Telefonica Is An Undervalued Defensive Stock
Summary
- Telefónica's stock has been in a downtrend for years while real results have been improving.
- In this article, I will value each of the individual units of the company using a DCF model.
- Combining the valuation of each unit I arrive at a fair value of 8.52€ or $9.5 per share, 57.7% above the current market value of 5.4€ per share.
- Although I do not expect the stock to generate outstanding returns, I recommend it as a defensive stock with a well-covered dividend of 7%.
The telecommunications business is highly competitive. Every year, consumers demand higher data caps and speeds at cheaper prices. These network upgrades require vast capital investments, and competition continuously forces companies to drive down prices in hopes of increasing market share.
Therefore, it should not be a surprise that the return of the STOXX Europe 600 Telecommunications Index for the last 5 years has been a disappointing -12.3% or -2.6% annualized.
Telefónica (NYSE:TEF) has not been immune to this competition. Its enterprise value has also been in a steady downward trend since 2015. At the start of 2015, it stood at ~107€ billion. Today, it is ~65€ billion, almost 40% less.
However, Telefónica's earnings have been improving since 2014, and in 2019 it achieved its highest underlying EBITDA in the last 6 years. The underlying EBITDA for 2019 was 16€ billion, compared to 15.83€ billion in 2018 and 15.51€ billion in 2014. Meanwhile, its CapEx (excluding spectrum purchases) has gone down from 8.15€ billion in 2014 to 7.28€ billion in 2019.
Nonetheless, the market only cares about the company's future, and Telefónica's future is full of opportunity. Thanks to the advancements made possible by 5G technology, Telefónica is in the center stage of industries that will see immense growth in the coming years.
Telefónica's Plan for 2022
Source: Telefónica 2019 earnings presentation
In November 2019, Telefónica announced its new design for the company and its objectives for 2022. The basis of this new plan is simple, to promote opportunities for growth while leveraging the value of their infrastructure and improving efficiency. Thanks to this plan, Telefónica expects to achieve growth of >€2bn in revenues and a 200 basis points expansion in its operating cash flow margin. To achieve these, the board approved 5 decisions:
1. Prioritize Spain, Brazil, the UK, and Germany as key markets. These 4 markets represent ~80% of revenue. The main telecom business is not expected to grow much, if at all, for the next few years, but it should provide stable cash-flows.
2. Operational spin-off of the businesses in Latin America. Latin America has been a constant drag on Telefónica's earnings. Although revenues and earnings have been increasing organically, the devaluation of currencies and more restrictive regulations in Latin America have been dragging down growth in € terms. Because of this, modulating the exposure to this highly fragmented region makes sense.
3. Launch of Telefónica Tech. Tech focuses on three businesses: cybersecurity, IoT and Big Data, and cloud. It generated 2.2€ billion in revenues in 2019, 26.2% more than in 2018. This unit will be the primary driver for growth in Telefónica for the upcoming years.
4. Creation of Telefónica Infra. Infra's objective will be to monetize the unique portfolio of telecommunications infrastructure that Telefónica already owns. These include towers, antenna systems, data centers, fiber projects and more. Although Telefónica is already monetizing a sizable part of its infrastructure, mainly through Telxius, this new unit should help increase returns of both past and future investments.
5. New operating model. This program aims to reduce costs and complexity while increasing agility. Realizing the benefits of digitalization and eliminating duplications across businesses will help Telefónica achieve these objectives.
A sum of the parts valuation of Telefónica
I will use an unlevered DCF model to attempt to value the following units of Telefónica: Spain, Deutschland, the UK, Brazil, Hispam, and Telxius. For this analysis, I will use the 2019 financial data provided by Telefónica as a base for the model. The projections will be based on the plan for 2022, the guidance provided with the 2019 results and previous results.
Although breaking out the Tech and Infra units would likely allow us to create a more accurate valuation, it is currently not possible, since the revenues of these units are still included in the main units.
These are the assumptions that I made for the models:
- For simplicity, I will assume D&A for all units will be 3% higher than CapEx until 2023, where they will converge. Telefónica has been reporting a lower CapEx than D&A since 2016 and expects the trend to continue.
- I will use underlying EBITDA-CapEx for the base inputs of the model, this excludes restructuring charges, capital gains, spectrum purchases, and impairments.
- Under IFRS 16, lease payments are now included in the financing cash-flow instead of operating expenses, I will keep them in operating expenses.
- Telefónica's capital was constituted of 67.3% debt and 32.7% equity at the end of 2019, I will assume the same ratio for all units.
- The cost of debt is 3.49% for all units.
- The tax rate is 25% for all units.
- Working capital as % of Revenue is 5.5%
1. Telefónica Spain
The assumptions for Telefónica Spain are based on these excerpts from the 2019 earnings call. Telefónica owns 100% of this unit.
