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By Damion Rallis, Senior Research Associate

A recent spate of regulatory fines, investigations, and tax issues at Spanish telecommunications provider Telefonica SA (NYSE:TEF) should compel investors to take a close look at the company's ESG risks and the reliability of its reported financials. By gobbling up its competitors and expanding its global reach, Telefonica "seemed poised to create a telecommunications empire." It appears, however, that the company has spread itself too thin, as the rapid expansion has exposed it not only to increased regulatory risk but also to recessionary trends in certain markets.

Currently, Telefonica's "C" rating for ESG reflects moderate risk, but continuing regulatory actions could result in a downgrade. Telefonica's AGR Rating-a measure of the integrity of accounting and governance practices-is "Aggressive." Further, GMI Ratings' Litigation Risk model has been showing warning signs for Telefonica for several rating periods. The company's score is 1 (on a scale from 1 to 100), meaning "High Risk." This places the company in the 1st percentile of all companies in Western Europe, indicating higher shareholder class-action litigation risk than 99% of all rated companies in this region.

While expanding to more markets has certainly taken its regulatory toll on Telefonica, the company is faring far worse in its home market of Spain. Here, the company recently lost 870,000 cell phone subscribers and cut 6,500 employees. Further, due to high levels of debt, Telefonica suspended its popular dividend program in October 2012 as an immediate measure to pay down its 58 billion euro debt. Still, our AGR model flags Telefonica for its Debt/Equity ratio. Companies with high levels of debt in relation to equity can experience problems in debt repayment and reduced flexibility in funding future projects. For the period ending in September 2012, Telefonica's debt to equity ratio stood at 3.319, well above its industry's median ratio of 1.123.

Tax issues further complicate Telefonica's risk profile. Peruvian authorities announced this week that they have "finally agreed to extend Spanish telecoms company Telefonica's license despite an unresolved tax dispute worth PEN2bn (USD860m)." While Telefonica will be able to continue its Peruvian operations, the regulatory scrutiny in Peru forces investors to consider the possibility that the company may fail to sustain the current scale of global operations. The following is a list of recent regulatory events recorded in our GMI Analyst research platform:

  1. In January 2013, Dow Jones reported that European Union regulators imposed a combined fine of EUR79 million on Telefonica SA and Portugal Telecom SGPS SA after the two telecommunications firms agreed not to compete with one another in the Iberian market. The European Commission said the non-compete clause for Spain and Portugal was illegal under European Union law and that Telefonica will be fined EUR66.9 million euros and Portugal EUR12.3 million.
  2. In December 2012, Reuters reported that Spain's antitrust body imposed a 120-million-euro fine on Telefonica SA (Telefonica), Vodafone Group Plc (Vodafone) and France Telecom SA'Orange. In a statement, the regulator said the three firms were found guilty of fixing artificially high termination prices for text messages. Telefonica, Vodafone and Orange said they would appeal the decision.
  3. In May 2012, Reuters reported that Argentina's government decided to fine Movistar, local wireless unit of Telefonica SA, due to massive mobile phone service outage in April 2012, in the amount of MXN 185 million (USD 42 million).
  4. In April 2012, Dow Jones reported that The European Commission has opened an investigation into the proposed creation of a joint venture in the United Kingdom between Telefonica SA, Vodafone Group Plc and Everything Everywhere in the field of mobile commerce. The Commission's preliminary investigation focused on potential concerns about anti-competitive practices in the nascent markets of mobile payment applications (so-called mobile wallets), mobile advertising and related data analytics services, where the joint venture may have very high market shares.
  5. In April 2012, Dow Jones reported that Argentina's government will fine the local wireless unit of Telefonica SA due to technical problems that left more than 16 million clients without phone and data service for several hours. The Argentine federal communications regulator will also require Telefonica to compensate consumers for the service outage.
  6. In March 2012, Dow Jones reported that the European Union's second court has upheld a fine of more than EUR 151 million imposed by the European Commission on Telefonica SA for charges related to the wholesale market for regional and national access between fiscal years 2001 and 2006.
  7. In January 2012, Reuters reported that Telefonica SA's Salvadorian subsidiary Telefonica Moviles El Salvador operator of Movistar, and America Movil SAB de CV's Digicel have been fined by the Salvadorian Government for having come to an agreement with other telephone companies in regard to collection of fees, which infringed the rules of competition.
  8. In October 2011, Dow Jones reported that the European Commission objects to Telefonica S.A. and Portugal Telecom SGPS SA agreement to not compete in the Spanish and Portuguese telecommunications markets. The commission is of the preliminary view that this agreement hinders competition in breach of EU antitrust rules that prohibit restrictive business practices, according to EU.
  9. In August 2011, Dow Jones reported that Telefonica SA, Banco Santander SA and Iberdrola SA may be forced to pay back Spain's government as much as EUR1 billion in goodwill deductions booked after foreign acquisitions before 2007, following the approval of new fiscal measures in Spain. Spain's parliament on August 23, 2011 approved a package of extra austerity measures, including the removal of goodwill deductions for some foreign deals that Spanish companies previously enjoyed. The companies forced to pay now will be allowed to recover the cash 21 years after the deal.
  10. In May 2011, Reuters reported that the Spanish government wants Telefonica SA (Telefonica) to pay unemployment benefits for 8,500 employees the Company plans to lay off, The cost of benefits for the 25% of Telefonica's Spanish workforce to be laid off would range from EUR 270 million to EUR 440 million (USD 615 million).
  11. In April 2011, Reuters reported that a regulatory agency, la Comision del Mercado de Telecomunicaciones (CMT), has initiated disciplinary proceedings against Telefonica SA after receiving a complaint from France Telecom on the methods the Company used to win back the clients. CMT announced that the Company's operations were a serious breach, which affected the process of portability (retaining the number after an operator's change) in a fixed telephony and broadband.
  12. In January 2011, Reuters reported that Comision Nacional de la Competencia (CNC) has opened disciplinary proceedings against Telefonica SA, Vodafone Group Plc and France Telecom SA regarding prices in SMS and MMS messages wholesale services.
  13. In July 2010, Reuters reported that the Argentinean Communications and Electric Energy Regulation Agencies have impose a ARS 30 million fine to Telefonica SA's subsidiaries and Edesur, for a blackout that hit last month and affected thousands of users. In addition, the Argentinean Communications Regulation Agency has imposed an ARS 15 million fine on Telefonica de Argentina SA and Telefonica Moviles SA, both Telefonica SA's subsidiaries, for disruption of basic services and cellular telephony last month.

