recognized by Embratel may differ from the year in which it is earned by
the partnership. The equity in earnings of the partnerships recorded in
each of the periods as other net non operating income (expense) was as
follows:
<TABLE>
<CAPTION>
Nine months ended
September 30,
------------------
1997 1998
-------- ---------
<S> <C> <C>
Intelsat............................................... R$ 6,735 R$ 17,122
Inmarsat............................................... 16 6,396
</TABLE>
Of these amounts, approximately R$4,155 and R$0, were related to amounts
which were transferred by Intelsat from the reserve account described above
to stockholders' equity in the nine months ended September 30, 1997 and
1998.
6. Income and social contribution taxes
Brazilian income taxes are comprised of Federal income tax and the social
contribution tax. In 1997 and 1998 the rate for income tax was 25% and
social contribution tax was 8%. As a result of legislation enacted in 1996
the social contribution tax was no longer deductible for its own
computation basis, nor was it deductible for income tax purposes. The
changes produced a combined statutory rate of 33% in 1997 and 1998.
Deferred taxes are provided on temporary differences which include the
effects of indexation adjustments that will not give rise to deductions
when subsequently depreciated, amortized or disposed of.
In prior years, the indexation adjustments to permanent assets and
shareholders' equity in accordance with the tax law gave rise to a tax
deductible expense if the indexation of equity exceeded the indexation of
permanent assets, and to taxable income called inflationary profit, if the
indexation of permanent assets exceeded that of equity. In the latter case,
payment of the related tax liability could be deferred until it had been
deemed to have been realized either through depreciation or disposal of the
permanent assets in existence at the time the liability was recorded
subject to a minimum realization rate of 10% per annum (5% per annum prior
to 1995).
In 1997, Embratel elected to prepay income taxes on inflationary profit
that it had previously deferred. Brazilian companies making such a
prepayment in relation to 1997 were entitled to a 50% discount on the
payment of income tax. The result for Embratel was a gain of R$ 3,153 in
1997 from the reduction of its deferred tax liabilities.
At September 30, 1998 Embratel had tax loss carryforwards totaling R$
248,736 for income tax purposes, to offset against future taxable income,
for which the future benefits have been fully recognized as deferred tax
assets. The offset of accumulated tax losses is restricted to 30% of
taxable profits of subsequent periods, but the losses have no expiration
date.
The following is a reconciliation of the amount calculated by applying the
combined statutory tax rates to the reported income before taxes and the
reported income tax expense:
F-57
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
<TABLE>
<CAPTION>
Nine months ended
September 30,
------------------
1997 1998
-------- --------
<S> <C> <C>
Income (loss) before taxes and other charges as
reported in the accompanying consolidated financial
statements............................................ 357,665 (146,733)
Tax (charge) credit at the combined statutory rate..... (118,030) 48,422
Permanent additions:
Non-deductible expenses................................ (4,161) (3,581)
Permanent exclusions:
Foreign income........................................ 83,301 68,991
Capitalized interest.................................. 1,368 710
Other................................................. 297 4,480
Other items:
Early payment incentives.............................. 3,153 --
-------- --------
Income tax (charge) credit as reported in the
accompanying consolidated financial statements........ (34,072) 119,022
======== ========
Effective tax rate..................................... 10% (81%)
-------- --------
</TABLE>
The composition of deferred tax assets and liabilities, based on temporary
differences is as follows:
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Deferred tax assets:
Provisions for contingencies .................. 31,099 3,007
Tax loss carry forwards ....................... 102,557 82,083
Provisions for permanent asset write-offs ..... 47,208 35,334
Provisions for pension plan vesting; healthcare
plan and voluntary severance ................. -- 149,749
Accelerated Depreciation....................... -- 16,184
Provision for doubtful accounts................ 3,795 18,017
Other ......................................... 7,514 10,355
------- -------
Total (Note 9) ............................... 192,173 314,729
======= =======
Deferred tax liabilities:
Current ....................................... 22,577 34,413
Non current ................................... 314,786 265,653
------- -------
Total......................................... 337,363 300,066
======= =======
</TABLE>
All of the deferred tax liabilities relate to the difference between the
tax basis of permanent assets, which was not indexed for inflation
subsequent to December 31, 1995, and the reporting basis, which includes
indexation through December 31, 1997.
F-58
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
7. Cash flow information
<TABLE>
<CAPTION>
Nine months
ended September 30,
-------------------
1997 1998
--------- ---------
<S> <C> <C>
Income and social contribution tax paid.................. 47,037 21,287
Interest paid............................................ 43,524 39,003
Non cash transactions:
Fiscal incentive investments............................ 904 --
</TABLE>
8. Accounts receivables, net
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Accrued amounts .................................. 204,963 457,100
Billed amounts ................................... 264,312 244,043
Allowance for doubtful accounts .................. (11,500) (54,235)
------- -------
457,775 646,908
======= =======
</TABLE>
<TABLE>
<CAPTION>
Nine months
ended
September 30,
---------------
1997 1998
------ -------
<S> <C> <C>
Allowance for doubtful accounts:
Beginning balance ........................................... 1,418 11,500
Provision for doubtful accounts ............................. -- 42,735
Charge-offs ................................................. (80) --
------ -------
1,338 54,235
====== =======
</TABLE>
9. Deferred and recoverable taxes
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Tax deducted at source ........................... 24,232 2,402
Social contribution tax recoverable............... 9,948 79,695
Deferred tax assets .............................. 192,173 314,729
Sales and other taxes ............................ 22,908 24,888
------- -------
249,261 421,714
======= =======
Current........................................... 249,261 304,257
Non current (included in other assets)............ -- 117,457
------- -------
Total........................................... 249,261 421,714
======= =======
</TABLE>
F-59
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
10. Property, plant and equipment, net
Composition:
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Indexed cost:
Construction-in-progress......................... 1,073,261 1,099,709
Automatic switching equipment.................... 1,648,399 1,647,908
Transmission and other equipment................. 4,252,347 4,638,233
Buildings and underground ducts.................. 1,350,017 1,423,379
Other............................................ 2,110,401 2,138,327
---------- ----------
Total......................................... 10,434,425 10,947,556
========== ==========
Accumulated depreciation:
Automatic switching equipment.................... (844,907) (934,511)
Transmission and other equipment................. (1,777,397) (2,087,429)
Buildings and underground ducts.................. (585,362) (632,201)
Other............................................ (900,551) (780,619)
---------- ----------
Total......................................... (4,108,217) (4,434,760)
========== ==========
Property, plant and equipment, net................ 6,326,208 6,512,796
========== ==========
</TABLE>
Transmission and other equipment include: aerial, underground and building
cables, private automatic exchanges, generating equipment and furniture.
Other property, plant and equipment include: underground cables, submarine
cables, computer equipment, vehicles, land and other assets. Contained
within Other property, plant and equipment is land with a book value of
R$175,732 and R$193,022 in 1997 and 1998, respectively.
11. Credit agreement defaults
The Company is party to certain credit agreements that contain covenants
restricting, among other things, (i) the ability of Telebras to dispose of
all or a substantial part of its assets or to cease to control a company
that was an operating subsidiary of the Telebras System and (ii) the
ability of the Federal Government to dispose of its controlling interest in
the Telebras System. The Breakup of Telebras on May 22, 1998 and the
privatization of the Company constituted an event of default under such
credit agreements. In addition, most of the Company's other credit
agreements include cross-default provisions and cross-acceleration
provisions that would permit the holders of such indebtedness to declare
the indebtedness to be in default and to accelerate the maturity thereof if
a significant portion of the principal amount of the Company's debt is in
default or accelerated. A substantial portion (R$449,037) of the Company's
outstanding debt is currently in default as a result of the privatization.
The Company is currently in negotiations with the appropriate creditors
with respect to this indebtedness.
The consolidated financial statements do not include any adjustments
relating to the recoverability of assets and classification of liabilities
that might be necessary should the Company be unable to renegotiate its
F-60
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
credit agreements. The Company believes that creditors will renegotiate the
terms of these credit agreements and/or provide appropriate waivers
regarding such defaults.
12. Contingencies
The Company is a party to certain legal proceedings arising in the normal
course of business, including civil, administrative, tax, social security
and labor proceedings. The Company has provided for amounts to cover its
estimated losses due to adverse legal judgments. In the opinion of
management, such actions, if decided adversely to the Company, would not
have a material adverse effect on the Company's business, consolidated
financial condition or results of operations.
Telebras, the legal predecessors of the Company, is a defendant in a number
of legal proceedings and subject to other claims and contingencies. Any
claims against Telebras which are not satisfied by Telebras could result in
claims against the Company or the Holding Company. Management of the
Company believes that the chances of any such claims materializing and
having a material adverse financial effect on the Company are remote.
