Market Underestimates Telefonica

Telefonica TEF is the incumbent telephone operator in Spain and, along with America Movil AMOV/AMX, it is one of two dominant operators in Latin America. Thanks to its acquisition of E-Plus in Germany, it is the largest wireless operator by number of subscribers in the country. It is also the second-largest wireless operator in the United Kingdom.

Beyond its size, which provides Telefonica with scale by spreading its fixed costs over a large number of subscribers, we like the company’s move into converged services, bundling fixed-line services with broadband, pay television, and wireless telephony. The company has been the leader in this movement, which positions it well to benefit from this growing-momentum trend. We believe Spain is the country that is furthest along in this transition, driven by Telefonica. The company has also led the way in laying fibre in order to increase broadband speeds. Its fibre network in Spain now passes over 21 million premises, which is significantly higher than its competitors, Vodafone VOD and Orange ORAN, in the country. We believe Telefonica’s positioning in Spain sets it up for continued long-term growth.

Beyond Spain, we believe the acquisitions of E-Plus in Germany and GVT in Brazil strengthen Telefonica’s operations in those countries. In Germany, Telefonica is now the largest wireless operator by number of subscribers. In Brazil, it has the ability to transport its converged strategy from Spain throughout the country. Both acquisitions also provide significant cost-cutting opportunities.

While we would like to have seen the company sell its U.K. operation in order to exit the more competitive U.K. market and reduce debt, this is still a good business. BT BT, Telefonica’s rival in this market, has moved slower to convergence than we’d expected after the acquisition of EE, which provides more chances for O2 (a Telefonica unit). We also believe the company has other options to reduce its debt. It has agreed to sell its operations in Central America and could exit other countries as well. In the rest of Latin America, outside of Mexico where America Movil dominates, Telefonica continues to perform strongly. It is well positioned, and we don’t see this changing.

Cost Advantages and Scale Dig Narrow Moat We believe Telefonica has a narrow economic moat based on cost advantages and efficient scale. The company is one of the largest telephone operators in the world, with total fixed and wireless telephony, Internet, pay TV, and wholesale accesses of 343.9 million. It dominates its home country of Spain with market shares of about 60% in fixed-line telephony, 44% in broadband, and 31% in wireless telephony. In many Latin American wireless markets, it is in a duopoly with America Movil; it has 184.7 million wireless customers in this region alone. As telecom markets are expensive to build and maintain, the more customers on a network, the lower the average cost per subscriber. We believe Telefonica's scale globally and particularly in many of its markets provides it with a cost advantage over the other operators in those countries.

Additionally, the large market shares that Telefonica and America Movil control makes it difficult for a new entrant to gain enough scale to compete profitably. Despite Spain’s weak economy and reduced revenue from a few years ago, Telefonica’s EBITDA margin in the country, at around 40%, is among the highest in Europe. In addition, the company’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. However, we are concerned about the sustainability of these advantages for 20 years and thus think the company’s moat is narrow rather than wide.

We do think the moat has a positive trend, however. Europe is moving toward a converged market of wireless and fixed-line telephony, broadband, and pay TV. Spain is the country furthest along in this progression, and Telefonica is the leading player there. We expect convergence of wireless services to reduce churn, increase margins, and increase revenue over time. The company 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 can offer a similar product across most of the rest of the country. Telefonica is dealing with its weakness in the rest of Europe by acquiring E-Plus from KPN, which makes it the largest wireless operator in Germany and gives it the necessary scale to compete with Deutsche Telekom DTEGY and Vodafone. To further focus on areas where it has a competitive advantage, Telefonica sold its operations in the Czech Republic and Ireland. While EU regulators killed its attempt to sell its U.K. operation to CK Hutchison, this business continues to perform well. Telefonica is now set for improving margins and returns on capital, which we think provide it with a positive moat trend.

Currency and Competition Are Concerns Latin American currencies are notoriously volatile. This was a major problem in 2001-02 and has been again recently. The company has virtually eliminated Venezuela's revenue. Other currencies in Latin America dropped significantly during 2014 and 2015, with additional declines in 2018 from the Brazilian real and especially the Argentine peso. Also, Telefonica has moved beyond its traditional Spanish- and Portuguese-speaking markets, and in doing so has added further political and economic risks as well as increasing leverage on the balance sheet from acquisitions. The company 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 company’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 purchase of Jazztel, an alternative carrier, competition in the country could increase even further. The current credit crisis is also hurting Telefonica’s performance and until recently had pushed up interest rates in Spain. In 2016, Telefonica cut its dividend from EUR 0.75 per share to EUR 0.40 in order to provide more cash to reduce debt. There is some concern in the market that the dividend could be cut again, but we believe management will maintain it.

Telefonica is making progress reducing its debt. Net debt is currently EUR 46.8 billion, as we calculate it, versus EUR 53.7 billion two years ago, or about 3 times trailing adjusted EBITDA, though this still makes Telefonica one of the most leveraged phone companies in Europe. That said, it has over EUR 8 billion in long-term financial assets that it could sell. The company subtracts about half of these, those not connected to derivatives, in calculating net debt; we don’t.

The company 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 Telefonica’s large debt position, we think the amount is manageable for such a large company 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 located in Spain, and its debt rating faces pressure from weakening Spanish sovereign credit ratings.