Telefonica: Debt And Dividend Appear To Be Sustainable

Sep.27.11 | About: Telefonica S.A. (TEF)
The Spanish telecommunications giant Telefonica SA (NYSE:TEF) has both a high debt load and a high dividend. Investors who see this are almost undoubtedly going to be concerned that this is unsustainable. As one of the most disheartening things for an investor is to face either a dividend cut or a debt default, it is important to determine if a company can afford to honor its commitments to its investors and creditors.
Telefonica reports its most recent quarterly results (pdf) on July 28, 2011. These results correspond to the three months from April – June 2011. This was officially released as the company’s half-year results, corresponding to January – June 2011. As of that date, Telefonica had 51,981 million euro in long-term financial debt and 1,709 million euro of “other long-term debt.” This compares with total stockholders’ equity of 26,048 million euro. This gives the company a long-term debt- to-equity ratio of 2.06. The company’s leverage ratio, calculated as net debt divided by the last twelve months’ OIBDA stands at 2.49. Here is how that compares with some of the other telecommunications companies:
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Source: Yahoo Finance and the respective corporate reports
Telefonica is one of the most heavily leveraged companies in its peer group. It also has the lowest OIBDA to LTD ratio. What this tells us is what percentage of its long-term debt the company could pay off with two quarters of operating income. The reason OIBDA is used instead of operating income is because depreciation and amortization are not a cash charge so the money that the company “spends” for that purpose is actually still available for other uses (such as paying off debt). Telefonica and France Telecom (FTE) would take the most time to pay off their debt if their entire operating income was devoted solely to that purpose. Vodafone (NASDAQ:VOD) could completely pay it off in just over half a year. None of these companies appears to be in real trouble though, particularly because telecommunications companies tend to have stable income.
Telefonica paid net interest (interest paid minus dividends received from non-fully consolidated subsidiaries) of 1,166 million for the first six months of this year. This is a relatively small decrease from the first half of last year despite debt increasing during the same period. This is largely due to the low interest rate environment that the global economy is in today. At some point, the costs of servicing this debt will rise. The continued economic malaise in both the United States and the eurozone make it unlikely that this low interest rate environment will end anytime soon, however. For now anyway, Telefonica will be enjoying the low debt carrying costs.
Telefonica had net operating income of 6,348 million euro during the six-month period. This is a decrease of 108 million euro from the prior year period. The company had much greater depreciation and amortization in 2011 compared with the first half of 2010. In fact, OIBDA (Operating Income Before Depreciation and Amortization) was 11,304 million euro in the first half of 2011 compared with 10,905 million euro in the prior year period. Telefonica also had total financial (non-operating) charges of 534 million euro during the six-month period. This can be found on the company’s income statement as a negative profit from associated companies. This brings the company’s EBIT down to 5,814 million euro. The company’s interest coverage ratio is 4.99. In other words, Telefonica can cover its interest on the outstanding debt nearly five times over with its earnings. This is more than sufficient to make me comfortable.
We have established that Telefonica can handle its debt load. What about its dividend?
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Source: Telefonica First-Half 2011 Financial Results
As you can see, Telefonica’s operating cash flows are not large enough to support the interest on the company’s debt, capital expenditures, and the dividend. Free cash flow has improved from the prior year period but still is not quite enough. Telefonica can, however, easily cover the interest on the debt and the dividend out of the cash that the company generates. I am not too concerned about this as long as the CapEx spending is used to purchase assets that generate more cash flow than what the company must pay to carry the additional debt that it accrues from this spending.
The company’s exposure to Spain may be a point of concern. I doubt that Spaniards will give up their telephones, cellular/smartphones, and internet connections in response to the current fiscal problems in that nation. There are many other areas of discretionary spending that would likely be cut by the average person should their income decline before they cut services like the ones that Telefonica offers. With that said, Telefonica does have a 126% penetration into the Spanish mobile telephony market. I do think it is unlikely that the Spanish people will stop buying services from Telefonica in the event of more economic trouble. There is, though, the possibility that some people will decide that they or their households do not need multiple mobile devices and will reduce the number of phones or other mobile devices that they have and proportionally reduce Telefonica’s revenues.
Telefonica only earns 36% of its OIBDA from Spain. Thus, the Spanish market does not even make up the majority of the company’s operating income. This should provide Telefonica will partial insulation against any potential economic slowdown in Spain. It is not fully protected though and the loss of most or all of this profit will certainly hurt the company. For reasons that I have already explained, I do not think that this outcome is likely. Furthermore, the risks of continuing economic problems in Spain could very well be priced into the stock at today’s levels.

Disclosure: I am long TEF, VZ.