Labor claims
The provision for labor claims amounted to R$11,019 and R$17,090 at
December 31, 1997 and September 30, 1998, respectively. These amounts
represent management's estimate of the most probable loss in relation to
numerous suits filed by current and former employees. An analysis of the
movement on the provision is as follows:
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Beginning balance .............................. 15,373 11,019
Provision charged to other operating expenses
(Note 4) ...................................... 18,776 9,112
Payments ....................................... (23,130) (3,041)
------- ------
11,019 17,090
======= ======
</TABLE>
Tax contingencies
FINSOCIAL and COFINS taxes
A predecessor tax to COFINS, called FINSOCIAL, was originally introduced at
a rate of 0.5% and was subsequently increased in stages to a rate of 2.0%
on gross operating revenues. The timing of these increases was successfully
challenged in court by a number of Brazilian companies, giving rise to tax
credits on account of past overpayments which could be compensated against
current payments of the similar tax, COFINS. The Company recorded a credit
for the overpaid FINSOCIAL tax in 1995 after a High Court ruling had been
published decreeing the unconstitutionality of the FINSOCIAL rate
increases. The Company realized this credit by offsetting overpaid
FINSOCIAL taxes against current liabilities to COFINS. Embratel recognized
a gain of R$42.9 million in 1995.
In 1997 Embratel was questioned by the COFINS authorities alleging that it
had underpaid the COFINS tax in prior years as a result of taking the
FINSOCIAL credit. Embratel and its lawyers are defending this claim, but,
because the existence of this dispute was making it difficult for Embratel
to obtain tax clearance
F-61
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
certificates it required (in order to be able to participate in public bids
as a supplier to government entities, import equipment which is tax exempt
and record real estate transactions in the public registry), management
decided to pay the tax in 48 monthly installments. This gave rise to an
additional charge of R$58.9 million in 1997. In April, 1998, as a result of
obtaining an initial favorable decision in legal proceedings initiated by
the Company to prove the unconstitutionality of charging COFINS for
telecommunications services, Embratel suspended its payment of installments
under the aforementioned agreement.
Withholding tax on remittances to foreign communications companies
The Company regularly makes payments to foreign communications companies to
complete international calls that originate in Brazil and terminate in a
foreign country. Brazilian income tax law generally requires Brazilian
recipients of services from foreign companies to withhold 15% from payments
to such foreign companies for such services. However, based on decisions in
1952 of both the Brazilian Finance Ministry and the Taxpayers' Council, the
Company has never withheld Brazilian income tax from such payments.
Brazil is a signatory to the International Telecommunications Agreement of
1989, known as the Melbourne Treaty, in which the members agreed, among
other things, not to tax payments of this nature. For this treaty to have
legal effect in Brazil, presidential approval is required. Although there
has been no indication that such presidential approval will not be granted,
it has not been granted to date.
Should a retroactive presidential decree not be signed, the income tax
authorities may reconsider their earlier decisions exempting payments to
foreign communications companies from Brazilian income tax. If the
authorities were to challenge this exemption and determine that their
earlier decisions are no longer applicable to the Company, then they may
claim unpaid taxes together with interest and penalties of approximately
R$776 million through September 30, 1998. Based on the decisions in 1952 of
both the Brazilian Finance Ministry and the Taxpayers' Council to exempt
the withholding of Brazilian income tax from payments to foreign
communications companies, the Company has never withheld Brazilian income
tax from such payments. Accordingly, the accompanying consolidated
financial statements do not include any provision for such taxes.
Management continually monitors and is evaluating its position with respect
to this tax contingency to determine if there have been changes, which
could, in the opinion of management, result in an unfavorable outcome to
the Company.
Income tax on net foreign source operating income
On January 1, 1996 a new Brazilian law came into effect requiring that any
income from abroad is subject to corporate income tax. The Company believes
that the foreign source operating income of Embratel is not subject to tax
because the new law does not cover income from telecommunications services.
Additionally, the Company believes that it is exempt in accordance with a
specific exemption granted to foreign source telecommunications income
before the advent of the new law. If the Company should be challenged by
the fiscal authorities, it may be liable to additional income tax which,
together with interest and penalties for late payment, would have amounted
to a liability of approximately R$512 million at September 30, 1998, for
which no provision has been made in the accompanying financial statements.
Management continually
F-62
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
monitors and is evaluating its position with respect to this tax
contingency to determine if there have been changes which, in the opinion
of management, could result in an unfavorable outcome to the Company.
Other taxes
The determination of the manner in which federal, state and municipal taxes
apply to the operations of Embratel is subject to varying interpretations
due to the unique nature of its operations. Management believes that its
interpretation of Embratel's tax obligations is substantially in compliance
with current legislation. Accordingly, any changes in the tax treatment of
its operations will be the result of new legislation or interpretive
rulings of the tax authorities which will not have any retroactive impact.
Other litigation
Management believes it has meritorious defenses to all lawsuits and legal
proceedings in which Embratel is a defendant. Based on its evaluation of
such matters, and after consideration of reserves established, management
believes that the resolution of such matters will not have a material
adverse effect on the Company's consolidated financial position or results
of its operations.
13. Pension and post-retirement benefit plans
Embratel sponsors a defined benefit pension plan and a post retirement
benefit plan, both managed by the Fundacao Embratel de Seguridade Social
(Telos'). Approximately 97% of Embratel's employees are covered by these
plans.
Subsequent to the privatization, the Company created a new defined
contribution plan (the "new plan"), through Telos, which was reviewed by
the Brazilian government. The Brazilian government approved the new plan on
November 18, 1998. All newly hired employees of Embratel will automatically
enter the new plan and entry into the existing Embratel pension and post-
retirement plans will be frozen. Current Embratel employees have been given
the option to migrate from the existing defined benefit pension and post-
retirement benefit plans to the new plan. Any employees who elect the new
plan will vest in certain pension benefits earned for the service period
prior to the conversion date in accordance with a new vesting schedule. In
connection with this vesting, Embratel has recorded pension expense of
R$341,230 based on actuarial calculations. The option expires on December
31, 1998.
The new defined contribution plan will provide an employer match on
employee contributions based on certain limits, transfer of the defined
benefit account balance, employee directed investment, and a lump sum
payment from the post-retirement benefit plan, which can be used to assist
with medical coverage in the future. Any employees not electing to migrate
to the new plan will remain in the existing plan and will not have a future
opportunity to move to the new plan.
F-63
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
A summary of the plans, in compliance with accounting principles generally
accepted in Brazil, is as follows:
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Accumulated pension and other post retirement
benefit obligations........................... 592,307 643,102
Other obligations.............................. 78,810 44,088
------- -------
Total obligations.............................. 671,117 687,190
======= =======
Combined plan assets:
Interest bearing deposits..................... 362,613 468,468
Stocks and shares............................. 296,619 237,396
Investment properties......................... 75,110 74,878
Loans to beneficiaries........................ 33,055 35,587
Other investments............................. 31,311 42,332
------- -------
Total plan assets............................. 798,708 858,661
======= =======
Employer's contributions for the plans during
the year...................................... 61,687 40,803
======= =======
</TABLE>
The Company is negotiating with the Brazilian pension regulators
(Secretaria de Previdencia Complementar) and the government state companies
secretariat to increase the funding of the Telos pension fund. An actuarial
study has determined that an additional contribution of R$213,000 is
required including R$106,000 relating to an income tax dispute of the
pension fund. If the tax dispute is decided in favor of Telos, then only an
additional R$107,000 will be required. It is management's intention to pay
the additional amount over 20 years. There can be no assurance that these
negotiations will continue or result in payment to Telos under the
aforementioned terms. This potential additional payment has not been
recognized as a liability at December 31, 1997 or September 30, 1998.
Post retirement health care plan
During the third quarter of 1998, the Company offered a cash payment to
employees who elect to exit the post-retirement health care plan, this
option expires on December 31, 1998. Based on estimates of the number of
people who will exit the plan, the Company recorded a charge of R$55,756 in
the third quarter of 1998.
14. Voluntary resignation incentive program
The Company recorded a charge in "Other operating income (expense) of
R$57.0 million related to a voluntary termination program offered by the
Company to employees engaged in activities that are expected to be
outsourced. Under Brazilian GAAP, this amount was accrued when the expense
became probable and reasonably estimable. Embratel's prior voluntary
termination programs (which had similar terms and conditions) provide a
basis for estimating the expected employee acceptance rate and cost of the
program. For U.S. GAAP, the charge for the voluntary termination program
will be recognized in the fourth quarter of 1998 in accordance with SFAS
No. 88. This statement requires an employer that offers special termination
benefits to employees to recognize a liability and a loss when the
employees accept the offer and the amount can be reasonably estimated. The
offer expired on November 23, 1998 and 1,537 of the Company's employees
accepted the offer, resulting in actual severance payments of R$72 million.
For Brazilian GAAP, the difference between the amount accrued in the third
quarter and the actual amount will
F-64
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
be recorded in the fourth quarter of 1998. Severance payments will be made
under this program in the fourth quarter of 1998. Management plans to fund
such payments with available cash or cash generated from operations.
15. Share Repurchase
On September 24, 1998, the Board of Directors of the Registrant authorized
the acquisition by the Company of up to 5.9 billion Common Shares and 21.0
billion Preferred Shares within the three month period ending December 24,
1998. The Company may from time to time purchase the Registrant's Common
Shares and Preferred Shares but had not done so as of November 30, 1998.
16. Transactions with related parties
The principal related party transactions take place with the fixed
telephony companies which were spun off from Telebras in the privatization.
