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A coarse examination of Telefonica's (NYSE:TEF) operating results over the past three years reveals some alarming trends. In the 2011 20-F filing, they list results for the past three years shown below. While margins rise in 2010, they fall sharply in 2011, especially in Spain and Latin America, Telefonica's two largest markets.

TEF Revenue & Income by Segment

(in millions)

2011

2010

2009

Spain

Revenue

17284

18711

19703

Operating Income

2984

6511

7617

Operating Margin

17%

35%

39%

Latin America

Revenue

29237

25756

22709

Operating Income

6158

9759

5341

Operating Margin

21%

38%

24%

Europe

Revenue

15524

15724

13954

Operating Income

1116

879

1011

Operating Margin

7%

6%

7%

Total

Revenue

62837

60373

56731

Operating Income

10064

16474

13647

Operating Margin

16%

27%

24%

What this analysis will show is that these margin spikes and falls are in fact the result of specific non-recurring accounting events - good news for investors.

Higher Personnel Expenses in 2011

While revenue was up in 2011, expenses rose enough to completely negate the extra incoming dollars. Looking at notes to the financial statements and examining the balance sheet solves the sudden increase in costs.

If you look at the balance sheet item "Non-current Provisions," you will notice that it has mysteriously risen from 2010 - 2011 by 2.3B Euros. In parentheses, the report references note 15. Examining note 15 reveals that the company's 'provision' is in fact a reserve for costs associated with an employee reduction plan.

On July 7, 2011, Telefónica de España, S.A.U. agreed with workers' representatives a collective redundancy procedure for the period from 2011 to 2013 for up to a maximum of 6,500 employees, through voluntary, universal and non-discriminatory programs. The "Redundancy Plan" was approved by employment authorities on July 14, 2011.The Group has recognized the cost of the 2011 Redundancy Plan, per Company estimates, under "Personnel expenses" in the accompanying consolidated income statement in an amount of 2,671 million euros (see Note 15).

The way income statement accounting works is, when an item is expensed in advance of actual cash payment, it is added as a liability on the balance sheet. So, the increase in the long term liability is a reserve for future expenses associated with the redundancy plan, however, it does not - yet - represent a cash outlay. This is good news for investors, because not only has the company not yet spent the cash, but it also means there will be fewer cash wage expenses in Spain in the future.

Unusually High Margins in 2010

The relatively higher margins in Latin America in 2010 were due to one specific event that increased 'other income,' which decreased by 3.8B euros from 2010 - 2011. According to the company 20-F filing:

In 2010, other income included a €3,797 million capital gain arising from the positive impact of re-measuring the previously held investment in Vivo at the acquisition date of the 50% stake of Brasilcel held by Portugal Telecom.

In fact, the added income was just a one-time gain resulting from the increase in value of the company's interest in Brasilcel.

Putting it All Together

Shown below is the total revenue picture with adjustments made to exclude the two events mentioned above:

Total

2011

2010

2009

Revenue

62837

56573

56731

Operating Income

12364

12674

13647

Operating Margin

20%

22%

24%

The picture in not of course completely serene. Margins are falling somewhat, and profit is falling relative to revenue as the company deals with weak economies in Europe. But, the company cannot be looked at merely based on value; it must be evaluated in the context of the price that one would pay for that value.

Net earnings in 2011 were 5.4B euros, yielding an EPS of 1.2 euros per share. However, adding back the one-time 2.3B employee restructuring charge increases net income by 43% to 7.7B euros. Increasing EPS by 43% yields a 1.7 per share figure. The current EUR/USD exchange rate is 1.33, so in dollars that figure is 2.26. Taking the current price of 15 and dividing it by earnings yields a P/E of just 6.6. (Those interested in the dividend should also note that this means the real payout ratio was less than 100% for 2011).

The bottom line is, a simple examination of Telefonica's income statement accounting reveals that the company's operations are much more stable than variations in EPS make them appear, and relative to earnings, the price of the company is currently very low. While there are headwinds, especially in Europe, the risk-adjusted return potential here is quite high.

Source: Accounting For Falling Margins At Telefonica