So, when we look into 2020, what we see is growth in key accesses, in value accesses, we see growth in digital services, we see the benefits from launching new services, and we see a positive continued outlook for B2B and wholesale revenues. This should support the evolution of the top line.
At the same time, in OIBDA, what we see is that the benefits from copper decommissioning and digitalization will continue, on top of improved trends in other cost lines. So, our expectation, and this is not guidance, but this is a trend that we see, is that we are aiming for operating cash flow growth in our Spanish operation.
Assumptions:
- Revenue growth: 0.5%.
- Operating expenses: start at 59% of revenue, declined to 58% by 2022.
- CapEx: 12.9% of revenue.
- Cost of equity: 8.5%
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 12,830.84 € | 12,894.99 € | 12,959.46 € | 13,024.26 € |
| - Operating Expenses | 7,535.45 € | 7,541.79 € | 7,547.99 € | 7,554.07 € |
| - D&A | 1,703.86 € | 1,712.38 € | 1,720.94 € | 1,679.17 € |
| EBIT | 3,591.52 € | 3,640.83 € | 3,690.53 € | 3,791.02 € |
| - Taxes | 897.88 € | 910.21 € | 922.63 € | 947.76 € |
| + D&A | 1,703.86 € | 1,712.38 € | 1,720.94 € | 1,679.17 € |
| - CapEx | 1,654.23 € | 1,662.50 € | 1,670.81 € | 1,679.17 € |
| - Chg in working capital | 3.51 € | 3.53 € | 3.55 € | 3.56 € |
| Unlevered Free Cash Flow | 2,739.76 € | 2,776.97 € | 2,814.48 € | 2,839.70 € |
| Present Value | 2,606.11 € | 2,512.65 € | 2,422.36 € | 50,231.50 € |
The enterprise value of Telefónica Spain is 57.77€ billion.
2. Telefónica Deutschland
The assumptions for Telefónica Deutschland (OTCPK:TELDF) are based on the financial outlook on its investor relations page. Telefónica owns 69.2% of this unit.
Source: Financial outlook Telefónica Deutschland
Assumptions:
- Revenue growth: 1.5% until 2022, 1% terminal.
- Operating expenses: start at 74.28% of revenue, declined to 73% by 2022.
- CapEx: 17.5% of revenue in 2020 and 2021, declines to 16% in 2022.
- Cost of equity: 8.5%
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 7,509.99 € | 7,622.63 € | 7,736.97 € | 7,814.34 € |
| - Operating Expenses | 5,554.40 € | 5,613.32 € | 5,672.76 € | 5,704.47 € |
| - D&A | 1,353.67 € | 1,373.98 € | 1,394.59 € | 1,250.30 € |
| EBIT | 601.91 € | 635.33 € | 669.63 € | 859.58 € |
| - Taxes | 150.48 € | 158.83 € | 167.41 € | 214.89 € |
| + D&A | 1,353.67 € | 1,373.98 € | 1,394.59 € | 1,250.30 € |
| - CapEx | 1,314.25 € | 1,333.96 € | 1,353.97 € | 1,250.30 € |
| - Chg in working capital | 6.10 € | 6.20 € | 6.29 € | 4.26 € |
| Unlevered Free Cash Flow | 484.75 € | 510.32 € | 536.55 € | 640.43 € |
| Present Value | 461.11 € | 461.75 € | 461.80 € | 12,700.60 € |
The enterprise value of 69.2% of Telefónica Deutschland is 9.75€ billion.
3. Telefónica UK
Telefónica UK guidance was not discussed during the 2019 conference call. The assumptions are based on this comment from the 2019 earnings call: "in the UK, we expect to continue outperforming the market". Revenue growth for the last 4 years averaged 2.47%, so I will use that as a base. Telefónica owns 100% of this unit.
Assumptions:
- Revenue growth: 2% until 2022, 1% terminal.
- Operating expenses: start at 73.34% of revenue, declined to 72% by 2022.
- CapEx: 12.9% of revenue.
- Cost of equity: 8.5%
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 7,251.18 € | 7,396.20 € | 7,544.13 € | 7,619.57 € |
| - Operating Expenses | 5,293.92 € | 5,374.96 € | 5,457.11 € | 5,486.09 € |
| - D&A | 963.46 € | 982.73 € | 1,002.39 € | 982.92 € |
| EBIT | 993.79 € | 1,038.51 € | 1,084.63 € | 1,150.55 € |
| - Taxes | 248.45 € | 259.63 € | 271.16 € | 287.64 € |
| + D&A | 963.46 € | 982.73 € | 1,002.39 € | 982.92 € |
| - CapEx | 935.40 € | 954.11 € | 973.19 € | 982.92 € |
| - Chg in working capital | 7.82 € | 7.98 € | 8.14 € | 4.15 € |
| Unlevered Free Cash Flow | 765.59 € | 799.53 € | 834.53 € | 858.77 € |
| Present Value | 728.24 € | 723.43 € | 718.26 € | 17,030.57 € |
The enterprise value of Telefónica UK is 19.2€ billion.