Embratel provides domestic and international long-distance
telecommunications services to the customers of the local operating
companies. However, all charges to customers are billed by the local
operating companies. As a result Embratel normally has a receivable
position with each of the local operating companies.
Before the Breakup and privatization, the Company was the exclusive
provider of interstate long-distance service under Brazilian law. Under the
regulatory regime in effect before the Breakup and privatization, each
cellular and fixed-line company generally operated within one of the 26
states of Brazil or the Federal District and Embratel had the exclusive
right to carry calls between any two cellular or fixed-line companies.
Prior to the Breakup and privatization, Embratel paid a network usage fee
if it accesses end customers via the network of a fixed-line
telecommunications company. In practical terms, even though the network
usage fee includes the costs of a variety of network elements and services,
the network usage fee primarily reflects the use of certain facilities of
the fixed-line company for which Embratel does not have adequate
substitutes, particularly the local loop between local exchanges and end
customers.
Until April 1, 1998, revenues for domestic and international long-distance
calls were divided between the Company and the regional fixed-line
companies. Under this system, each regional fixed-line company billed its
customers for all domestic and international long-distance telephone calls
and retained a fixed percentage of the revenue, transferring the remainder
of the revenue to the Company. The fixed percentage varied by regional
fixed-line company. As of March 31, 1998, the regional fixed-line companies
transferred an average of 33% of the total revenue for such calls to
Embratel.
As part of the liberalization of the Brazilian telecommunications sector,
this system was eliminated as of April 1, 1998. Under the new system, the
Company receives 100% of the revenues from domestic and international long-
distance calls and pays certain per-minute interconnection charges to the
regional fixed-line companies for connection to and use of their networks.
In addition, until June 30, 2001, the Company must pay a supplemental per-
minute charge for such interconnection, the Parcela Adicional Temporaria
(the "PAT"). The Company does not expect that implementation of this new
system will have a material impact on its net income. However, the
allocation to the Company of 100% of the revenues generated by long
F-65
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
distance calls has caused operating revenues to increase substantially.
This increase has been substantially offset by increased cost of services
resulting from the network usage charges and PAT paid to the fixed-line
companies.
The Company and MCI WORLDCOM have entered into a Management Agreement
effective August 4, 1998, which was approved by the shareholders of the
Company, pursuant to which MCI WORLDCOM will provide advice regarding the
management, operations and business of the Company. Under the agreement,
Embratel is to pay MCI WORLDCOM as compensation for its management services
in 1998, 1999 and 2000, an amount equal to one percent of Embratel's annual
revenue during each such year. The compensation for management services to
be provided in 2001 and 2002 is one half percent of Embratel's annual
revenue in each such year. For 2003, the compensation for management
services to be provided is two tenths percent of Embratel's annual revenue
for such year. Under the Management Agreement, Embratel separately
reimburses MCI WORLDCOM for any expenses incurred in connection with the
provision of services under the Management Agreement. Embratel had at
September 30, 1998 accrued R$27.9 million and R$3.6 million for management
services fees and expense reimbursement, respectively, pursuant to the
Management Agreement with respect to management services provided from
August 4, 1998 to September 30, 1998. Pursuant to the terms of the
Management Agreement, the amount of fees accrued with respect to such
services was determined based on revenues reported during the period
January 1, 1998 through September 30, 1998.
F-66
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
17. Summary of the differences between Brazilian and U.S. GAAP
Embratel's accounting policies comply with generally accepted accounting
principles in Brazil ("Brazilian GAAP"). The impact of accounting policies
which differ significantly from generally accepted accounting principles in
the United States of America ("US GAAP") are reflected in the following
tables:
Net income reconciliation of the differences between US and Brazilian GAAP
<TABLE>
<CAPTION>
Nine months ended
September 30,
------------------
1997 1998
-------- --------
<S> <C> <C>
Income (loss) as reported............................... 294,382 (45,140)
Add (deduct):
Different criteria for:
Capitalized interest.................................. (19,601) 3,087
Amortization of capitalized interest.................. 34,109 52,203
Pension and other post retirement benefits:
SFAS 87 adjustment.................................... (22,034) (2,479)
SFAS 106 adjustment and curtailment of post retirement
Healthcare plan...................................... (11,650) (19,985)
Voluntary severance plan............................... -- 56,804
Stock compensation for shares sold to Employees by the
Federal government.................................... -- (52,000)
Change in pension plan................................. -- 282,230
Reversal of COFINS tax credit.......................... 42,900 --
Payment for voluntary exit from post-retirement
healthcare plan....................................... -- 55,756
Items posted directly to shareholders' equity accounts:
Deferred tax effect of the non deductibility of the
indexation increments to
shareholders' equity................................. (132,676) 1,207
Effects of changes in income tax rates................ 2,917 --
Fiscal incentive investments.......................... 904 --
Interest on construction in progress.................. 60,821 62,545
Deferred tax effect of the above adjustments........... (7,829) (143,181)
Effect of minority interest in the above adjustments... (652) 4,400
-------- --------
US GAAP income(2)....................................... 241,591 255,447
======== ========
</TABLE>
Net income per thousand shares in accordance with US GAAP
<TABLE>
<CAPTION>
September 30,
------------------------
1997 1998
----------- ------------
<S> <C> <C>
Basic:
Common shares..................................... 0.75 .78
Weighted average (thousand) common shares
outstanding...................................... 124,351,903 124,351,903
Preferred shares.................................. .75 .78
Weighted average (thousand) preferred shares
outstanding(1)................................... 196,311,647 205,457,214
</TABLE>
(1) Weighted average preferred shares outstanding includes from April 1998 the
13,718,350 thousand preferred shares issued in April 1998.
(2) US GAAP net income for the nine months ended September 30, 1997 does not
include net income relating to the discontinued operations of Telebras and
its subsidiaries, except for those operations of Embratel. (See Note 29 to
the Consolidated Financial Statements for the years ended December 31,
1995, 1996 and 1997.)
F-67
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
Net equity reconciliation of the differences between US and Brazilian GAAP
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Total shareholders' equity as reported.......... 5,908,044 5,925,958
Add (deduct):
Different criteria for:
Capitalized interest........................ (925,395) (916,042)
Amortization of capitalized interest........ 432,702 484,905
Reversal of proposed dividends and net
interest on capital.......................... 296,081 --
Reversal of dividend distribution tax......... 23,810 --
Pension and other post retirement benefits:
SFAS 87 adjustment.......................... (507,938) (228,187)
SFAS 106 adjustment......................... (166,015) (186,000)
Provision for voluntary exit from post-
retirement healthcare plan..................... -- 55,756
Voluntary severance plan........................ -- 56,804
Deferred tax effects of the above adjustments... 384,993 241,812
Effect of minority interest on the above
adjustments.................................... 5,772 1,372
---------- ---------
5,452,054 5,436,378
US GAAP net assets of discontinued operations... 26,591,377 --
---------- ---------
US GAAP shareholders' equity(1)................. 32,043,431 5,436,378
========== =========
</TABLE>
--------
(1) The presentation of the U.S. GAAP adjustments to the total net equity
of the Company at December 31, 1997, is consistent with the
presentation in the published consolidated financial statements of
Telebras except for (1) reversal of COFINS tax credits totalling R$
137,819 recorded in 1994, 1995 and 1996 under Brazilian GAAP relating
to a tax dispute which for U.S. GAAP purposes do not meet the SFAS 5
criteria for gain recognition and (2) reversal in 1997 of the R$42,900
COFINS gain recognition adjustment in respect of the continuing
operations of the Company when Embratel again recognized a liability
for COFINS.
The deferred tax effect of the US GAAP adjustments relating to continuing
operations noted above of R$384,993 in 1997 and R$241,812 in 1998, would
principally be classified as non-current on the balance sheet.
Under US GAAP R$449 million of long-term debt would be classified as
current due to the default described in Note 11.
A description of the U.S. GAAP differences which arose during 1998 are as
follows:
a) Pension and post-retirement healthcare plan
Employees were offered the option to convert to a defined contribution plan
in the third quarter of 1998. As part of the incentive for employees to
convert to the new plan, those employees that elected to convert
automatically vest in any pension benefits earned for the service period
prior to conversion date. The actuarial calculation of those vested
benefits totaled R$341million under Brazilian GAAP. The pension obligation
arising from such conversions is expected to be funded over seventeen
years, which is the
F-68
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
actuarial estimate of the average remaining working life of the converting
employees. The third quarter charge is based on such actuarial estimates.
In accordance with U.S. GAAP, this change has been treated as a curtailment
under SFAS No. 88, resulting in a charge of $R59 million, which is lower
than the Brazilian GAAP charge due to the fact that a large portion of
those liabilities had been previously recorded under SFAS No. 87 for U.S.
