This hasn't been a good year for investors in Spanish companies, with the Spanish market as represented by the IBEX (^IBEX) down by around 20% to date. This can be attributed to the European sovereign debt crisis and Spain's deepening financial crisis that has seen many of the country's banks brought to the brink of insolvency.
One standout performer, for all the wrong reasons, has been Spain's second largest company, Telefonica (TEF), which saw its NYSE listed American depositary receipts early this month hit a new 52 week low of $10.90. It is now down by around 27% for the year to date and almost 50% over the last year, when more than $50 billion was wiped off the company's market value. As a result, the company is now trading with a compelling price to earnings ratio of 10 and a double digit dividend yield of almost 15%, which has seen many analysts and market pundits argue that now is the time to invest in this unloved telecommunications giant. Despite this, and the company's geographic diversification and strong market presence, I believe that the current valuation correctly reflects the deep seated issues faced by the company.
Not only has Telefonica under-performed the IBEX but, as the chart below shows, it has also under-performed its peers including Vodafone (VOD), America Movil (AMX), Telecom Italia (TI) and BT Group (BT).
While the performance of Telefonica's peers can be attributed to the difficult operating environment, its inferior performance in comparison to those peers is not solely due to the economic crisis in Telefonica's home market of Spain. The company is also dealing with a number of operational and structural issues that have been magnified by the current operating environment and are reflected in its most recent financial results.
Recent financial performance
The company reported first quarter 2012 results that were lower in comparison to the previous quarter, with revenue falling by 4% to $20.7 billion and net income by 72% to $999 million. However, more troubling was in comparison to the equivalent quarter in 2012, the company's OIBDA (Operating Income Before Depreciation and Amortization) fell 9% despite capital expenditure rising by 11% and its OIBDA margin (which measures the company's margin after allowing for direct costs associated with retaining customers) fell by 3.3% to 32.8%.
The company reported these disappointing financial results, despite the geographic diversity of its revenues, which should mitigate the impacts of any economic slowdown or other country specific event from significantly affecting the company's revenue. As the chart below shows, the company receives around 75% of its revenue from outside of Spain and almost half of its total revenues are derived from Latin America alone.
Of the Latin American revenues, 23% are received from Brazil, where the company operates through its independently listed Brazilian subsidiary Telefonica Brasil (VIV). The geographic diversity of the company's markets and operations becomes more apparent when analyzing the geographic uptake of the company's products and services. Over 66% of the company's accesses or connections are in Latin America with almost a half of these being in Brazil, while only 15% of connections are located in Spain as illustrated in the chart below.
However, this geographic diversity has not assisted the company with maintaining revenues or margins, which can be partly attributed to the confluence of global macro-events but also because of the company's high capital expenditure in low margin markets.
High cost low margin growth strategy
The first issue that arises relates to the company's expansive capital expenditure program and focus on growth at all costs in Latin America and particularly Brazil. Latin America's telecommunications market in comparison to established markets is quite immature and in many places lacking in critical infrastructure. As a result Telefonica has embarked on a significant capital expenditure program in the region to take advantage of growing demand for telecommunications products and services as well as the low penetration rates. The company has also used this program as a means of leveraging greater market share from competitors in the regions including Carlos Slim's America Movil (AMOV) and Telecom Italia's TIM Participacoes (TSU) and Telecom Argentina (TEO).
Despite Telefonica's total capital expenditure falling by half in the first quarter 2012 in comparison to the previous quarter, it still totaled $2.3 billion. More than half of this was allocated to Latin America with almost a third of the total expenditure going to Brazil as illustrated.
Currently, Telefonica has a group wide capex to revenue ratio of 11% compared to its European based peers such as Vodafone, with a ratio of 14% and Telecom Italia's ratio of 20%. Telefonica's Latin American operation has a capex to revenue ratio of 12% which is the same as TIM Participacoes at 12% and marginally lower than both America Movil and Telecom Argentina which have ratios of 13%.
