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, Barel Karsan (373 clicks)
Long only, deep value, contrarian, bonds
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Shares of global telecom giant Telefonica (NYSE:TEF) have been decimated lately as most Spanish stocks (even those cross-listed in the U.S. like Telefonica) have taken a beating due to the economic crisis in Spain. But while Spain does suffer from a recessionary environment and an unemployment rate of 23%, the market has likely overreacted when it comes to Telefonica: its shares are down 43% in the last year, even though only 30% of the company's profits come from Spain, whereas over half of the company's profits come from a healthily growing Latin American market.

As a result of the share price decline, Telefonica has a market cap of $65 billion despite free cash flow on the order of 8 billion euros per year (which at current exchange rates, equates to over $10 billion). The company pays most of this cash out to shareholders as a dividend, which makes for a very fat yield at current prices.

What likely scares investors away is the poor economic trend in Europe combined with Telefonica's debt load which, after including pension and employee obligations, is on the order of $90 billion. To better assess the riskiness of this debt load, it's useful to understand the nature of Telefonica's industry.

As a provider of telecom networks in the many countries it serves, Telefonica benefits from being a large player in an industry where natural barriers to entry exist. It is costly for upstarts to build out a fixed-line or wireless network without revenue to pay for those costs, while at the same time it's difficult to generate that revenue without an expensive network in place! As a result, Telefonica operates as part of an oligopoly in most of the markets in which it operates, with fairly steady (and high) market share and excellent equity returns.

That's not to say that competition between industry rivals cannot exist. Indeed, Telefonica is seeing some of that now, as deflationary pressures in many of its markets (including in its home market of Spain) mean price competition wars are being waged as consumers tighten their wallets. But for the value investor with a long-term outlook, an industry structure which effectively blocks new entrants reduces risk considerably, as price wars do end.

Of course, industries with such monopolistic characteristics are also prone to government intervention, in order to protect consumers from pricing practices that companies would otherwise undertake in order to take advantage of their market power. Telefonica has experienced a number of such interventions, including recent requirements that it reduce interconnection fees, which hurt results in 2011.

One benefit Telefonica has over more regional players such as Telus or Bell in Canada is that it is diversified across many countries throughout the world. If any one country decided to enact regulations that reduce returns to their cost of capital or below (e.g. price caps, low lease rates for new entrants, or in the extreme cases of Argentina or Venezuela, repatriation of assets), Telefonica is diversified enough geographically to survive.

One final risk worth mentioning is that a fair amount of capital investment is required to continually upgrade the company's networks. Though this does act as a barrier for new entrants, the rapid changes in technology could also pose a risk of obsolescence. Disruptive changes in technology (radio phones? satellite phones?) may also one day wreak havoc on Telefonica's business model.

For now, however, Telefonica appears to operate in an industry that is not going away any time soon. In most of Telefonica's markets, in fact, subscribers and accesses continue to grow. At the same time, Telefonica benefits from an industry structure that is difficult for new entrants to penetrate, reducing the risk that its debt is a threat.

As it currently stands, the company has an EBIT/interest ratio of over 3, which should comfort shareholders considering the industry's characteristics and Telefonica's diversification. Shareholders at the current price may thus be able to comfortably take advantage of the company's high free cash flow to market cap yield.

Source: Telefonica A Long-Term Buy