GAAP purposes.
b) Voluntary Severance Plans
Under Brazilian GAAP, an expense that is known and can be reasonably
estimated must be accrued in the period it can be estimated. The Company
accrued R$57 million related to a plan offered to employees beginning in
the third quarter of 1998 for voluntary termination (See Note 14). Under
U.S. GAAP, restructuring expenses can only be accrued in the period in
which the amount is actually fixed and determinable.
c) Stock Compensation
As part of the privatization of the Telebras System, the Federal Government
offered Telebras System employees the right to purchase the Federal
Government's entire holding of Telebras preferred shares and preferred
shares of each of the twelve new holding companies formed as a result of
the breakup of Telebras ("New Holding Companies") (representing 2.18% of
the outstanding capital stock of Telebras and of each New Holding Company)
at a price of R$69.24 per lot of 13,000 shares (each a "lot" and comprised
of 1,000 preferred shares of each of Telebras and the twelve New Holding
Companies). This price represents a 50% discount from the market price of
1,000 Telebras preferred shares at the time the Federal Government
authorized the plan. Each employee had the right to purchase up to 144 lots
of 13,000 preferred shares, subject to proration if the shares are
oversubscribed.
The Federal Government has made 7.2 million lots available for sale, or 60%
of the 12.1 million lots that would be taken up if each employee purchased
the maximum 144 lots allowed. The period to sign up to purchase the shares
ended on October 30, 1998. On August 4, 1998, the date on which the offer
to employees commenced and the measurement date for 60% of the shares, the
market price of 1,000 Telebras shares was R$127.20. Under U.S. GAAP, the
charge for the third quarter would be approximately R$52 million, which
represents Embratel's share of the offer price/market price differential on
60% of the shares offered for which the measurement date was August 4,
1998. As of October 30, 1998, the original expiration of the program,
Embratel employees had subscribed to 859,584 lots. This amount is slightly
below the 60% pro rata portion available to those employees, however the
R$2.0 million reduction of expense that would have resulted from this
shortfall was not recorded in the fourth quarter, as the Brazilian
government has extended the expiration of the program to April 9, 1999.
Pursuant to the extension, employees can rescind their subscriptions at any
time prior to April 9, 1999 and shares relating to rescinded subscriptions
will be reassigned to the remaining subscribers on a pro rata basis. Any
difference between the 60% of the shares already recorded and the ultimate
number of shares subscribed by Embratel employees will be recorded at the
new expiration date. Based on subscriptions as of October 30, 1998 and the
fact that the market price of the shares is still higher than the exercise
price, the Company believes that there will not be a significant change in
the original amount of shares recorded.
Although the Federal Government, rather than the Company or Telebras
offered the shares to employees, under U.S. GAAP the deemed compensation
amount is "pushed down" to each of the New Holding Companies in accordance
with the number of shares purchased by each New Holding Company and its
subsidiaries' employees.
F-69
<PAGE>
EMBRATEL PARTICIPACOES S.A.
(See Notes 1 and 2)
NOTES TO THE UNAUDITED CONSOLIDATED CONDENSED
FINANCIAL STATEMENTS--(Continued)
(Amounts expressed in thousands of constant Brazilian reais, of December 31,
1997),
(thousands of Brazilian reais of September 30, 1998)
d) Classification
For purposes of U.S. GAAP income statement presentation, employee profit
sharing of R$(25,485) and R$(18,000) and net other nonoperating expense of
R$(137,725) and R$(77,560) for the nine months ended September 30, 1997 and
1998, respectively, are considered operating expenses.
18.Loss-making Services
The Company offers a number of ancillary telecommunication services
pursuant to licenses. Under the terms of the licenses, the Company is
generally required to continue for an indefinite period to offer to its
existing customers at July 27, 1998 (the date such licenses were granted)
telex and dedicated line telegraph, radio signal and television signal
satellite retransmission, mobile satellite communications, mobile maritime
telecommunications and certain data communications services. The Company is
also required to continue to offer telex services to new customers through
August 2001 (or such later date as is required for another service provider
to offer the same service). The Company is effectively prohibited from
increasing the fees charged for the above-described services (except, in
some cases, for increases up to the rate of inflation). The Company has
generated losses from the provision of these services and expects to
continue to do so in the future.
Management does not consider the services described above to constitute a
separate line or lines of business and historically has not accounted for
them separately. Management estimates that these activities generated gross
losses (net operating revenues less cost of services) of approximately R$78
million in each of 1995 and 1996, R$45 million in 1997 and R$32 million in
the first nine months of 1998. Management expects that these activities
will continue to generate losses and that the aggregate of such losses will
range from approximately R$120 and R$150 million between September 1998 and
September 2001. This estimate was computed by comparing projected direct
costs (mainly labor, materials and depreciation) of the services over the
three years from August 1998 (or shorter periods, in some cases) to
revenues projected to be generated by the services over the same periods.
Management believes that the level of losses will decline after 2001, by
which time management believes it should be possible to substantially
reduce the provision of such services.
19.Subsequent events
On January 13, 1999, the Central Bank of Brazil effectively devalued the
Brazilian real by 8% by resetting the band within which the currency was
permitted to trade. On January 18, 1999, the band was suspended and the
currency allowed to float freely. Since that time, the exchange rate has
been very volatile and the market rate was R$2.0033 to each U.S. dollar as
of February 24, 1999. At September 30, 1998, virtually all of the Company's
R$637,155 of debt is denominated in foreign currency and the Company has
not hedged its debt against devaluation. The net foreign currency liability
position of R$541,591 at September 30, 1998 has not changed significantly
since that date.
F-70
<PAGE>
EXHIBIT 10.5
MANAGEMENT AGREEMENT
MANAGEMENT AGREEMENT dated as of August 4, 1998, by and between Empresa
Brasileira de Telecomunicacoes S.A. - EMBRATEL, a sociedade anonima
established and existing under the laws of Brazil, registered with the
C.G.C./M.F. under number 33.530.486/0001-29, with offices at Av. Presidente
Vargas, 1012, CEP 20179-900, Rio de Janeiro, RJ, Brazil ("EMBRATEL') and MCI
Global Resources, Inc., a Delaware corporation, with offices at 2 International
Drive, Rye Brook, NY 10573, USA ("MCI").
WITNESSETH:
WHEREAS, Startel Participacoes Ltda., a limited liability company
organized under the laws of Brazil ("Purchaser"), and the Union, a/k/a the
Government of Brazil, have entered into a Share Purchase Agreement dated August
4, 1998 (the "Share Purchase Agreement"), pursuant to which Purchaser initially
acquired 51.79% of the voting stock of Embratel Participacoes S.A. "Embratel
Participacoes");
WHEREAS, Embratel Participacoes owns 98.75% of the voting stock of
EMBRATEL;
WHEREAS, Purchaser is an Affiliate of MCI;
WHEREAS, MCI has the management, technical and financial capability, and is
committed to developing and maintaining EMBRATEL's telecommunications system as
a technologically advanced, efficient system and EMBRATEL's services as
technologically current and responsive to customer requirements for the benefit
of Brazil and its citizens; and
WHEREAS, EMBRATEL desires to benefit from, and MCI desires to provide
EMBRATEL with, access to management, policy, operational, marketing and other
related experience of the senior management of MCI and its Affiliates for the
development and maintenance of EMBRATEL's telecommunications system and
services.
NOW THEREFORE, in consideration of the foregoing, it is agreed by and
between the Parties hereto as follows:
DEFINITIONS
-----------
Capitalized terms used in this Agreement and not otherwise defined shall have
the following meanings:
"Affiliate" shall mean with respect to any person, any other entity
---------
that, directly or indirectly, through one or more intermediaries, controls, is
controlled by or is under common control with, the specified person. For
purposes of this definition, the term "control" as applied to any entity, means
the possession, directly or indirectly, of the power to direct or cause the
direction of the management of that entity, whether through ownership of shares,
voting securities, partnership or other ownership interests, agreement or
otherwise. As used in this Agreement, the term "Affiliate," as it applies to
MCI, shall not include EMBRATEL and, as it applies to EMBRATEL, shall not
include MCI.
"Agreement" means this Management Agreement as amended or supplemented from time
- -----------
to time in accordance with its terms.
<PAGE>
"ANATEL" means the Brazilian Agencia Nacional de Telecommunicacoes.
- ---------
"Annual Revenue" means total annual revenue, arising out of the Services, as
--------------
defined hereinbelow, net of indirect taxes and contributions (ICMS, PIS and
COFINS).
"Brazil" means the Federative Republic of Brazil.
------
"EMBRATEL " shall mean Empresa Brasileira de Telecomunicacoes S.A. -
--------
EMBRATEL and its Affiliates, as applicable.
"Fiscal Year" shall mean a year commencing on I January and ending on 31
-----------
December of each year.
"Intellectual Property" means all current and future worldwide rights to any
- ----------------------
inventions, discoveries or improvements, whether or not patentable; copyrights;
trade secrets; know-how; utility models; Confidential Information; tradenames,
trademarks and service marks, whether or not registered; all other intangible
proprietary rights, including all applications and registrations with respect
thereto; and all tangible embodiments of any of the foregoing.
"MCI" shall mean MCI Global Resources, Inc. and its Affiliates, as applicable.
---
"Parties" shall mean both parties to this Agreement, each of whom is sometimes
referred to herein as a "Party."
