Telefonica S.A. Investment Report

 

TEF (ADR):  06/07/2007

 

Current Price: @ US $65.10 / Market Cap: $107b / Dividend: $2.66 (4.08%)

 

Telefonica is one of the largest telecoms in the world (ranking 5th by market cap).   Based out of Spain, Telefonica operates global fixed-line, wireless, broadband and other telecom-related services.  The majority of their business (about 2/3rd) is based in Europe (mainly Spain, the UK, Germany & the Czech Rep.) while their main growth drivers are based in Latin America, most notably Brazil.

 

Risks (not in order of importance):

  • This industry is heavily capital-intensive, most notably in the following 2 areas:
    • Infrastructure – companies must spend massive amounts of capital to build out networks, run cable, etc. (ex. TEF has invested 75 bil€ thus far in Latin America).
    • Market share – customer acquisition costs are high as wireless and broadband services are mainly price-based.  Being an incumbent fixed-line operator can help mitigate this through bundling packages but even then, competition exists if a cable operator is also bundling packages (i.e. Triple Play).
  • The telecom industry is becoming heavily competitive, especially in some of TEF’s core markets (the UK, Brazil, Germany), and as a result, margins are under pressure.
  • High level of debt with over 50 bil€ on the books as a result of the O2 acquisition.  
  • Over half of their customer base reside in Latin America, which carries several risks:
    • Less revenue per customer compared to affluent Europe
    • Currency risks when revenues are brought back to €
    • Political risk as evidenced by Venezuela’s CANTV nationalization.
  • An increasingly hostile regulatory environment in Europe (& Brazil to a lesser extent) is starting to cut into revenues and margins as the EU caps roaming and termination rates.
  • Telefonica is more exposed to global economic shocks than other European telecoms (though less than Latin American rival America Movil) due to
    • its emerging markets exposure via Latin America (Brazil, Argentina, Venezuela, etc)
    • Spain has a possible housing bubble which could affect TEF if it pops.
  • An extensive hedging and derivatives portfolio.  From the 2006 annual report:
    • “At December 31, 2006, the nominal value of outstanding derivatives with external counterparties came to 120,267 million euros. This amount implies a 107% increase on 2005 and evidences the increase in the Group’s debt resulting from the O2 acquisition. This figure is inflated by the use in some cases of several levels of derivatives applied to the nominal value of a single underlying liability. For instance, a foreign currency loan can be hedged into floating rate and then each interest rate period can be fixed using an FRA. Even using such techniques to reduce the position, it is still necessary to take extreme care in the use of derivatives to avoid problems arising through error or a failure to understand the real position and its associated risks.”

 

 

Upside:

  • Strong market positions:
    • Rules the domestic (Spain) market giving it a solid base of operations which accounts for over 35% of revenues and 65% operating income.
    • Controls Telesp, the dominant fixed-line provider in the largest province in Brazil (Sao Paulo) as well as half of the leading wireless provider, Vivo (jointly with Portugal Telecom with a position to fully acquire)
    • O2 UK has the largest subscriber base in the UK and is maintaining its market position despite intense competition while competitors (Vodafone & France Telecom’s Orange) are seeing results slip.
  • As with most mega-telecoms, TEF is a massive cash-flow generator as its capital investment and corresponding depreciation entries affect net income but not actual cash.  They’ve put in the pain and now are reaping the cash gain.
  • The company has committed to doubling 2005 EPS & dividend by 2009.
  • That commitment wouldn’t mean much except that the company has hit all targets regarding revenues, operating income and earnings for at least the last 3 years.  So a good track record.
  • Unlike the other European mega-telecoms, Telefonica has a very attractive growth profile due to the operations in Latin America as well as the Czech Republic & Slovakia which should drive growth for the foreseeable future.
  • Well-balanced portfolio of assets with roughly a third of revenues each coming from Spain and Latin America and most of the balance from Western Europe ex. Spain.
    • Allows for stable revenue source while driving growth
    • High level of profitability
  • Well-run business with some of the best margins in European telecom, a smooth integration of UK’s wireless operator O2 and a regionalized corporate restructuring that’s realized over 1 bil€ in synergies.
  • Commitment to return cash to shareholders with a solid dividend of ~4% & increases coming as well as a 2.7 bil€ share buyback set to run through 2007.

 

Competitors

I reviewed the following industry competitors:

 

1.      France Telecom - Leading French Telecom moving into other markets            

a.      Pros         

                                                                           i.            strong domestic market position throws off cash to expand into other markets

                                                                         ii.            competitors have to use FTE's network so they make "royalties" even on competitors’ customers

                                                                        iii.            good margins, returns on capital for telecom

                                                                       iv.            good entries into wireless emerging markets, mostly Poland and former African colonies, a third of their base

                                                                         v.            strong broadband business with over 9 mil subs globally

                                                                       vi.            4.7% dividend yield (paid annually)

b.      Cons        

                                                                           i.            fixed line business coming under pressure from new competitors, VOIP

                                                                         ii.            losing wireless market share in France (down 1% YOY)

                                                                        iii.            govt has a stake in the company

                                                                       iv.            have lowered revenue guidance 3 times in the past year

                                                                         v.            large debt position

                                                                       vi.            French unions make restructuring difficult

                                                                      vii.            Low growth profile

2.      Vodafone - one of the largest wireless operators in the world                

a.      Pros         

                                                                           i.            entered high-potential India with the Hutchison Essar acq.

