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In the following article we want to illustrate why we believe Telefonica (NYSE:TEF) is mispriced by the market and why we purchased Telefonica for our small investment fund. Our investment in Telefonica common stock represents about 8% of our investable funds. Generally, we suggest Telefonica for long-term oriented value investors who are looking for an undervalued company with significant growth potential in emerging markets and attractive dividend prospects. While we primarily believe that the fundamentals merit a long-term investment in Telefonica, risk-seeking traders might find our trading proposition interesting.

Telefonica business model

Telefonica is a Spanish telecommunications provider with operations in Europe, America and Asia. In particular, growth markets in Latin America, such as Argentine, Brazil and Venezuela, are critical for earnings growth and free cash flow generation. Dividend sustainability and dividend increases will largely depend on further growth capitalization in those markets. We suggest, that, in terms of product group, Telefonica will be able to deliver strong results in broadband and mobile data, both in developed and developing markets. Telefonica's main competitors are Deutsche Telekom (DT), Orange (NYSE:ORAN), Vodafone (NASDAQ:VOD), AT&T (NYSE:T) and Verizon (NYSE:VZ).

Why we believe Telefonica is undervalued

Our thesis

We believe Telefonica is currently mispriced because the company has made strong progress in its financial and operational restructuring which the market continues to ignore.

Secondly, a narrow focus on Telefonica's European business, which posted declining revenues and earnings, obscures the true value of Telefonica's Latin American business. This segment will become more important for OIBDA and free cash flow generation going forward.

Thirdly, after reducing net debt in FY11/12 and FY12/13, the company is ready to reintroduce its dividend with an estimated annualized yield of 6.6% based on Euro rates.

These three factors justify a reassessment of the company's accomplishments and a revaluation of its stock price:

  • Investors should recognize the strong focus Telefonica applies to leverage reduction. A large part of the decline in the stock price in 2012 was caused by investors fearing both a Spanish recession and Telefonica's high leverage ratios. In order to address those fears, Telefonica suspended its dividend (yielding about 10% at the time) and shifted its focus toward leverage reduction. Consequently, in the last 12 month alone net debt was reduced by $10 billion (down about 17% in just one year). The company has made remarkable progress by addressing investors' concerns head on and is ready to pay a dividend of Euro 0.35 per share in November. Yield-seeking investors, who shunned the company in 2012, are likely to put Telefonica back on their radar.
  • Telefonica is going to pay an annualized dividend of Euro 0.75 which is below previous dividends of over Euro 1.00 per share. As such, the dividend will be more sustainable, increasing the market's confidence in the durability of this dividend stream.
  • We assume, conservatively, that the company's free cash flow generating capability, mainly driven by Latin America, will allow a dividend payment of Euro 1.00 per share in FY14/15.
  • Free cash flow generation, our main value metric, stands at Euro 2 billion as of the second quarter, which further supports the reintroduction of a dividend. Free cash flow has grown 16% year on year. Normalized free cash flow (free cash flow less non-recurring items) stood at an even more impressive Euro 2.6 billion.
  • Management further concentrates on creating a leaner, more efficient company which will drive OIBDA margins. The current OIBDA margin stands at 33.7%. We estimate, Telefonica will reach a FY14/15 OIBDA-margin of 30%.
  • We believe Telefonica will reap benefits of its increased investment in information security services to enhance its digital services presence which should offer significant growth potential.
  • Transaction synergies: Telefonica's purchase of E-Plus, a German mobile business, is increasing Telefonica's customer base in Germany by an estimated 23 million and could be a transformational move to consolidate market share and create value in Europe's largest telecommunications market.

Long-term investment opportunity

Telefonica trades at a forward P/E ratio of only 6.7 bringing the annualized earnings yield up to a strong 15%. Long investors can expect an initial, annualized dividend yield of 6.6% while purchasing the very attractive growth markets in Latin America at a discount. Furthermore, investors get a leaner, restructured, de-leveraged business with the prospect of future dividend increases. An investment in Telefonica would be suitable to income-seeking investors who desire European equity exposure. Given the size of the company and its international footprint, we judge the risk of the company and its common stock to be medium.

We also believe that long-term oriented investors will profit from an improvement in European business sentiment and, ultimately, a brighter economic picture in Europe. A stronger European market, supplemented by growth from Latin America, should give the company the resources to make dividend increases probable in the near future.

Risks

We see risks primarily in the European economy, particularly in Spain and Germany, where key performance indicators such as average revenues per user as well as earnings have been declining. A deterioration in the economic picture will likely affect Telefonica's top- and bottom-line. Given that the company has just announced its dividend reintroduction, which we take as a vote of confidence in the company's future, we judge the overall risk to be low.

Short-term trading opportunity

Short-term oriented traders might be interested in taking a call position at $12.50, a frequently tested cyclical short-term support level, and playing the upside to about $14.50. A put option might be interesting in the range of $14.70-15.00 where a short-term resistance level lies and the stock has frequently rebounded over the course of the last year. A break of this resistance level indicates stronger momentum and should be understood as a very bullish sign.

Source: Telefonica Will Rise Again