Why Telefonica Might Be A Good Investment Right Now

Jun.12.13 | About: Telefonica S.A. (TEF)

Introduction

Madrid-based Telefonica (NYSE: TEF) is one of the largest telecommunications companies in the world. The company is mainly focused on the European and South American markets, where it has a relatively large market share. South America is becoming increasingly important for Telefonica, as the region was good for approximately 51.1% of Telefonica's revenue in Q1 versus just over 38% five years ago in FY2008.

In this article, I'll provide my insights on Telefonica, and will explain why I think the company belongs in a diversified portfolio. I'll mainly focus on its financial report of FY 2012 and its net debt situation. Thirdly, I'll also discuss the reinstatement of the dividend, which was cut last year.

Please note, as Telefonica is a Spanish company, all numbers here will be reported in Euros.

The 2012 financial results

For the full year 2012, Telefonica announced an underlying net profit (this is the net profit excluding major exceptional items) of 1.44 EUR per share, and a reported net profit of 0.87 EUR/share. Reported net income was 3.92 billion euros on a revenue of 62.4 billion Euros, meaning the net margin (net profit/revenue) was 6.28%. According to analyst expectations, the net margin for Telefonica is expected to increase to 8.64%.

As you can see in this table where I compare Telefonica's net margin with other European operators (Deutsche Telekom (OTCQX:DTEGF), Telecom Italia (NYSE:TI) and France Telecom (FTE)), Telefonica's expected net margin is higher than its peers.

Company Name

Expected Net Margin

France Telecom

7.03%

Deutsche Telekom

4.67%

Telecom Italia

7.84%

Telefonica

8.64%

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Telefonica reported a net margin of 6.38% at the presentation of its Q1 financial results, and although this is just a minimal increase versus the FY 2012 net margin, it shows the company is heading in the right direction.

Geographical Diversity

The real strength of Telefonica is its geographical diversity. The company receives in excess of 51% of its revenues from Latin American countries and I expect this number to increase even further, highlighting the revenue potential of this region. At the end of Q1 2012, Brazil was actually Telefonica's largest market by revenues and the company continues to perform well there as it has a significant advantage over the local competition by being the largest domestic provider.

At the presentation of its Q1 financial results, Telefonica reported an increase of organic revenue in Latin America by 3.4%, as compared to a revenue decrease in Europe by 5.2%.

Debt Situation

As part of a turnaround plan to keep the company healthy, Telefonica announced back in the summer of 2012 it would suspend the dividend payments in order to reduce the net debt, which was standing at 56.3 billion euros, for a Debt/EBITDA ratio of 2.62.

At the end of Q1 2013, Telefonica's net debt position was 51.8 billion euros (for a Debt/OIBDA ratio of 2.44), which was slightly higher than the net debt at the end of 2012 (which was 51.2 billion euros and a Debt/OIBDA ratio of 2.36). This was caused mainly caused by the devaluation of the Venezuelan Bolivar, which had an impact of 873M EUR on the net debt situation.

I expect its net debt ratio to continue to decrease at a rate of 2 billion EUR per year from now on, so by the end of 2016, I'm aiming at a net debt situation of 42 billion EUR, which would be approximately twice the OIBDA. This would put Telefonica in a comfortable position compared to most of its competitors.

By decreasing the total net debt position by 15 billion euro from 2012 to 2016 and based on a 5% yield (at the end of Q1 the 12 month rolling interest rate for Telefonica was 5.22%), I estimate Telefonica will save about 750M euros in interest payments, which would in return significantly increase the free cash flow of the company and ultimately its net profit by approximately 10 euro cents per share.

Dividend

Telefonica announced in July last year it wouldn't pay a dividend for the year, as the focus would be on debt reduction. The markets obviously didn't like the announcement and the share price fell 9% on the day of the announcement.

The management has always stated very clearly the dividend cut was just a temporary measure, and as expected they announced last month they will start rewarding their shareholders again by paying a dividend.

The company has put a number of 0.75EUR/share forward for this year, and a first tranche of 0.35 EUR will be payable in November. The payment of the final dividend (0.40EUR) is expected in April next year.

This table calculates the gross dividend in US Dollar based on different exchange rates for the EUR/USD.

Currency Exchange Rate (EUR/USD)

Dividend in USD (based on 0.75 EUR)

1.25

0.9375

1.275

0.95625

1.30

0.975

1.325

0.99375

1.35

10.125

Click to enlarge

Finally, keep in mind Spain levies a 21% withholding tax on dividend. Always consult your broker or tax consultant to find out if your country has a double tax treaty with Spain and what documents you need to fill in to ask for a (partial) refund of the Spanish withholding tax.

Conclusion and Investment Thesis

Whilst you wouldn't think any Spanish company could be a good buy right now, I think Telefonica earns a position in any portfolio focused on both income and quality stocks. Telefonica's revenues are mainly dictated by Latin America, which is a real growth engine in the world economy.

The management of the company was successful in slashing its debt by a total of 5 billion dollars in 2012, and the debt level is expected to decrease even further this year and the next few years, which will save the company several hundreds of million dollars in interest payments on debt. Telefonica will now start to see the compounded effect of its reduction in debt. For every billion of reduced debt, the company will save between 40 and 50 million EUR per year in interest payments.

Last but not least from November onwards, the company will start to pay a dividend again. Telefonica has indicated it will pay 75 eurocents per share, of which a first interim-dividend of 35 euro cents will be payable in November of this year.

Based on a current price of $13.43 at the NYSE, I think Telefonica might be a good investment. As there are option series available, it might be worthwhile to explore the possibility to write a put option with a lower strike price in order to increase the expected dividend yield.

At the moment of publishing this article, the P13 September looks interesting as it yields an option premium of 0.55, meaning if the share price at the time of expiration is lower than $13, you'll have to buy stock at $13/share (and your net price would be $13 - $0.55 or $12.45excluding broker fees). In this table you can see what the influence is of a higher and lower share price on the dividend yield of the stock, using a fixed EUR/USD exchange rate of 1.30.

Share Price (in USD)

Percentage Gross Dividend

12

8.125

13

7.5

13.43

7.26

14

5.96

15

6.5

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As Telefonica is actively looking to slash its debt even further, has reinstated the dividend and has a real growth business in South America, it definitely deserves further due diligence!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TEF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I currently have no long position in the common shares of Telefonica, but have written put options with various strike prices and expiration dates.