Based on our ratings methodology, the greatest impact on Telefonica's overall score comes from governance issues that include board composition, executive compensation, and ownership structure. Specifically, board members serve for five-year terms so that shareholder votes are not only infrequent but also quite toothless. Shareholders have expressed their discontent over several directors over the past two years-six directors with more than 11% withhold votes in 2011 and five directors with over 12% withhold votes in 2012. (As a point of reference, the median withhold percentage for nearly 37,000 directors in our coverage universe is less than 2.5% as of the end of January 2013.) Withholding votes affords Telefonica shareholders the opportunity to voice their grievances once every five years. This recourse remains largely ineffectual as classified boards of this nature would make more difficult and lengthy any attempt to gain control of a majority of the board.

Telefonica board's industry experience is unimpressive. Of the 18 directors, we believe only four board members-22% of the board compared to an industry average of 44%-have substantial industry knowledge that could provide an obvious benefit for their board service. Moreover, Telefonica's board-with 18 directors-may simply be too large to govern effectively, given the telecommunications industry average of 11 board members. Furthermore, of the 18-member board, three directors are executives, two directors have current or prior relationships with Telefonica that weaken their independence, and five directors have relationships with significant Telefonica shareholders. Overall, according to Telefonica's own math, only 44% of the board can be considered truly independent. A board composition of this nature does not represent an effective counterbalance to management.

Despite their claims of independence, we note that "independent" directors at Telefonica received average compensation of 350,000 euros for fiscal 2011. This is more than the average amount paid to proprietary or non-independent board members. Five independent directors also received compensation from companies of the Telefonica Group other than Telefonica SA. (Note that these additional amounts were not listed in their official compensation totals.) In fact, four directors received more than 240,000 additional euros for other services at Telefonica entities, including Mr. Javier de Paz Mancho, who received an additional 840,667 euros for total Telefonica compensation of nearly 1.3 million euros. In sum, we hesitate to call such directors independent.

Considering the company's regulatory issues, we note that five of the board's six Regulation Committee members (including Mr. de Paz) received additional compensation in 2011 so that the average Regulation Committee member earned 630,000 euros. (As an aside, shareholders are in apparent agreement with our assessment as not only have several directors received significant withhold votes, but the company's compensation report received less than 61% "Yes" votes at the companies last annual meeting.)

Lastly, one more board feature at Telefonica calls us to question whether or not there is effective and independent oversight. According to the company's most recent Annual Corporate Governance Report, the board of directors "has delegated all its powers to an Executive Commission, except those that cannot be delegated by Law, by the Company Bylaws, or by the Regulations of the Board of Directors." The Executive Commission, which is comprised of a majority non-independent directors, met 17 times in 2011 compared to only 12 full board meetings, yet another indication of the board's lack of full independence. In sum, Telefonica's risk profile has suffered from aggressive expansion during an economic boom. We wonder if a fully independent board with industry experience may have provided more effective leadership.

Disclaimer: GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.

Source: Telefonica SA Exposes Investors To A Complex Mix Of ESG Risks