Update On Telefonica: A Tale Of Two Worlds

Jul.26.12 | About: Telefonica S.A. (TEF)

T&T Capital Management (OTCPK:TTCM) profiled Telefonica S.A. (NYSE:TEF) on June 1, and our investment thesis remains the same -- the stock should be a core long-term holding for income investors. However, we wanted to provide an update, which reflects second quarter earnings and the announcement of the elimination of the dividend.

In the second quarter Telefonica reported operating income before depreciation and amortization (OIBDA) of $5.35 billion euros, up 5.3% from the first quarter. This resulted in a consolidated OIBDA margin of 34.6%, up sequentially from 32.8%, largely due to the company's aggressive expense reductions. Net income for the quarter was $1.327 billion euros, up from $748 million euros in the previous quarter.

Somewhat surprisingly, despite the dismal Spanish economy, Telefonica Espana increased OIBDA by 3% sequentially to $1.718 billion euros on improved margins. In Spain and other areas, Telefonica is reducing handset subsidies for new customers and focusing on aggressive efforts to minimize churn by emphasizing better customer service.

Consolidated revenues for the first half of 2012 were $31 billion up 0.3% YOY, where 7% YOY growth in Latin America offset the (-6.1%) decline in Europe. Telefonica Latinoamerica has produced $2.73 billion in operating income in the first half of 2012, while Telefonica Europe has generated $2.691 billion.

Telefonica continues to benefit from the shift to smartphones, which translated to higher mobile data revenues that rose 15.7% YOY. The company ended the second quarter with 312 million accesses -- a 6% increase YOY, led by 7% YOY expansion in mobile accesses, and 51% growth in mobile broadband accesses.

The company maintained its 2012 guidance for flat revenue, a lower OIBDA decline than in 2011, similar CAPEX as 2011, and net financial debt/OIBDA 2.35x. The company finally took some tough medicine and cut the dividend for 2012 and the first half of 2013. Instead, it will allocate these funds towards debt reductions. This action enables the company to have all of its debt maturities covered until the end of 2013.

While many shareholders will abandon the company based on this decision, our investment thesis hasn't changed in the slightest, as we watch free cash flow yields. We believe the dividend cut ultimately reduces Telefonica's reliance on temperamental capital markets, reducing risk to shareholders.

The dividend cut creates the perfect opportunity to sell put options on Telefonica, as now investors don't have to worry about missing out on the dividend yield while awaiting expiration, or exercise of the option if it's in the money. We'd suggest selling the December 12 $10 TEF puts for $0.70 per option. If Telefonica expires above $10 in 148 days, the profit on maximum risk is 7.5% (70/930), equivalent to 18.5% annualized. If Telefonica closes below $10 at expiration, the investor will own the stock at $9.30, or 14% below the already ridiculously cheap share price.

Since the eliminated dividend will be dedicated to reducing debt, equity and cost of capital should decrease, and ultimately, we'd expect to see Telefonica's stock price begin a strong upward trend over the next several years. By owning the stock, a shareholder will end up with a fabulous stream of future dividends bought on the cheap due to extreme market pessimism.

Disclosure: I am long TEF.