"Service" shall mean the services that EMBRATEL is authorized to provide under
- ---------
the terms and conditions of the:
Concession Contract - National Long Distance, and
Concession Contract - International Long Distance
which were executed on June 2, 1998, between EMBRATEL and ANATEL (collectively,
the "Concession Contracts'); and the
Authorization Term of Network Transport Telecommunications Service,
Term of Right of Exploitation of Brazilian Satellites,
Authorization Term of Mobile Global Service by Satellite, and
Authorization Term of Maritime Mobile Service
which were executed on July 27, 1998, between EMBRATEL and ANATEL (collectively,
the "Authorization Terms"), which services are listed and detailed on Attachment
I hereto, provided, however, in the event of any discrepancy between the list on
Attachment 1 and the terms and conditions of the Concession Contracts and
Authorization Terms (as drafted in the original Portuguese), the Concession
Contracts and Authorization Terms shall prevail. In addition to the foregoing,
the term ""Services," as used in this Agreement, shall automatically include, as
of the effective date authorization is granted, any additional services that
EMBRATEL is authorized to provide during the Term hereof.
2
<PAGE>
ARTICLE I
APPOINTMENT
-----------
1.01 Appointment. EMBRATEL hereby appoints MCI to manage and advise and assist
-----------
with respect to the operations and administration of its business, and in
particular, the provision of the Services, subject to the terms and conditions
hereof, the Concession Contracts, the Authorization Terms, the Share Purchase
Agreement, the Certificate of Incorporation and Bylaws of EMBRATEL, and the
general authority, supervision and control of EMBRATEL acting through its Board
of Directors.
It is understood that the Management Services to be provided under this
Agreement are limited to offering advice and assistance of MCI's senior
management based upon MCI's experience in, and knowledge of, telecommunications.
EMBRATEL shall be responsible for determining whether to act upon, and
implementing, such advice and assistance and for day-to-day management and
operations. No provision of this Agreement shall require MCI or its Affiliates:
to dedicate, (calculated on a quarterly average basis) more than 25% (twenty-
five percent) of any respective member of senior management's work time to
providing the Management Services hereunder, to second full or part-time
personnel to EMBRATEL, to provide monetary contributions or loans to EMBRATEL,
to transfer Intellectual Property, or to offer advice and assistance in respect
to any EMBRATEL offerings other than the Services. In addition, any MCI senior
management or other personnel providing Management Services hereunder shall have
no authority to conclude or execute agreements on behalf of MCI or its
Affiliates while present in Brazil, shall remain employees of MCI or its
Affiliates and shall remain subject to all of MCI's policies, and shall continue
to receive all compensation and benefits directly from MCI or its Affiliates.
1.02 Acceptance. MCI hereby accepts its appointment hereunder and agrees to
----------
make available such skills, services and expertise, and to work in good faith
and in close cooperation with EMBRATEL, with the goal of strengthening the
strategic position of EMBRATEL in the telecommunications industry in Brazil and
making it a more business-driven, customer-oriented and technologically advanced
telecommunications operator.
ARTICLE II
GENERAL SERVICES
----------------
2.01 Management Services. MCI shall make experienced representatives of the
--------------------
senior management of its existing organizational areas and those of its
Affiliates reasonably available to EMBRATEL to provide advice and services in
the following areas: General Management and Oversight, Finance and Financial
Reporting, Business Planning, Business Strategy, Investor Relations, Regulatory,
Legal, Operations, Human Resources, Marketing, Sales, Advertising, Competitive
Analysis, Billing, Pricing, Customer Service and Satisfaction, New Products,
Procurement, and Network Planning (the "Management Services").
2.02 Management and Operating Experience. MCI will provide the Management
-----------------------------------
Services by coordination with EMBRATEL management and by means of making MCI's
senior management personnel available to EMBRATEL, as more fully described in
this Agreement, in the areas listed in Section 2.01 above.
3
<PAGE>
ARTICLE III
MANAGEMENT
----------
3.01 Responsibilities of MCI.
------------------------
(a) MCI shall, as requested by Embratel, provide advice regarding the
management, operations, and business of EMBRATEL as they relate to the Services,
including, but not limited to, the development and implementation of general
performance policies, organizational structure, annual budgets and business and
strategic plans ("Strategic Plans"), as described in Section 3.02. To this end,
EMBRATEL shall provide to MCI all the information requested by MCI and
unrestricted access to books, records and other data that MCI deems advisable
for exercising its management advisory responsibilities.
(b) MCI shall use its experience and information and theoretical and
practical knowledge, in its capacity as a telecommunications provider and
service operator, and those methods and procedures MCI presently knows and uses,
as well as all those resulting from the future development of MCI's knowledge
and experience, with the aim of improving and enhancing the operations, business
and value of EMBRATEL through the application of operating strategies and
management policies and practices available.
(c) At all times EMBRATEL may consult with MCI and may request advice of
MCI on any question relating to its business activities within the scope of this
Agreement.
(d) MCI shall offer to EMBRATEL the tangible and intangible benefits
arising from the relationship with MCI including, among other things, economies
of scale in the purchase of equipment, if and to the extent available. In
addition, upon mutual agreement of EMBRATEL and MCI, MCI shall assist in the
negotiations for EMBRATEL and its Affiliates to obtain certain technology from
outside sources other than MCI or any Affiliate thereof.
3.02 Strategic Plans.
----------------
(a) Within one hundred twenty (120) days of the date of this Agreement and,
for each subsequent year, at least thirty (but not more than ninety) days prior
to the beginning of EMBRATEL's fiscal year, MCI shall use its management
expertise and experience to assist EMBRATEL in the development of a Strategic
Plan for EMBRATEL and for the approval of EMBRATEL's Board of Directors. MCI
shall provide Management Services to assist EMBRATEL in implementing such
Strategic Plan as requested. Such strategic Plan shall address:
(i) Business strategies; planning (including technical, commercial,
acquisitions, information systems and real property) and short, medium and long
term timetables for the fulfillment of the plans;
(ii) Financial aspects, with particular emphasis on the analysis of
the financial performance which may include the financing needs and the
utilization of the most suitable financing sources, improving EMBRATEL's return
on capital invested; and assistance regarding the relationship with financial
institutions and entities in order to obtain improved financing terms; and
4
<PAGE>
(iii) Administration and human resources with particular reference to
the adoption of the most advisable administrative, accounting, tax, budgetary
and fiscal practices, methods and controls.
(b) Each Strategic Plan shall be developed by Embratel with MCI's
assistance and presented to the Board of Directors of EMBRATEL (the "Board") for
its approval.
3.03 Organizational Structure and Designation of Personnel.
------------------------------------------------------
(a) MCI shall advise EMBRATEL on any restructuring of, or modifications to,
the organizational structure of EMBRATEL (the "Organizational Structure") which
MCI may deem advisable and propose to EMBRATEL, from time to time, the personnel
to occupy positions within EMBRATEL and its Affiliates. MCI shall endeavor that
any such proposal comply with all pertinent labor laws, regulations, and
agreements (including the Share Purchase Agreement). Any action shall be taken
only at the direction of Embratel management and shall strictly comply with all
pertinent labor laws, regulations, and agreements (including the Share Purchase
Agreement). The designation and/or ratification of senior management and changes
in the Organizational Structure shall be subject, where appropriate, to the
approval of the Board in accordance with EMBRATEL's By-laws.
(b) The officers and senior management employees proposed by MCI shall, to
the knowledge of MCI, have the professional and technical qualifications to
perform the functions that in each case are assigned to them. MCI shall assess
such qualifications on the basis of objective evaluation methods. Such persons
may come from MCI and its Affiliates, from EMBRATEL through internal promotion
or from unaffiliated third parties.
ARTICLE IV
PAYMENTS
--------
4.01 Management Fee. EMBRATEL shall pay MCI as compensation for the Management
-----------
Services a management fee (the "Fee") as follows:
(a) for the period as of August 4, 1998, through December 31, 1998, one
percent (1%) of EMBRATEL's Annual Revenue derived from the Services during
Fiscal Year 1998;
(b) for the period January 1, 1999, through December 31, 1999, one percent
(1%) of EMBRATEL's Annual Revenue derived from the Services during Fiscal Year
1999;
(c) for the period January 1, 2000, through December 31, 2000, one percent
(1%) of EMBRATEL's Annual Revenue derived from the Services during Fiscal Year
2000;
(d) for the period January 1, 2001, through December 31, 2001, one half
percent (0.5%) of EMBRATEL's Annual Revenue derived from the Services during
Fiscal Year 2001;
(e) for the period January 1, 2002, through December 31, 2002, one half
percent (0.5%) of EMBRATEL's Annual Revenue derived from the Services during
Fiscal Year 2002; and
(f) for the period January 1, 2003, through December 31, 2003, two tenths
percent (0.2%) of EMBRATEL's Annual Revenue derived from the Services during
Fiscal Year 2003.