When Telefonica's capex is analyzed, it becomes clear that the level of revenue generated for each dollar spent is proportionally lower in Latin America than in the company's more mature European operations. As the chart below shows, in Brazil, for every dollar of capex, Telefonica is generating $7 of revenue, while in Chile it is generating $6 of revenue. source data: Telefonica January - March 2012 Results
However, in the more mature and developed European markets, Telefonica's capex is generating a greater return. Spain, which accounts for the second largest allocation of capex after Brazil at 22%, is generating $11 for every dollar of capex and the German business which accounts for only 8% of capex is generating $9 for every dollar. This indicates that despite the huge growth potential that exists in Brazil and other Latin American countries, Telefonica needs to maintain greater capital expenditure than it does in more mature markets in order to generate proportionate revenue.
The lower amount of revenue being generated for every dollar of capex in Brazil and other Latin American countries can be attributed to the low uptake of higher margin products and services in the region. As the chart below shows, the majority of Telefonica's customer connections are in the mobile telephony segment and in Latin America this segment clearly dominates.source data: Telefonica January - March 2012 Results
But in Brazil and the other Latin American countries within this segment the lower margin prepaid mobile phone connections dominate. In Brazil alone 65% of the country's total connections are for prepaid mobile phones. The same trend can be seen in Mexico with 88% of all connections being prepaid mobiles, with 64% in Colombia and 59% in Peru, as the chart below illustrates. source data: Telefonica January - March 2012 Results
The high level of lower value prepaid connections can be attributed to the countries in Latin America being less developed economically than those in Europe where Telefonica operates. As a result, the consumer markets in Latin America are less mature with significantly lower average incomes and a lower availability of consumer credit.
This indicates that the majority of consumers are unable to afford the higher margin products like bundled voice and data contracts, pay television and broadband internet connections. But these prepaid connections while generating lower margins for Telefonica still require a similar degree of infrastructure and therefore capital expenditure to maintain that infrastructure as higher margin wireless products.
As a result, I don't believe that Latin America represents the level of growth potential for Telefonica that is attributed to it. Particularly when it is considered that it is also a highly competitive market, which requires substantial capital investment to support the company's expansion at a time when capex is being reduced in response to the difficult operating environment.
Furthermore, from an economic and developmental perspective I do not believe that Brazil or the other Latin American telecommunications markets will mature to the same level as Spain or the other European markets and have the same penetration of higher value services.
Another significant factor that weighs heavily against the company particularly when considered in conjunction with the current operating environment is the high degree of leverage. Currently, the company has total liabilities of $101.6 billion including long-term debt of $77.8 billion and net financial debt of $76 billion. This gives Telefonica a debt to equity ratio of around 2.6, which is significantly higher than many of its peers including American Movil, Telecom Italia and Vodafone, which have debt to equity ratios of 1.27, 1.48 and 0.44 respectively.
This high degree of leverage increases the volatility of the company's net income, unnecessarily exposes the company to interest rate movements and reduces the company's operational flexibility because of stricter debt covenants. The European sovereign debt crisis and Spain's banking solvency crisis have contributed to significantly reducing the supply of debt financing as lenders are already over-extended or are deleveraging to reduce debt exposure and risk. All of which in combination with growing sentiment to avoid risk has tightened the supply of credit and driven up financing costs.
This creates two immediate problems for Telefonica: First, there may be insufficient capital available to meet the company's funding requirements. At this time there is around $10 billion of debt that will be maturing at various intervals over the next four years which Telefonica will need to refinance. In the current environment finding such a large amount of credit in Europe will be particularly difficult. The second issue is the increasing cost of capital because of its scarcity and increased degree of perceived risk associated with debt financing at this time.
These issues, in conjunction with Telefonica's significant debt holding, saw Standard and Poor's downgrade the company's long-term credit rating in May 2012 to BBB with a negative outlook. While this is still an investment grade rating one step above the minimum investment grade rating of BBB-, it doesn't bode well for the company's ability to refinance cost effectively.
The high level of debt also leaves the company particularly vulnerable to rises in interest rates and the increased earnings volatility this can create. In addition, with revenues falling due to the increasingly difficult operating environment there is an increasing likelihood of debt covenants being triggered. These have the potential to activate penalties including early repayment or higher penalty interest rates. All of which can substantially affect the company's profitability and make any debt refinancing more difficult.