4. Telefónica Brazil
Due to the constant depreciation of the Brazilian Real to the Euro, the reported results for Telefónica Brazil (VIV) are consistently worse than organic results. Although this won't give us a very accurate valuation, I will assume that revenue growth is more than offset by currency depreciation. Telefónica owns 73.7% of this unit.
Reported revenue growth for the last 5 years was -11.7% while organic revenue growth was 9.8%. The Brazilian real depreciated 21.5% against the euro over the last 5 years.
Assumptions:
- Revenue growth: -1%.
- Operating expenses: start at 62.11% of revenue, declined to 61% by 2022.
- CapEx: 20% of revenue.
- Cost of equity: 12%.
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 9,934.65 € | 9,835.30 € | 9,736.95 € | 9,639.58 € |
| - Operating Expenses | 6,143.04 € | 6,054.25 € | 5,966.62 € | 5,880.14 € |
| - D&A | 2,046.54 € | 2,026.07 € | 2,005.81 € | 1,927.92 € |
| EBIT | 1,745.08 € | 1,754.98 € | 1,764.52 € | 1,831.52 € |
| - Taxes | 436.27 € | 438.75 € | 441.13 € | 457.88 € |
| + D&A | 2,046.54 € | 2,026.07 € | 2,005.81 € | 1,927.92 € |
| - CapEx | 1,986.93 € | 1,967.06 € | 1,947.39 € | 1,927.92 € |
| - Chg in working capital | -5.52 € | -5.46 € | -5.41 € | -5.36 € |
| Unlevered Free Cash Flow | 1,373.93 € | 1,380.71 € | 1,387.22 € | 1,379.00 € |
| Present Value | 1,292.84 € | 1,222.53 € | 1,155.79 € | 14,865.35 € |
The enterprise value of 73.7% of Telefónica Brazil is 13.66€ billion
5. Telefónica Hispam
Telefónica Hispam includes Argentina, Chile, Uruguay, Peru, Venezuela, Ecuador, and Colombia. Costa Rica and El Salvador were sold in 2019, so I will remove their results from the base inputs. Telefónica owns 67.5% of Telefónica Colombia, I have adjusted the ownership of the total unit to reflect that using the % of EBIT corresponding to Colombia.
This unit suffers the same problem as Telefónica Brazil, the constant depreciation of currencies is a continual drag on revenue growth. I will assume again that revenue growth will be more than offset by currency depreciation.
Reported revenue growth for the last 5 years was -22.7% while organic revenue growth was 57.2%. However, Telefónica has sold Costa Rica, El Salvador, Guatemala, Nicaragua, and Panama since 2015, which, including Venezuela, were 9.6% of revenues of Hispam in 2015.
Assumptions:
- Revenue growth: -1%.
- Operating expenses: 74.08% of revenue, declined to 72% by 2022.
- CapEx: 15.42% of revenue.
- Cost of equity: 12%.
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 9,502.02 € | 9,407.00 € | 9,312.93 € | 9,219.80 € |
| - Operating Expenses | 6,989.54 € | 6,870.78 € | 6,753.69 € | 6,638.26 € |
| - D&A | 1,509.17 € | 1,494.08 € | 1,479.14 € | 1,421.69 € |
| EBIT | 1,003.31 € | 1,042.15 € | 1,080.11 € | 1,159.85 € |
| - Taxes | 250.83 € | 260.54 € | 270.03 € | 289.96 € |
| + D&A | 1,509.17 € | 1,494.08 € | 1,479.14 € | 1,421.69 € |
| - CapEx | 1,465.21 € | 1,450.56 € | 1,436.05 € | 1,421.69 € |
| - Chg in working capital | -5.28 € | -5.23 € | -5.17 € | -5.12 € |
| Unlevered Free Cash Flow | 801.72 € | 830.35 € | 858.33 € | 875.01 € |
| Present Value | 754.40 € | 735.22 € | 715.14 € | 9,432.47 € |
The enterprise value of 92% of Telefónica Hispam is 10.71€ billion.
6. Telxius
Although guidance for Telxius is not available, I expect it to grow at least at the same rate of the past 3 years as Telefónica increases the portfolio of towers. I have also normalized CapEx. Telefónica owns 50.01% of this unit.
Assumptions:
- Revenue growth: 5% until 2022, 3% after.
- Operating expenses: 52.5% of revenue.
- CapEx: 28% of revenue.
