Telefonica: A 6.8% Yielding Telco With Nearly 70% Upside Potential

Mar. 2.14 | About: Telefonica S.A. (TEF)

Telefonica (NYSE:TEF) is still my top telco bet for 2014 and beyond. The Spanish telecommunications giant with a large presence in Latin America has fallen from grace in 2012 as the company decided to suspend its dividend payments and instead focus on reducing its net debt burden (Telefonica has reduced net debt by about Euro 16 billion since June 2012). At the same time, Telefonica's home market in Spain went through a deep-cutting recession characterized by high unemployment, GDP contraction and mounting economic uncertainty. The dividend suspension ultimately contributed in driving Telefonica's share price down to $11 on May 28, 2012.

Interestingly, once again, investors who bought the Spanish telecommunications company in 2012 when negative newspaper headlines defined investors' attitudes toward Telefonica, made a great deal after all. I still believe that Telefonica is a top choice for income-oriented investors who are structuring a long-term portfolio that also accentuates growth.

Share performance

After Telefonica announced in 2013 that it is going to resume its dividend payments, investor demand for Telefonica shares suddenly increased, and shares rose up to $18. However, shares have since consolidated by about 16% from their 52-week high at $18.05. I think that investors can now profit from an even more attractive entry price and higher initial dividend yield.

(Source: Yahoo Finance)Click to enlarge

Less than five years ago, Telefonica shares were trading at above $29 (November 30, 2009) while rapidly giving away most gains in 2011 and 2012 due to economic troubles in Telefonica's home market. The five-year performance chart for Telefonica helps to put things into perspective:

(Source: Yahoo Finance)Click to enlarge

Free cash flow valuation

I have slightly updated my previous estimates for Telefonica's free cash flow to equity per share. I estimate that Telefonica can grow its FCFE/share by 4.83% in 2015, 5.26% in 2016 and 4% beyond 2016 with FCFE growth predominantly coming from Telefonica's Latin American presence. Correspondingly, I calculate Telefonica's intrinsic value per share at $25.57, implying about 68% upside potential. Investors looking at the five-year performance chart above will realize that this is about the price Telefonica traded at in 2011 before the Spanish economy collapsed.

(Source: Achilles Research)Click to enlarge

Dividend yields

I think Telefonica is an interesting telco alternative for US-based investors. The largest US telecommunications companies also offer investors attractive dividend yields: AT&T (NYSE:T) currently yields 5.76% while Verizon (NYSE:VZ) 4.46%. However, in my opinion, Telefonica offers investors much better dividend growth prospects -- a key reason to purchase any dividend stock. Telefonica has a large presence in Latin America, particularly in Brazil, Argentina, Mexico, Colombia and Venezuela. Telefonica's cash flows and earnings will largely be driven by its booming mobile broadband segment, especially in emerging markets like the ones mentioned above. In addition, I expect Latin America to grow at a higher real GDP rate than the United States in the long-run.

Telefonica currently pays €0.75 per share -- about US-$1.04 per share based on the current €/US-Dollar exchange rate ($1.38 per Euro). I expect Telefonica to pay a dividend of €1.00 (US-$1.38) in 2015/2016, covered by its free cash flow, which would translate into an estimated dividend yield of 9%.

Telefonica currently has the highest dividend yield in the peer group: 6.75%. Potential dividend increases after 2014 will only add to the appeal of this resurgent Spanish dividend machine.

(Source: Achilles Research, Yahoo Finance)

Bottom line

Investors who are looking for alternatives to Verizon and AT&T should consider Telefonica. Telefonica's share price got extraordinarily hammered during the Spanish recession which precipitated a dividend suspension that investors clearly disliked. The fall in Telefonica's share price over the last five years is astonishing, but also points toward significant rebound potential. Just a few years ago, Telefonica's share price was approaching the $30 mark, and I see no reason why Telefonica wouldn't be able to return to the $20s region given that economic conditions in Spain improve.

The free cash flow valuation model suggests that Telefonica has an intrinsic value of around $25 per share, and I think the underlying assumptions with respect to capital costs and growth rates are fairly conservative. Investors looking for a telecommunications company with a high dividend yield and an attractive growth profile should consider Telefonica a long-term buy.

Disclosure: I am long TEF. 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.