                                                                         ii.            generates huge revenues, 75% from Western Europe

                                                                        iii.            has a 45% stake in Verizon Wireless (US)

                                                                       iv.            size allows for scale

                                                                         v.            good FCF

                                                                       vi.            4.4% dividend

                                                                      vii.            no legacy problems like unions, pensions, etc

b.      Cons        

                                                                           i.            wrote off 36.5 billion pounds in goodwill (over $72 billion)

                                                                         ii.            no non-wireless businesses could be disadvantage as others use landline cash flow to help fund wireless operations

                                                                        iii.            doesn't have complete control over all operating segments

                                                                       iv.            Vodafone network (GSM) not compatible with Verizon's (CDMA) so any possible synergy is mute

                                                                         v.            majority control in 17, minority in 22

                                                                       vi.            may have overpaid for Hutchison

                                                                      vii.            EU regulatory environment potentially harmful as roaming and termination fees are cut down

3.      America Movil - Largest wireless operator in Latin America                   

a.      Pros         

                                                                           i.            Dominant market position in Mexico

                                                                         ii.            2nd largest operator in Brazil (behind TEF's Vivo) but gaining

                                                                        iii.            Leading market position throughout much of Latin America

                                                                       iv.            Subsidiary of Carlos Slim's holding group

                                                                         v.            Strong growth profile and operating margins, esp in Mexico but even in other markets

b.      Cons        

                                                                           i.            High exposure to "emerging market" risk, i.e. currency and political risks

                                                                         ii.            Intense competition in Brazil and Telefonica is attempting turnaround in Mexico

                                                                        iii.            No exposure in "stable" (ex Mexico which may not be that stable as the firm's credit rating is higher than the govt's) markets

                                                                       iv.            Latin America has low ARPU rates compared to Europe, US, etc.

                                                                         v.            most of the LatAm currencies are sympathetic with the weakening US dollar

                                                                       vi.            lower dividend compared to other telecoms

4.      Deutsche Telecom - Lumbering German telecom                     

a.      Pros         

                                                                           i.            owns T-Mobile, which accounted for 51% of revenues

                                                                         ii.            53% of revenues from Europe, 47% from US

                                                                        iii.            nice dividend yield of 4.5%

                                                                       iv.            dominant landline market position in Germany, the largest country in the EU

                                                                         v.            new CEO Rene Obermann driving changes for growth

b.      Cons        

                                                                           i.            fixed telephone lines are coming under pressure due to VOIP, wireless substitution, etc

                                                                         ii.            intense wireless competition across Europe (Telefonica's O2, FT's Orange, Vodaphone) & US (Cingular, Verizon, Sprint-Nextel)

                                                                        iii.            broadband competition as well

                                                                       iv.            civil-servant employee status makes restructuring difficult

                                                                         v.            growth will be harder to achieve and margins will be under pressure going forward

                                                                       vi.            government owns 32% of shares which could lead to conflicting interests

                                                                      vii.            T-Mobile has high exposure to weakening US dollar

                                                                    viii.            lower margins than peers both in Europe and US

 

Management:

  • Integrity: B Cesar Alierta, CEO:  While Alierta is the CEO, Telefonica reorganized their corporate structure, integrating operations along 3 regional divisions: Telefonica Espana, Telefonica LatAm & Telefonica Europe.  Each division has a VP which runs that region. 
    1. The results at Espana (Spain) are very strong and speaks well of management. 
    2. Management have also implemented some new strategies for Latin America to bolster their leading wireless position in Brazil and make inroads in Mexico against America Movil’s dominant position. 
    3. Telefonica Europe was recently formed with the acquisitions of O2 and Telecom Czech so performance can’t yet be fully gauged.  However, Telefonica has already surprised some analysts with their margin improvement at O2.
  • Past Performance: A-. The company has hit stated targets the last 3 years and has set good upcoming targets including debt reduction and increasing shareholder payouts in addition to the usual business targets.  That the company is in such a strong position of throwing off massive amounts of cash while having a PEG ratio of less than 1 (according to Yahoo!) speaks well to the business prowess of management.

 

The Story:

At the heart of it, Telefonica operate in a business that most of us can understand.  They provide telephone, wireless, broadband Internet access, pay TV and other related services to consumers and businesses.  While the telecom industry at large is still trying to fully recover from the overcapacity of the tech bubble days, entrenched incumbents like Telefonica enjoy strong competitive advantages even as they face new challenges brought on by consumer technology changes.  Telefonica has dubbed this “revenue evolution.”

