Balance The Pros And Cons Before Buying High-Yield Telefonica

| About: Telefonica S.A. (TEF)

On my list of large-cap foreign stocks trading as ADRs in the U.S., Telefonica S.A. (NYSE:TEF) ranks near the top with a current dividend yield of about 12%. In December 2011, the company made its second dividend policy shift in three years as an adjustment to a changing business environment. At this point in time, a double-digit yield appears to be sustainable, but the company must reverse the trend of the troubled results which started in 2011.

First up, the dividend policy changes. From 2000 through 2011, Telefonica followed the policy of paying a steadily increasing semi-annual dividend. The company has most recently updated its dividend targets in 2009. However, in 2011, the company was hit by financial set backs - more on this below - and a decision was made to change the dividend policy. The May 2012 was scheduled to be €0.87 cash per share. Now the distribution will be split between cash and shares with up to €0.30 paid out of the company's treasury shares. For 2012 and 2013, the company plans to pay €1.50 per share in remuneration. For 2012, €1.30 will be in cash and the balance will be spent on share buy-backs. The company reserves the right to decide how the €1.50 will be divided for 2013. Fiscal year dividends are split between a November payment and the balance paid in the following May. The €1.30 cash dividend divided into the current €11.06 share price for a current yield of 11.7%. For the U.S. traded American Depository shares - ADS - the prices all convert to dollars at the current euro/dollar exchange rate, producing the same yield. The tax withholding rate for dividends in Spain is 19%.

For 2011, Telefonica reported increasing revenue but much faster growing expenses - especially personnel costs. As a result, operating income before depreciation and amortization declined by €5.6 billion, down to €22.2 billion from €25.8 billion in 2010. Dividends paid for 2011 were €7.6 billion, up from €6.2 billion, resulting in a net squeeze of €7 billion out of cash available for capital expenditures, taxes and other investments. Free cash flow for 2011 was €9.3 billion, out of which the dividends were paid.

For the first quarter of 2012, Telefonica's OIBDA again declined by 7.6% compared to the first quarter of 2011. For the full year, Telefonica guidance is slightly higher revenue and slightly lower OIBDA compared to 2011. The new dividend rate lowers the cash dividends to be paid down to €5 billion for the year, so there should be sufficient cash flow to cover the distributions.

The major positive factor for Telefonica is that the company now generates close to half of revenue and more than half of OIBDA from the Latin America operations. The company is a top one or two wireless service provider in most of the countries in the region. The challenge for investors is to determine if the company can stabilize the European results in the current financial climate and turn the Latin America growth into overall revenue and cash flow growth. The share price has been on a steady decline for a full year. The company website does not yet show the May dividend paid, but the ADS price should go ex-dividend by about $1.00 in the next few days.

The Telefonica ADS is an investment for investors looking to pick up a large-cap European stock and collect handsome dividends while waiting for an economic recovery to boost growth. The stock may sink further to bring the yield on the new dividend rate back up to the 14% to 14.5% range where the shares traded at the previous dividend rate. With the euro at $1.30, that puts the Telefonica ADS price floor at $11.70 to $12.10. The shares could slide to this level over the summer, presenting an attractive buy-in opportunity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.