Telefonica Still Undervalued

The problems began when the company acquired Portugal Telecom's stake in Vivo, its Brazilian wireless business. The debt that Telefonica took on for this acquisition, along with the worsening of the Spanish recession, caused management to lose financial and operating flexibility. While we liked Telefonica's full control over its Brazilian operation, we thought it overpaid. We also didn't like its aggressive dividend policy, which raised the dividend faster than free cash flow growth. This came to a head in 2012, and the firm first cut and then eliminated the dividend in order to pay down debt.

Telefonica followed this by selling part of its German and Central American operations and its Irish and Czech businesses. We never thought the Czech business fit very well with the rest of the firm, so we are happy to see it go. We are less enthusiastic about the other divestitures, but the firm's priorities were improving the balance sheet and restoring financial flexibility. We are pleased to see Telefonica buy KPN's German operation. The combined firm is now the country's largest wireless operator by number of subscribers. We anticipate significant cost savings due to this merger from the reduction of overlapping back offices, distribution, and customer service.

While management has lost some credibility over the past few years, we like its strategy of moving to a converged quadruple-play service. We also like Telefonica's acquisition of GVT in Brazil; in our eyes, this business fits much better with Telefonica than it did with Vivendi, and the price paid was fair and will provide cost-saving opportunities. Additionally, it will allow the firm to offer a converged product throughout most of Brazil. We are somewhat concerned about the additional debt from these acquisitions, but if the firm receives regulatory approval for its proposed U.K. asset sales, its balance sheet will be in decent shape.

Size Contributes to Narrow Moat Telefonica has total fixed and wireless telephony, Internet, pay television, and wholesale accesses of 318.7 million (excluding customers of O2 UK, which is considered a discontinued operation). It dominates its home country of Spain with market share of about 60% in fixed-line telephony, 45% in broadband, and 31% in wireless telephony. In many Latin American wireless markets, it is in a duopoly with America Movil AMX and has 193 million wireless customers in this region alone. The two operators' large market shares make it difficult for a new rival to enter the market with the hope of gaining enough scale to compete profitably. Despite Spain's weak economy and reduced revenue there, Telefonica's margins in the country were among the highest seen in Europe. In addition, the firm's size allows it to get better pricing on handsets and equipment than smaller operators. Altogether, it can operate at a lower cost than its competitors and take more profits to the bottom line. We think this provides the firm with an economic moat. However, we are concerned about the sustainability of these advantages for 20 years and thus think the firm's moat is narrow rather than wide.

Europe is moving toward a converged market of wireless and fixed-line telephony, broadband, and pay television. Spain is the furthest along in this progression, and Telefonica is the leading player in that country. We expect convergence of wireless services to reduce churn, increase margins, and increase revenue over time. The firm is also leading Brazil in this direction. It is already having success in selling quad-play packages in Sao Paulo state, where it owns the incumbent fixed-line operator as well as the largest wireless operator; with its acquisition of alternative telecom carrier GVT, it will be able to offer a similar product across most of the rest of the country. It is also dealing with its weakness in the rest of Europe after acquiring E-Plus from KPN, which makes it the largest wireless operator in Germany and gives it a scale to compete with Deutsche Telekom DTEGY and Vodafone VOD. To further focus on areas where it has competitive advantage, Telefonica has sold its operations in the Czech Republic and Ireland and has agreed to sell its U.K. business. Altogether, Telefonica is set for improving margins and returns on capital.

Volatile Currencies and Expansion Present Risk Latin American currencies are notoriously volatile. This was a major problem in 2001-02 and has been again more recently. Telefonica has virtually eliminated Venezuela's revenue by adopting a currency exchange rate of VEF 220 to EUR 1 versus the official Venezuelan rate of 7.10. Other currencies in Latin America have dropped significantly during the past year, with the most important being the Brazilian real. Telefonica has also moved beyond its traditional Spanish- and Portuguese-speaking markets, and in doing so it has added further political and economic risks as well as increased leverage on the balance sheet from acquisitions. The firm has been on a buying spree and risks overpaying for additional acquisitions similar to Vivo or overleveraging its balance sheet. Competition is increasing in all of Telefonica's markets, which could impede the firm's ability to boost its margins. Unlike the majority of those in continental Europe, the cable TV industry in Spain has been competitive for years, offering high-speed Internet access and telephony. With Vodafone's acquisition of Ono, the largest cable operator in Spain, and Orange's ORAN purchase of Jazztel, an alternative carrier, competition in the country could increase even further. The credit crisis is also hurting Telefonica's performance and pushed up interest rates in Spain.

Along with maintaining the dividend, we expect Telefonica to use its free cash flow to reduce debt. It could make additional small acquisitions, but we don't think it will make any more large ones until it has achieved significant debt reduction. Despite the large debt position, we think the amount is manageable for such a large firm with relatively steady cash flows. The maturities are nicely staggered over many years, so no single year is a major concern for refinancing. However, Telefonica is more concerned about rollover risk than some other incumbent European telecom operators, given that its headquarters are in Spain and its debt rating faces pressure from weakening Spanish sovereign credit ratings.