Performance and efficiency measures
Another concern regarding Telefonica's high degree of leverage is the company's inability to convert that leverage into a superior return on equity. When taking the first quarter 2012's financial results and averaging them over the year, the company has a return on equity of 13%. Based on the company's full year 2011 results it has a return on equity of 21%. This is well below the return on equity being delivered by its Latin American competitor America Movil, which with a debt to equity ratio of less than half Telefonica's is generating a first quarter 2012 annualized return on equity of 44% and a trailing 12 month return on equity of 28%.
Telefonica's thin profit margin of 5% is also of some concern particularly when the high degree of leverage and capex is taken into account. The thin profit margin can be attributed to the volume based growth in Latin America where the majority of revenue is derived from low margin products. This market as discussed makes up half of the company's revenues and two-thirds of its connections.
Another aspect of investing in Telefonica that appeals to investors is the high dividend yield. In accordance with its dividend policy, Telefonica is paying total shareholder remuneration of €1.50 or $1.90 per share for 2012. This gives the company a theoretical dividend yield of around 15% with a payout ratio of 114%, which over the long-term is unsustainable. Even if earnings per share increase by 2% to the analyst consensus of $1.70 per share the company still has a pay-out ratio of 112%. This would then seem to indicate given the company's financial position that a dividend cut would be a sensible option, just as the company did in December 2011 when it cut the dividend by 14% to its current level.
However, the company has devised a unique scheme to structure its dividend in a way that allows it to remain at its current amount while substantially reducing the payout ratio. The current dividend payment for 2012 will be composed of two components, a dividend payment of €1.30 or $1.65 per share with a share buyback for the remaining amount of €0.20 or 0.25 per share. Furthermore, the dividend payment of $1.65 per share will be made up of two components, firstly a cash dividend of €0.40 or $0.51 per share to be paid in November 2012 and the remaining €0.90 or $1.14 per share to be distributed in mid 2013 by a way of a scrip dividend.
The manner in which the company has structured its dividend payment effectively reduces the payout ratio to 31% for the cash component, leaving it to issue scrip in lieu of the remaining $1.14. This will see around 400 million additional shares issued by the company to meet this component of the payment. This raises concerns relating to the dilution of current shareholders as it represents approximately 9% of the total shares currently on issue, though it is likely that the share buyback component will reduce this somewhat. It is highly likely that Telefonica will return to a whole cash dividend once the operating environment and net income stabilizes, but how long this will be is unclear and at least for the short-term it is clear that net income won't increase.
The current operating environment couldn't be more difficult for Telefonica with its home market of Spain, which accounts for 25% of the company's revenues, caught in a deepening economic crisis. The extent of the crisis particularly the solvency issues afflicting many of Spain's banks is illustrated by the recent bailout package extended to Spain by the European Union totaling $126 billion.
It appears there is no short-term solution to Spain's economic problems and with unemployment at 24%, the consumer confidence index down by 20% and the general retail trade index down by 11% it will be sometime before economic growth resumes and consumer confidence returns. This will inevitably have a significant impact on Telefonica's revenues and profitability.
Economic growth in the company's key Latin American markets, which Telefonica's management have labeled as their 'growth engine', has also slowed dramatically. Particularly in Telefonica's key Latin American market of Brazil which contributes 23% of Telefonica's revenue, reporting first quarter 2012 GDP growth of 1.89%. It is unlikely that Brazil's economy will improve for the short-term particularly because it is reliant upon Chinese demand for its commodities of iron ore, coal and oil. It is expected that for 2012 Brazil's total GDP growth will be 1.5%. This is, again, creating downward pressure on the company's market share and revenues as discretionary consumer spending falls. For those few Latin American countries like Colombia that are still experiencing strong economic growth their governments are using monetary policy to slow domestic consumption as part of an attempt to rein in inflation.
