In response to questions I have received regarding my investment in Telefonica (TEF) and my last TEF article I would like to more thoroughly lay out my valuation approach using a dividend discount model (DDM) and add a bit more substance to the discussion. In my last article, I argued that TEF is worth substantially more than the current (depressed) price of $14 which is overly influenced by a clouding general economic picture in Spain. In addition, the entire telecommunication sector seems to be disapproved of, and accordingly, attractively priced. So why would I go for TEF instead the other telecommunication companies and how did I arrive at a price substantially higher than the one being quoted in the markets?
TEF is a telecommunications company and its business model can be defined as defensive. A characteristic of a defensive business is reduced business-cycle sensitivity and lower cash flow volatility (in contrast to cyclical firms). It is in the nature of those firms to utilize their cash flows for shareholder remuneration in the sense of cash dividends which might be partly complemented by share repurchases. Since telecommunication companies have historically had high free-cash-flow-to-equity payouts, earnings and cash flows are comparatively stable and dividends are linked to profitability, a DDM can be justified. Considering that the proportion of dividends measured against cash flow is quite high, a DDM is very well justified.
Some have argued a DDM is inappropriate because share repurchases are not cash and dividends might be even decreasing. I disagree because: Firstly, share repurchases constitute shareholder remuneration and investors can sell allocated shares in the market at any time to produce their own home-made dividends. Secondly, TEF reduced its dividend about 6.25%, which for some may be an indicator of what is about to come, but really is not significant yet. The DDM can incorporate any growth rate assumption, whether it is positive, negative or flat. The argument, that a DDM cannot be used because the dividend was just reduced neglects that still a large amount of cash flow is designated as dividends and the DDM allows all dividend-growth assumptions.
TEF has lowered its dividend to 1.50 Euro per share going forward. If one assumes no growth in dividends going forward whatsoever, the annuity would be worth, considering an equity capital cost of 10% (which is reasonable given the risk profile), 15 Euro which is around $20 a share. Is a pessimistic no-dividend-growth scenario the basis for a reasonable long-term valuation for a company with strong historical cash flows to back up dividends and with a strong footprint in Latin America where more and more earnings- and cash contributions will be coming from in the future? I do not think so. I believe that TEF would deserve a valuation premium for their strong footprint in emerging markets alone. In fact, I believe TEF is the best positioned European telecommunications company significantly less exposed to saturated central European markets. Dividends in the future will be more and more driven by cash generated in Latin America, not Europe.
Others have argued, that the dividend in general is at risk and that Spain and TEF are both in decline. The first argument, may be a very valid one. There is always the chance that a dividend will be reduced perhaps to appease debt- and shareholders to reduce capital structure risk and rolling over significant debt or reducing it altogether. However, my reasoning is, that at these low valuation levels I get a great bargain company. In fact, I believe dividend yields are not risk-adjusted, they are a bit to high given the lower risk-profile of their cash flow streams compared to other companies. My approach, however, is contrarian, which many people have a problem with (based both on the criticism as well as the tone which carried the criticism). I do not want to buy a stock that everybody loves. The way I see it, the higher the uncertainty, the higher the criticism, the better. Spain is not going to go down. There are challenges, no doubt. But European leaders have shown over and over that they work together productively and, quite frankly, efficiently.
Even though the outlook for Spain will be over-hyped in the media, extrapolating negativity has never profited anyone. I prefer a more reflected and constructive approach. Since I am holding TEF for my long-term retirement portfolio I am confident to buy stock as the headlines get more negative.