5
<PAGE>
The Parties agree that the Fee does not include MCI expenses which arise from or
relate to the Management Services provided by MCI under this Agreement, among
which may be included, without limitation, office and lodging expenses
(including, without limitation, the payment of leases, electric bills and
taxes), wireless and wireline telephone, e-mail, fax, travel and other expenses
relating to the foregoing (the "MCI Expenses"). Travel costs and related
expenses will be calculated in accordance with the travel and entertainment
expense reimbursement policies of MCI or its respective Affiliates. The MCI
Expenses shall be borne exclusively by EMBRATEL, as provided for in Section 5.01
below. Embratel agrees to provide MCI with appropriate office space, computer
equipment and software, telephones, copiers, etc. at its own expense.
4.02 Payment Terms.
-------------
(a) The Fee shall be payable in advance in quarterly installments payable
no later than the first day of the corresponding calendar quarter and shall be
calculated by applying the formula set forth in Section 4.01 of this Agreement
to the applicable portion of EMBRATEL's revenue for that quarter as set forth in
the current business plan approved by the Board ("Advance Fee"). In order to
reconcile discrepancies between the Advance Fee, based on forecasted revenue,
and actual revenue earned by EMBRATEL during the same quarter, at the end of
each calendar quarter EMBRATEL will calculate all revenue of said quarter
arising out of the Services, including revenues due but not yet paid
("EMBRATEL's Quarterly Revenue"). The percentages set forth in Section 4.01
of this Agreement will then be calculated over EMBRATEL's Quarterly Revenue. The
Fee payment at the end of each quarter (in addition to the Advance Fee, if
applicable) shall be calculated by multiplying the final full quarterly portion
of Annual Revenue, based upon the applicable financial statements of EMBRATEL,
by the applicable percentage referred to in Section 4.01, and subtracting
therefrom the Advance Fee payment made with respect to such quarter ("Adjusted
Fee"). Any excess Advance Fee payments shall be deducted from subsequent
installments due, or at EMBRATEL's option, shall be promptly refunded by MCI. As
the Services are invoiced by EMBRATEL in Brazilian current currency, but the
Fees are to be paid in U.S. dollars, the calculation of both the Advance Fee and
the Adjusted Fee shall use the average U.S. dollar sales rate, employed by major
commercial banks operating with the floating exchange rate (commercial rate) in
the City of Rio de Janeiro, Brazil, for the first day of the calendar quarter
for which such Advance Fee or Adjusted Fee is calculated. Once said conversion
to U.S. dollars has been made, the corresponding Fee shall henceforth for all
legal purposes be referred to in U.S. dollars. EMBRATEL shall send to MCI every
quarter, within 30 (thirty) days following the end of said period, a written
report of all invoicing and the calculation of the Fees during said period. In
addition, the Fee payment at the end of each Fiscal Year shall be calculated by
multiplying the final full year Annual Revenue based upon the audited financial
statements of EMBRATEL by the applicable percentage referred to in Section 4.01,
and subtracting therefrom all prior Fee installment payments made with respect
to such Fiscal Year. Any excess payments shall be deducted from subsequent
installments due, or at EMBRATEL's option, shall be promptly refunded by MCI.
Any late payments made by EMBRATEL will be subject to a fine of 5% (five
percent) and a late payment interest rate of 1% (one percent), calculated pro
rata monthly, over the amounts due in US dollars. ANY AND ALL DIFFERENCES
ARISING OUT OF THE FACT THAT QUARTERLY EXCHANGE RATES FOR THE PAYMENTS OF FEES
HAVE BEEN USED, AS OPPOSED TO THE YEAR END EXCHANGE RATE, SHALL NOT BE
CONSIDERED AS EXCESS PAYMENT AND CONSEQUENTLY SHALL NOT BE DEDUCTED OR REFUNDED.
(b) All fees, reimbursements and other sums payable to MCI under this
Agreement are exclusive of any applicable sales, use, excise, utility, gross
receipts and value added taxes and other similar tax-like charges levied by any
duly constituted authority within or outside Brazil, all
6
<PAGE>
of which shall be paid and borne exclusively by EMBRATEL. If EMBRATEL is obliged
to make any deduction or withholding on account of any such taxes or charges,
the amount payable shall be grossed up to the extent necessary to ensure that
after such deduction or withholding the amount paid is equal to the amount
otherwise due MCI. If Embratel is required under Brazilian law to make any
deduction or withholding of income taxes or social contributions taxes, Embratel
shall promptly remit such withheld tax to the appropriate governmental taxing
authority, and shall provide MCI with official tax receipts for such remittances
within a commercially reasonable period but in no event more than 90 days after
the close of Embratel's Fiscal Year.
(c) All payments to MCI pursuant to this Agreement shall be made in U.S.
dollars by wire transfer to a bank account designated by MCI.
ARTICLE V
ADDITIONAL AGREEMENTS/INTELLECTUAL PROPERTY
-------------------------------------------
5.01 Additional Agreements. The Parties agree to negotiate in good faith and
---------------------
enter into separate agreements as necessary, in forms substantially similar to
those to be provided by MCI or its Affiliates, which shall govern the specific
terms and conditions, including but not limited to MCI's compensation, other
than the Fees, under which MCI and/or its Affiliates may supplement management
obligations under this Agreement and/or assist EMBRATEL with implementation of
recommended actions. Such agreement may include, without limitation, an
agreement providing for reimbursement of the MCI Expenses, an agreement whereby
MCI or its Affiliates would provide consulting services to EMBRATEL, and/or
project consultant agreements. In addition, the Parties agree to negotiate in
good faith and enter into a separate agreements as necessary, in forms
substantially similar to those to be provided by MCI or its Affiliates, which
shall govern the specific terms and conditions including but not limited to
MCI's compensation other than the Fees, under which MCI and/or its Affiliates
shall provide additional management services related to EMBRATEL products or
services other than the Services.
5.02 Intellectual Property. EMBRATEL acknowledges that MCI and its Affiliates
---------------------
are the owners of various Intellectual Property. This Agreement is not to be
construed in any respect that any license or other right is granted to EMBRATEL
for such Intellectual Property, other than the rights granted in accordance with
Section 5.03. EMBRATEL shall not dispute the validity of such Intellectual
Property, nor oppose the registration of such Intellectual Property within any
jurisdiction in the world.
5.03 License Agreements. At the sole option of MCI or its Affiliates, as
--------------------
applicable, Intellectual Property of MCI or its Affiliates may be made available
to EMBRATEL on a case-by-case basis pursuant to a separate license agreement.
Such license agreement will specify the terms under which the Intellectual
Property is to be made available, the limitations on its use, the consideration
to be paid, other than the Fees, and the effect on the licenses of the
Intellectual Property of various termination events.
7
<PAGE>
ARTICLE VI
INDEMNIFICATION
---------------
6.01 Indemnification. EMBRATEL shall indemnify MCI and its Affiliates and all of
-----------------
their officers, directors, employees, shareholders, Affiliates, partners,
representatives and agents (individually, an "Indemnitee") from and against any
and all claims, demands, costs, damages, losses, liabilities, expenses of any
nature (including, without limitation, attorneys', accountants' and experts'
fees and disbursements), judgements, fines, settlements and other amounts
(collectively, "Damages") arising from any and all claims, demands, actions,
suits or proceedings, whether civil, criminal or administrative (collectively,
"Claims") in which an Indemnitee may be involved or threatened to be involved,
as a party or otherwise, arising out of or related to MCI's performance of its
obligations under this Agreement, regardless of whether this Agreement continues
in effect, or the Indemnitee continues to be an officer, director, employee,
Affiliate, shareholder, partner, representative or agent of MCI or any of its
Affiliates, at the time any such Claims are made or Damages incurred, provided
the Indemnitee's conduct did not constitute willful misconduct. Expenses
incurred by an Indemnitee in defending any Claim will, from time to time, be
advanced by EMBRATEL to such Indemnitee prior to the final disposition of such
Claim provided EMBRATEL has received an undertaking given by or on behalf of the
Indemnitee to repay such amount if it is finally determined by a court of
competent jurisdiction that such Indemnitee is not entitled to indemnification
pursuant to this Section 6.01. The indemnification rights contained in this
Section 6.01 will be cumulative, and in addition to any and all other rights,
remedies and recourse to which an Indemnitee, its heirs, successors, assignees
and administrators are entitled, whether pursuant to some other provision of
this Agreement or to the law. The indemnification rights contained in this
Section 6.01 will inure to the benefit of the heirs, successors, assignees and
administrators of each of the Indemnitees and shall survive the termination of
this Agreement for any reason.
6.02 DISCLAIMER OF WARRANTIES. IT IS EXPRESSLY UNDERSTOOD THAT MCI MAKES NO
------------------------
WARRANTY TO EMBRATEL OR ITS AFFILIATES WITH RESPECT TO THE PERFORMANCE OR
FITNESS FOR ANY PURPOSE OF THE PRODUCTS OR SERVICES CONTEMPLATED BY THIS
AGREEMENT. MCI EXPRESSLY DISCLAIMS ALL WARRANTIES INCLUDING, WITHOUT LIMITATION,
THE IMPLIED WARRANTIES OF TITLE, MERCHANTABILITY AND FITNESS FOR A PARTICULAR
PURPOSE.
ARTICLE VII
DURATION
--------
7.01 Initial Term. This Agreement shall become effective as of the date hereof,
------------
and shall continue through December 31, 2003.