All of which doesn't bode well for increasing consumption within the region and despite the utility like nature of mobile telephony does not guarantee revenues or margins as customers continue to purchase lower margin prepaid mobile services. Furthermore, with the majority of the region's economies primarily being driven by commodities demand from China and the European Union there will be no uptick in economic activity until those economies improve.
I also don't expect to see a significant increase in the maturity of consumer markets in the region leading to a significant uptake in higher value products and services. This is because economic growth in the region is being fueled by the development of natural resources within economies where much of the profits are offshored. Capital in these economies is also tightly controlled and there are tremendous disparities in wealth, which not keeps the costs of production low but limits the size of the domestic consumer market particularly for higher margin discretionary consumer goods and services.
Rising political risk in Latin America
The current economic climate is also driving increased political risk in Latin America as governments in the region are using whatever means available to boost economic growth. Already there have been a series of events in two of Telefonica's Latin American markets, Brazil and Argentina, that indicate a significant increase in political risk.
The Brazilian government has already shown a willingness to increasingly regulate the oil industry as a means of funding domestic economic growth. It has done this through the introduction of local content rules and fixed gasoline prices, affecting the profitability of oil companies operating in the country. It has also instituted measures to curtail imports of consumer products, limit the foreign ownership of farmland and protect local industry from foreign competitors.
Whether these or similar measures would be extended to other industries such as telecommunications is difficult to predict. But as Brazilian economic growth has declined the government's economically protectionist rhetoric and policies have become increasingly aggressive.
Already this year the Argentine government has nationalized YPF (YPF) which was majority owned by Spanish oil company Repsol (REPYY.PK). It has also fined Telefonica $43 million for a service outage in its Argentine wireless unit Movistar. In addition, the government has indicated that it expects to see increased infrastructure investment by the country's main telecommunications operators. The direction that the Argentina government will take is difficult to predict just as are any future events that will impact Telefonica, but for further information can be found in my previous article 'Argentina's Telecommunications Sector: The Latest Target For Nationalization?'.
Deleveraging and raising capital through asset sales
Telefonica has recognized that in order to sustain growth and weather the current difficult economic operating environment it needs to deleverage through cutting debt. This has seen the company embark on an ambitious capital raising program through the sale of assets. A significant part of this plan is the planned IPO of Telefonica's German O2 business with 20% of the business to be listed. When it is considered that O2 is valued at between $9 billion to $12 billion, it would realize between $1.8 billion and $2.4 billion. Telefonica has also made the decision to sell half of its 9.6% stake in China Unicom back to its parent company which should raise around $1.4 billion.
It has also announced that it will sell off between 23% and 25% of its non-core Latin American assets although at this time it has yet to identify the assets to be sold. However, it has stated that this will not affect its Mexican operations and that it intends to retain a controlling interest in the assets sold. Currently Telefonica's Latin American assets excluding Venezuela and Argentina are valued at around $63 billion. But how much Telefonica will be able to realize from the asset sale is unknown particularly because in the current economic climate it is likely the company won't be able to realize the full value of those assets.
While these asset sales will assist the company to reduce debt and strengthen its balance sheet they also curtail its future growth prospects. Particularly when it is considered that O2 is one of Telefonica's most profitable businesses in the strongest economy in the region. It is also reducing its exposure to the rapidly growing Chinese and Latin American telecommunications markets.
It is undeniable that Telefonica's association with Spain has been a key factor in the sell down of the company's shares. However, the current crisis has been the catalyst that has allowed investors to realize the true state of the company and its significant deficiencies. These include the substantial debt, low margins and an inability to increase the uptake of higher value products and services in Latin America.
Furthermore, I don't expect the company to be able to sustain the rapid pace of growth that it has historically experienced for two reasons. Firstly, it is reducing its exposure to high growth markets through the sale of assets in China and Latin America. Secondly, the company is reducing capital expenditure, which will prevent it from funding its expansion in infrastructure poor Latin America. Added to this are additional issues, including the uncertainty surrounding the company's current asset sales with asset prices far below their peak, increasing political risk in Latin America and a deeply impaired operating environment. From this the only conclusion can be that there won't be a substantial recovery in Telefonica's share price for some time and that investors will find better value elsewhere.