 

Traditionally, the telecom market resembles an oligopoly as laying fiber was so expensive that only the largest companies could make the investment, precluding smaller operators and thus competition.  Situations like this prompted the breakup of Ma Bell in the US.  However, as cell phone usage becomes ubiquitous, consumers are forgoing land lines altogether.  In developed economies, fixed-line business is almost universally declining and companies like Telefonica are forced to expand into other markets.  Thus Telefonica must “evolve” their revenue base from fixed phone service to other services that branch out to broadband access, wireless service while (hopefully) maintaining fixed-line business.

 

So the challenge for Telefonica is to slow the atrophy of their wireline business while aggressively grabbing market share in the wireless markets.  Of all the big European telecoms, I think TEF is in the best position to meet this challenge.  They are dominant in their home market of Spain despite attempted competitive efforts.  They have one of the best wireline churn rates in Europe @ -1% while their landline business in Brazil is still growing.  And while European wireless heavyweights like Vodafone and Orange are slugging it out in mature European markets (or US markets via T-Mobile), Telefonica are growing business in Latin America where competition is less intense (except for Brazil & Mexico) and still holding their own in the UK.  And TEF stand in good position to grow their broadband business across Europe as well as Latin America.

 

That’s the business side.  On the investment side, you’ve got a company that’s going to pay a 4% dividend (in euros) but it’s got a PEG ratio of 0.86.  Now I don’t put much stock in analyst estimates of growth rates (especially 5 years forward) but the good thing here is that there’s visibility for growth.  The company has committed to increasing EPS and dividends and you can see how they’re going to get there because they’ve laid out their plan for growing the business.  They are rolling out triple play packages in Spain and parts of Latin America.  They’re fixing distribution channels in Mexico and Colombia and addressing operations issues in Brazil.  They are starting service in Slovakia and rolling out broadband in the UK and Germany.   And there’s still potential for future consolidation in Brazil via the Telecom Italia acquisition if it gets by Brazilian regulators.  So you can see the growth and where it’s coming from and the company is highly profitable with great industry margins and it throws off a ton of cash like a stodgy old boring low-growth megacap behemoth.

 

Finally, it’s a nice hedge against the US dollar.  While the LatAm currency exposure isn’t ideal, this company gives us good exposure to the euro.  So there’s potential for dividend growth as well as currency capital gains even if the stock goes nowhere.

 

 

Valuation:  

My crude DCF model gives me a pretty high number that I don’t necessarily trust but being ultra-conservative, I’ve got to say that intrinsic value is at least $80 per ADR.  This assumes a 5-year growth rate ranging from 7% which is half of what Yahoo is estimating next 5 years growth. 

 

The return on capital is in the mid-teens which looks solid.  So the company generates lots of cash and makes money.

 

Certainty Rating: B. 

Rule number 1 is don’t lose money.  Over the long-term, I have a strong certainty that we will not lose money on Telefonica.  The biggest risks would probably be some unanticipated “financial event” that affects emerging economies and the capital markets as TEF have a big hedge book but if that happens, the global economy will be roiled and who knows what happens at that point.  The other concern is if a huge pop in the Spanish housing bubble sends that economy into a downward spiral. Spain accounts for 37% of revenues but a disproportionately larger chunk of OIBDA (48%) and OI (67.5%).  So anything that gets people and businesses in Spain to cut back on phone calls, broadband, cells, etc will be bad news.

 

That said, my biggest reservation is that we may not gain much from stock appreciation.  TEF is a $100+ billion market cap so it’s going to take a lot to move that needle.   While the ADR doesn’t get much volume here in the states, Telefonica is one of the most heavily traded stocks in Europe.  That said, with the dividend yield and potential currency gains, I think we’ll do alright regardless, even if the stock goes sideways. 

 

Economic Value Measurements:  

·         Company hits 2007 guidance:

o        Consolidated revenues will grow between 6% and 9%

o        OIBDA growth for the year 2007 in the 8% to 11% range.

o        OI growth for the year 2007 in the 14% to 20% range.

o        2007 CapEx to stand below 7,814 million euros.

·         Must improve operating results in Mexico

o        Get to positive OI in Mexico

o        Hit 20% market share by 2009 (currently at 16%)

·         Improve wireless business in Brazil

o        Stop the loss in wireless customers

o        Update on TI acquisition

·         Watch margins in UK and Germany – if they stay under pressure, then volume must come up

·         Increased dividends and fully utilize share buyback

·         Reduce debt levels.

·         Maintain Spanish market position while increasing the other 2 regions’ contribution to percent OIBDA/OI.

 

Intrinsic Value Range: $80

Accumulation Range: nibble at $68 -- buy @ $66 or better  (margin of safety is fairly low @ 17.5% but this is a conservative estimate and doesn’t take dividend/currency advantages)