ARTICLE VIII
TERMINATION
-----------
8.01 Termination by EMBRATEL. EMBRATEL may terminate this Agreement in the event
-------------------------
MCI materially fails to perform its obligations and responsibilities under this
Agreement and does not cure such failure within three months after receipt of a
written notice of such failure setting forth in reasonable detail the nature of
the alleged failure or, if such failure or breach is not capable of being cured
within such three-month period and MCI diligently pursues a cure, such
8
<PAGE>
longer period of time as may be reasonable under the circumstances; provided,
however, that EMBRATEL may not exercise the right of termination set forth in
this Section 8.01 if MCI has previously notified EMBRATEL of its intention to
terminate this Agreement pursuant to the provisions of Section 8.02.
8.02 Termination by MCI. MCI may terminate this Agreement in the event of any
------------------
of the following:
(a) EMBRATEL fails to pay any amounts owed under this Agreement for more
than 90 days;
(b) EMBRATEL materially impedes the ability of MCI to perform its
obligations under this Agreement or is otherwise in material breach of this
Agreement;
(c) EMBRATEL shall at any time fail to comply with or breach any of its
representations, warranties, indemnities or other obligations under this
Agreement and does not cure such breach within thirty days after receipt of a
written notice of such failure setting forth in reasonable detail the nature of
the alleged failure;
(d) EMBRATEL is at any time the subject of an action under any winding up,
liquidation, dissolution, insolvency or bankruptcy law or proceeding;
(e) MCI is no longer able to fulfill its obligations under this Agreement
due to a Force Majeure Event that continues for more than 60 days; or
(f) Failure to receive any necessary approvals of this Agreement as written
within 90 days of the date of this Agreement by any government entities,
including, but not limited to (as may be applicable), ANATEL, the Comissao de
Valores Mobiliarios, the Banco Central do Brasil, or the Instituto Nacional de
Propriedade Intelectual, provided, however, that MCI may comply, in its sole
discretion, with any government mandated modifications to this Agreement which
MCI deems acceptable.
(g) Failure to receive any necessary corporate approvals of this Agreement
by EMBRATEL or its Affiliates, as applicable.
8.03 Performance by MCI after Termination. After receipt of written notice of
-------------------------------------
termination of this Agreement, but prior to the effective date of such
termination, MCI shall continue to perform under this Agreement unless
specifically instructed to discontinue such performance. In any event, even if
so instructed, MCI will nonetheless be entitled to reimbursement of reimbursable
expenses incurred and payment of the Fees earned for the period ending on the
effective date of termination. Such amounts shall be due and payable within 30
days of the effective date of the termination.
8.04 LIMITATION OF LIABILITY. THE TERMINATION OF THIS AGREEMENT PURSUANT TO THIS
-------------------------
ARTICLE VIII SHALL NOT AFFECT THE RIGHTS OF ANY PARTY IN RESPECT OF ANY DAMAGES
THEY MAY HAVE SUFFERED AS A RESULT OF ANY BREACH OF THIS AGREEMENT, NOR SHALL IT
AFFECT THE RIGHTS OF ANY PARTY WITH RESPECT TO ANY LIABILITIES OR CLAIMS
ACCRUING, OR BASED UPON EVENTS OCCURRING, PRIOR TO THE EFFECTIVE DATE OF
TERMINATION. NOTWITHSTANDING THE FOREGOING, THE TYPES OF DAMAGES RECOVERABLE
UNDER THIS AGREEMENT SHALL NOT INCLUDE LOSS OF PROFITS, LOSS OF
9
<PAGE>
BUSINESS OPPORTUNITY OR INCIDENTAL, CONSEQUENTIAL, OR PUNITIVE DAMAGES, AND BY
EXECUTING THIS AGREEMENT THE PARTIES WAIVE FOR ALL PURPOSES AND UNDER ALL
CIRCUMSTANCES THE RIGHT TO CLAIM ANY OF THE SAME. IN ADDITION, THE PARTIES
ACKNOWLEDGE AND AGREE THAT DAMAGES PAYABLE BY MCI TO ANY OTHER PARTIES UNDER
THIS AGREEMENT SHALL BE LIMITED TO THOSE ACTS CONSTITUTING WILLFUL MISCONDUCT ON
THE PART OF MCI.
ARTICLE IX
GENERAL PROVISIONS
------------------
9.01 Governing Law. This Agreement and the rights of the Parties shall be
--------------
construed and interpreted in accordance with the laws of the State of New York
and the United States of America, as applicable, in all respects, including
matters of construction, enforcement and performance without giving effect to
the principles of choice of laws thereof.
9.02 Arbitration. If the Parties are unable to resolve any dispute by amicable
-----------
settlement, such dispute shall be settled by binding arbitration under in
accordance with the Arbitration Rules of the United Nations Commission on
International Trade Law ("UNCITRAL Rules") as in force on the date of
commencement of arbitration, and as modified by this Section 9.02. Claims
alleging violations of the telecommunications laws of the United States of
America, however, shall be brought solely before the United States Federal
Communications Commission. ADR Associates, of Washington, D.C., U.S.A., shall
serve as both the appointing authority and the administering body under the
UNCITRAL Rules. ADR Associates shall appoint a single arbitrator of a
nationality other than the nationalities of the Parties. All arbitration
proceedings shall be conducted in English. The place of arbitration shall be
Bermuda. Neither the Parties, nor the arbitrator, nor ADR Associates shall
disclose the existence, content or results of any arbitration except with the
prior written consent of all Parties to the arbitration. The law governing the
arbitration proceedings shall be the Bermuda International Arbitration Act of
1993. The arbitrator shall abide by the rules of Ethics for International
Arbitrators established by the International Bar Association. The arbitrator's
authority to grant relief is subject to the terms of this Section 9.02, the
terms of this Agreement and the law governing the Agreement. The arbitrator
shall have no authority to award exemplary, punitive or treble damages. Each
Party shall pay an equal share of the costs of the arbitration (as defined in
Article 28 of the UNCITRAL Rules), except that each Party shall pay the expenses
it incurs for its own legal representation and assistance. Judgment on the award
may be entered in any court of competent jurisdiction. The post-award
proceedings shall be governed by the Inter-American Convention on International
Commercial Arbitration of 1975 (the Panama Convention). The validity and
construction of this Section 9.02 shall be governed by the law of the State of
New York, U.S.A., without regard to its conflict of laws rules.
9.03 Waiver. None of the terms of this Agreement shall be deemed to have been
------
waived by any Party, unless such waiver is in writing and signed by that Party.
The waiver by any Party of a breach of any provision of this Agreement shall not
operate or be construed as a waiver of any other provision of this Agreement or
of any further breach of the provision so waived. No extension of time for the
performance of any obligation or act hereunder shall be deemed to be an
extension of time for the performance of any other obligation or act.
10
<PAGE>
9.04 Notice. All notices and other communications that are required or permitted
------
to be given under this Agreement shall be in writing in Portuguese and English
and shall be deemed to have been duly given if delivered personally or by
registered mail (return receipt requested) or courier service (documented by
receipt) or telefaxed and addressed as follows:
if to EMBRATEL:
Luigi Massimo Giavina Bianchi
Finance Director
EMBRATEL
Av. Presidente Vargas, 1012 - 15 andar
CEP 20179-900 Rio de Janeiro, RJ
Brazil
fax +55-21-233-7798
if to MCI:
Walter Schonfeld
Vice President, Corporate Development
MCI WorldCom, Inc.
1801 Pennsylvania Ave. NW
Washington, DC 20006
USA
fax (202) 887-2443
with a copy to:
Ann LaFrance
Chief Counsel, International Affairs
MCI WorldCom, Inc.
1717 Pennsylvania Ave. NW, 8th Floor
Washington, DC 20006
fax (202) 721-2790
and/or such other addressee and/or address as either of the above shall have
specified by notice delivered in accordance with this Section 9.01. Each notice
or other communication, which shall be delivered personally, mailed, telexed or
telefaxed in the manner described above, shall be deemed sufficiently given,
served, sent, received or delivered for all purposes on the first business day
following the date that it is delivered to the addressee (with the return
receipt, the delivery receipt, the affidavit or messenger or, with respect to a
telex or telefax, the answer back being deemed conclusive, but not exclusive,
evidence of such delivery) or at such time as delivery is refused by the
addressee upon presentation.
9.05 Entire Agreement. This Agreement contains the entire agreement, and
----------------
supersedes all prior agreements and understandings and arrangements, oral or
written, between the Parties with respect to the subject matter hereof.
11
<PAGE>
9.06 Amendment. This Agreement may not be modified, amended or changed in any
---------
respect except in writing duly signed by the Party against whom enforcement of
such modification, amendment or change is sought.
9.07 Successors and Assigns. All of the terms and provisions of this Agreement
----------------------
shall be binding upon and shall inure to the benefit of the Parties and their
respective successors and permitted assigns.
9.08 Assignment. Except as provided in Section 9.09, no Party shall assign this
----------
Agreement, in whole or in part, without the prior written consent of the other
Party, and any such assignment contrary to the terms hereof shall be null and
void and of no force or effect. No permitted or purported assignment of all or
any portion of this Agreement shall effect a release of the transferor of its
obligations under this Agreement without an express written release from such
obligations by the other Party.