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 884.10 € | 928.31 € | 974.72 € | 1,003.96 € |
| - Operating Expenses | 464.09 € | 487.29 € | 511.64 € | 526.98 € |
| - D&A | 254.97 € | 267.72 € | 281.11 € | 281.11 € |
| EBIT | 165.03 € | 173.30 € | 181.97 € | 195.87 € |
| - Taxes | 41.26 € | 43.32 € | 45.49 € | 48.97 € |
| + D&A | 254.97 € | 267.72 € | 281.11 € | 281.11 € |
| - CapEx | 247.55 € | 259.93 € | 272.92 € | 281.11 € |
| - Chg in working capital | 2.32 € | 2.43 € | 2.55 € | 1.61 € |
| Unlevered Free Cash Flow | 128.89 € | 135.34 € | 142.11 € | 145.30 € |
| Present Value | 122.60 € | 122.46 € | 122.31 € | 5,589.21 € |
The enterprise value of 50.01% of Telxius is 2.98€ billion.
Sum of the parts valuation
Adding the value of all units, I arrive at a valuation of Telefónica of 114.07€ billion. Subtracting net debt of 37.7€ billion, equity valuation is 76.37€ billion or 14.93€ per share.
A Levered DCF model of Telefónica
Due to the highly leveraged profile of Telefónica and the low cost of debt, the unlevered DCF model gives us a much higher valuation than the levered DCF model. The model uses the same inputs as the sum of the parts valuation.
Using this model I arrive at a more grounded valuation of 43.6€ billion of equity value, 8.52€ or $9.5 per share. You will notice that in my projections, revenue growth is not even close to the >2€ billion guided in the new plan, This is mainly because of my negative growth projections in Brazil and Hispam due to my expected currency depreciation.
Clarifications:
- All FCF after dividends and FCF to non-controlling goes to debt repayments until 2023.
- The share of FCF to equity that goes to non-controlling is equal to the FCF corresponding to the % of units not owned by Telefónica, I calculated it using the % of EBIT.
- The cost of equity is according to the % of EBIT of each unit.
| 2020 | 2021 | 2022 | Terminal Year | |
| Revenues | 47,912.77 € | 48,084.44 € | 48,265.17 € | 48,321.52 € |
| - Operating Expenses | 31,980.45 € | 31,942.37 € | 31,909.81 € | 31,790.01 € |
| - D&A | 7,831.68 € | 7,856.96 € | 7,883.97 € | 7,543.11 € |
| EBIT | 8,100.65 € | 8,285.10 € | 8,471.38 € | 8,988.40 € |
| - Interest | 1,827.50 € | 1,765.26 € | 1,696.57 € | 1,621.22 € |
| EBT | 6,273.14 € | 6,519.84 € | 6,774.81 € | 7,367.17 € |
| - Taxes | 1,568.29 € | 1,629.96 € | 1,693.70 € | 1,841.79 € |
| Net Income | 4,704.86 € | 4,889.88 € | 5,081.11 € | 5,525.38 € |
| + D&A | 7,831.68 € | 7,856.96 € | 7,883.97 € | 7,543.11 € |
| - CapEx | 7,603.57 € | 7,628.12 € | 7,654.34 € | 7,543.11 € |
| - Chg in working capital | 8.95 € | 9.44 € | 9.94 € | 3.10 € |
| Free CF | 4,924.01 € | 5,109.28 € | 5,300.80 € | 5,522.28 € |
| - Debt Repayments | 1,783.46 € | 1,968.12 € | 2,159.01 € | 0.00 € |
| Free CF to equity | 3,140.56 € | 3,141.16 € | 3,141.79 € | 5,522.28 € |
| - Free CF to non-controlling | 284.56 € | 285.16 € | 285.79 € | 575.76 € |
| Free CF to Telefónica | 2,856.00 € | 2,856.00 € | 2,856.00 € | 4,946.52 € |
| Cost of equity | 9.56% | 9.56% | 9.55% | 9.55% |
| Present Value | 2,606.79 € | 2,379.46 € | 2,172.11 € | 36,440.45 € |
| Dividends | 2,856.00 € | 2,856.00 € | 2,856.00 € | 2,856.00 € |
| Gross debt end of the period | 50,580.54 € | 48,612.43 € | 46,453.42 € |
Conclusion
Years of results negatively impacted by currency depreciation and restructuring charges have hidden the improvement of results by Telefónica the past 5 years. In addition, the dislike of the market for the telecom industry and highly leveraged companies have made Telefónica an undervalued stock.
The correct execution of Telefónica's new plan for 2022 will, without doubt, create value for shareholders and improve results over the next 3 years. Although I do not expect that the market will value Telefónica much higher soon, I believe that it is a great defensive stock that has a sizable upside and a well-covered dividend of 7%.
This article was written by
Analyst’s Disclosure: I am/we are long TEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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