Telefonica Stays On Course To Deliver Value

Sep.16.13 | About: Telefonica S.A. (TEF)

Telefonica (NYSE:TEF) is an international telecommunications provider with operations in Europe and Latin America and a presence in 24 countries across the two continents. About 77% of business is conducted outside its home market, Spain. The aggregate number of customers across its countries of operations is 317 million: ~215M in Latin America and almost 102 million in Europe. Telefonica owns four brands: same-name Telefonica, Movistar, O2 and Vivo. The company is number one in Europe in terms of integrated operations and has a market capitalization of $67.8B (Enterprise Value = ~$137B). In the last 12 months, the company earned an EBITDA of $20.7B, which gives it an implied multiple of ~7.0X. P/E ratio floats around 12.4X, which comparable to its competitors', show below:

Data Courtesy of TD WaterhouseClick to enlargeA recent run-up in stock price, caused by consolidation talks among telecoms in Europe (Kabel Deutschland and Vodafone, AT&T's potential play, etc.), sent the price to a 1-year resistance level of $15.00. However, in the long run, the stock has been stagnating for the past year and a half:

Data Courtesy of TD WaterhouseClick to enlarge

This underperformance relative to a broader S&P 500 index has had a lot to do with the company's mounting debt levels of circa $68B. On the other hand, the company has been on a mission to cut debt to levels below 47B euros this year:

Telefonica has agreed to sell its Irish subsidiary to Hutchison Whampoa for over $1.1B and is in talks with three other Italian telecoms to sell Telecom Italia (NYSE:TI).

Telefonica is growing its position in the German market through M&A activity, having agreed to buy E-Plus from Dutch Royal KPN NV for $11.4B in exchange for a 20% stake in Telefonica Deutschland and $5B in cash. The cash will come from hybrids, high-yield (7-8%) subordinated debt, which will save the company's equity from dilution and give the delicate D/E ratio a status quo.

Recent M&A

In August 2013, Telefonica provided updates on its pending acquisition of E-Plus from the struggling Dutch telecom KPN. Telefonica has raised consideration for E-Plus to over $11B, buying it for 2.4X 2012 revenues of 3.4B euros. This will enable Telefonica to serve 43 million customers at a 38% market share with more than $11B in annual revenues:

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As the German telecom market is turning into an oligopoly, Telefonica will also exercise over 5B euros in synergies:

From TelefonicaClick to enlarge

The company plans to develop LTE network in Germany and capitalize on the lagging smartphone market in the country. The following is the pro-forma snapshot of the company's worldwide operations:

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The deal supposedly increases total revenues by ~4B euros (a 6.5% upside) and grows EBITDA by 1B euros or 4.7%. Germany will now contribute at least 13% to total revenues, while showing a similar number in EBITDA. More than quarter of European revenues will arrive from Germany, which will also provide the company with 23% of European EBITDA.

Overall, the deal makes sense to Telefonica: the company bought E-Plus at the right price and will use it to further leverage its position in the oligopolistic competition in Germany. This also enabled the company to become No. 1 in Europe by customer base. Telefonica's financials are revamped with perpetual debt, while senior debt keeps shrinking.

Historical Financials

Despite stagnating revenues, Telefonica has consistently delivered stable free cash flows, which it had used to pay dividends up until the beginning of 2013, when the economic situation in Spain worsened:

Data Courtesy of TD WaterhouseClick to enlarge

(During the past 5 years cash from operations has consistently covered Telefonica's investment activities in entirety).

One can see that Net Income margin has slid off to a single-digit area, although the company has maintained a ~23% ROE mainly thanks to high leverage of 6.5X:

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Telefonica has maintained a median EBITDA margin of ~35% but has seen a decrease in the past two years to a level of 33%. This was offset by smaller financing expenses, which made Telefonica look stable even amid the European economic instabilities.

Valuation

Fundamental

I have looked into EPS and FCF estimates for Telefonica provided by a number of institutions and constructed a P/E sensitivity matrix, having applied current P/E levels and WACC:

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Graham's Number: $12.5 [(22.5*1.15*6.04)^(0.5)]

Compared to the current price of ~$14.8 per share the stock is fairly valued at 2013E EPS, although offers significant upside in relation to 2014E and 2015E EPS levels (11% and 18%, respectively, at Medium estimates). EPS growth is expected to be internal, that is, from optimizations in SG&A and financing expenses, associated with the reduction in debt levels.

Technical

Chart and data analysis have been provided by Recognia Inc. I choose the Intermediate-Term time frame to exclude noise and short-term volatility:

Data Courtesy of TD Waterhouse Click to enlarge

The current price of ~$14.8 suggests that the $14.4 resistance level has been broken and the stock may keep rallying to the next level at about $15 per share. The stock has been trading above the 50-day average for the past six weeks. It seems that the recent rally was largely fuelled by M&A rumors in the wake of Verizon-Vodafone buyout.

Summary

Telefonica is a long-term play as it remains a well-positioned business with stable revenues and cash flows. The company's stronghold is in its vast customer base and geographical diversification. Telefonica is on the deleveraging course and keeps strengthening its position in key European markets with potential in the postpaid smartphone niche.

Conclusion

I issue a BUY recommendation for Telefonica with a target price of around $16-$16.5 per share. Investors beware of currency risks associated with the ownership of Telefonica's ADRs.

Analyst Ratings

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.