9.09 Assignment by MCI. Notwithstanding Section 9.08, MCI may assign or transfer
-----------------
its rights and obligations under this Agreement to any Affiliate of MCI without
the consent of EMBRATEL.
9.10 Interpretation. Whenever possible, each provision of this Agreement shall
--------------
be interpreted in such manner as to be effective and valid under applicable law,
but if any provision of this Agreement shall be unenforceable or invalid under
applicable law, such provision shall be ineffective only to the extent of such
unenforceability or invalidity, and the remaining provisions of this Agreement
shall continue to be binding and in full force and effect. In the event of such
unenforceability or invalidity the Parties shall negotiate in good faith to
agree on changes or amendments to this Agreement which are required to carry out
the intent of this Agreement in light of such unenforceability or invalidity.
9.11 Counterparts. This Agreement may be executed in counterparts, each of which
------------
shall be deemed to be an original, and all such counterparts together shall
constitute one and the same legal document.
9.12 Language. This Agreement and any amendments or other modifications hereof
--------
shall be executed in the English language and translated into Portuguese for
convenience. In the event of a conflict between the English language and the
Portuguese language versions of this Agreement, the English language version
shall prevail.
9.13 Headings. The Article and other headings contained in this Agreement are
----------
for convenience only and shall not be deemed to limit, characterize or interpret
any provision of this Agreement.
9.14 Force Majeure. Any failure by a Party to perform obligations and
---------------
responsibilities under this Agreement (other than payment obligations) shall not
be considered a breach of this Agreement if and to the extent such failure to
perform is caused by one or more occurrences beyond the reasonable control of
the Party affected, including without limitation acts of God, earthquakes,
volcanic eruptions, hurricanes or other natural disasters, embargoes, acts of
government in exercising its sovereign capacity, governmental restrictions,
strikes, labor unrest, riots, wars or other military action, civil disorders,
rebellion, acts of terrorism, sabotage, or political or economic crisis or
instability (each a "Force Majeure Event"). The Party suffering the Force
Majeure Event shall promptly notify the other Party in writing of the details of
such Force Majeure Event and thereupon the obligations of the Party giving such
notice shall be suspended during, but not longer than, the continuance of the
Force Majeure Event. The affected Party shall
12
<PAGE>
use all reasonable diligence to remove the Force Majeure Event as quickly as
possible, provided that this requirement shall not require the settlement of
strikes, lockouts or other labor difficulty by the Party involved, contrary to
its wishes, and how all such difficulties shall be handled shall be entirely
within the discretion of the Party involved.
9.15 Confidentiality.
---------------
(a) Confidential Information. By virtue of this Agreement, the Parties may
have access to, or exchange, information that is confidential to one another. As
used in this Agreement, the term "Confidential Information" shall mean only such
information of the other Party that may be reasonably understood from legends,
the nature of such information itself and/or the circumstances of such
information's disclosure, to be confidential and/or proprietary to the other
Party or to third parties to which the other Party owes a duty of non-
disclosure.
(b) Obligations. Each of the Parties agrees that as to any Confidential
Information disclosed by one Party ("Discloser") to the other Party
("Recipient") hereunder:
(i) to use such Confidential Information only in the performance of
this Agreement, during its term, or as otherwise expressly permitted by this
Agreement or by the prior written consent of the Discloser;
(ii) not to make copies of any such Confidential Information or any
part thereof except to the extent expressly permitted by this Agreement or by
the Discloser;
(iii) not to disclose any such Confidential Information to any third
party, using the same degree of care used to protect Recipient's own
confidential or proprietary information of like importance, but in any case
using no less than a reasonable degree of care; provided, however, that
Recipient may disclose Confidential Information received hereunder to (aa) its
Affiliates who are bound to protect the received Confidential Information from
unauthorized use and disclosure under the terms of a written agreement
(including without limitation a pre-existing written agreement), and (bb) to its
employees, consultants and agents, and its Affiliates' employees, consultants
and agents, who have a need to know to perform or exercise rights under this
Agreement, and who are bound to protect the received Confidential Information
from unauthorized use and disclosure under the terms of a written agreement
(including without limitation a pre-existing written agreement).
(c) Exceptions. The restrictions set forth in this Section 9.15 on the use
and disclosure of Confidential Information shall not apply to information that:
(i) was publicly known at the time of Discloser's communication
thereof to Recipient;
(ii) becomes publicly known through no fault of Recipient subsequent
to the time of Discloser's communication thereof to Recipient;
(iii) is in Recipient's possession free of any obligation of
confidence at the time of Discloser's communication thereof to Recipient;
(iv) is developed by Recipient independently of and without use of any
of Discloser's Confidential Information or other information that Discloser
disclosed in confidence to any third party;
13
<PAGE>
(v) is rightfully obtained by Recipient without restriction from third
parties authorized to make such disclosure; or
(vi) is identified by Discloser in writing as no longer proprietary or
confidential.
(d) Disclosure Pursuant to Legal Requirement. In the event Recipient is
required by law, regulation or court order to disclose any of Discloser's
Confidential Information, Recipient will promptly notify Discloser in writing
prior to making any such disclosure in order to facilitate Discloser seeking a
protective order or other appropriate remedy from the proper authority.
Recipient agrees to cooperate with Discloser in seeking such order or other
remedy. Recipient further agrees that if Discloser is not successful in
precluding the requesting legal body from requiring the disclosure of the
Confidential Information, it will furnish only that portion of the Confidential
Information which is legally required and will exercise all reasonable efforts
to obtain reliable assurances that confidential treatment will be accorded the
Confidential Information.
9.16 No Authority to Bind. MCI shall have no authority to enter into contracts
--------------------
or otherwise incur obligations on behalf of or bind EMBRATEL, except as
otherwise expressly approved by the Board.
IN WITNESS WHEREOF, the Parties hereto have executed this Agreement as of
the day and year first above written.
Empresa Brasileira de Telecomunicacoes S.A. MCI Global Resources, Inc.
- - EMBRATEL
- ------------------------------- -----------------------------
Dilio Sergio Penedo Jorge L. Rodriguez
President Vice President
- ------------------------------- -----------------------------
Witness Witness
- ------------------------------- -----------------------------
Print Name Print Name
- ------------------------------- -----------------------------
ID Number ID Number
14
<PAGE>
ATTACHMENT I
The Services
------------
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------------
CONCESSION SERVICES DESCRIPTION SERVICES
AUTHORIZATION
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
CONCESSION CONTRACT Switched Fixed Telephone Service is Inter-City, Inter-State, and Inter-Region
NATIONAL LONG DISTANCE the telecommunications service which, Switched Fixed Telephone Service
by means of the transmission of voice within Brazil.
and other signals, is used for
communication between fixed and
specific points, utilizing telephony
processes.
- ---------------------------------------------------------------------------------------------------------------------------------
CONCESSION CONTRACT - Switched Fixed Telephone Service is International Switched Fixed Telephone
INTERNATIONAL LONG the telecommunications service which, Service
DISTANCE by means of the transmission of voice
and other signals, is used for
communication between fixed and
specific points, utilizing telephony
Processes.
- ---------------------------------------------------------------------------------------------------------------------------------
AUTHORIZATION TERM OF Network Transportation Service is Special repetition of TV and video
NETWORK TRANSPORT the service designed for transporting signal service
TELECOMMUNICATIONS voice, telegraphic, data or any other
SERVICE (NATIONAL AND kind of telecommunications signals Special repetition of audio signal service
INTERNATIONAL) between fixed points.
Dedicated line service (SLD)
Analogic signals dedicated line service
(SLDA)
Digital signals dedicated line service
(SLDD)
Dedicated line service for telegraphy
(SLDT)
International dedicated line service
(SLDI)
International dedicated line service for
analogic signals (SLDIA)
International dedicated line service for
digital signals (SLDID)
International dedicated line service for
telegraphy (SLDIT)
Packet switched network service
Circuit switched network service
Text communications service - telex
- ---------------------------------------------------------------------------------------------------------------------------------
TERM OF RIGHT OF Transport of telecommunications signals
EXPLOITATION OF
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------------
CONCESSION SERVICES DESCRIPTION SERVICES
AUTHORIZATION
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
BRAZILIAN SATELLITES Provision of Space Capacity
- ---------------------------------------------------------------------------------------------------------------------------------
AUTHORIZATION TERM OF Global Mobile Satellite Service is the
MOBILE GLOBAL SERVICE telecommunications service which uses
BY SATELLITE a set of satellites to provide direct
communication between a mobile earth
station and another telecommunication
station.
- ---------------------------------------------------------------------------------------------------------------------------------
AUTHORIZATION TERM OF Mobile Maritime Services is the
MARITIME MOBILE SERVICE service designed to provide
communication between onshore
coastal stations and ship stations and
between coastal earth stations and earth
stations installed on board ships,
vessels or rescue crafts.
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
16
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS
EMBRATEL PARTICIPACOES S.A.
We hereby consent to the use of our report included herein.
/s/ KPMG Auditores Independentes
Brasilia, Brazil
March 12, 1999
