David Ramos
Dear readers/followers,
Investing in telecommunications shouldn't be complex in terms of understanding the upside, especially when things are cheap. While there are examples of telco companies having to either modestly cut or reduce their dividends in order to address growth challenges, these examples are rare than what people would have you believe. The fact is, and this is how I see it, Telco companies remain solid income generators for the quality-conscious investor as we move forward here.
Telefonica (NYSE:TEF) remains one of the more solid international ones with a great upside to consider here, based on valuation.
And here is my thesis for 2023 for the company.
Telefonica in 2023 - the case to be made
First off, investing in the undervaluation we've been seeing for Telefonica hasn't been a bad idea. My own position is in the green even without dividends, and the RoR since my last piece looks like this.
Telefonica Article (Seeking Alpha)
While the company from my initial position still presents a negative investment overall, I continue to believe that the underlying qualities coupled with reversal once the market and the company stabilize, will result in year-over-year outperformance in the long-term.
The company's shareholders, chief among them BlackRock (BLK) with 6.7% of the float, with Banks like BBVA, Societe Generale, Caixa, and others in second places, continue to be proponents of the company here. The company is easily the largest telco in Spain, and still holds a dominant market position in its home market. Today, however, you will find Telefonica in around 20 nations around the EU and Americas - the following.
Telefonica is an attractive mix of legacy Europe play, where the company has been establishing itself for decades, mixed with emerging market South America and Asia growth, as well as having solid operations in the US as well. Telefonica is actually the second-largest corporation in all of Spain, behind the Santander Group, and operates under the aforementioned Movistar and O2 brands, with Movistar being the largest broadband and phone (both cellular and line) operator in Spain.
The company has a significant presence in Germany and the UK through its O2 brand, which it has held for years.
It is also the largest telephone operator in nations such as Chile, Venezuela, Brazil, and Peru, and the largest in Argentina for fixed lines.
If you believe anything in the emergence of South America or even in the relative stability of this region to be able to pull off a positive profit, there is little reason you should not view Telefonica at least with a modicum of positivity here.
Also, Telefonica learned its lessons about "poor" expansion, when it left its eastern-European behind over 10 years back. This is a complex company to look at, similar to Orange S.A. (NYSE:ORAN) given its non-traditional/emerging market operations. The focus tends to make these companies volatile, and Telefonica is absolutely no exception.
However, as a value-oriented income/dividend investor, I fear "no evil", and certainly no volatility. Despite having one of the worst 10-year performances of any telco I've looked at, this does not faze me - after all, I did not invest when the company was in the doldrums.
I invested when the company started to get cheap - and where it certainly is today.
Telefonica reports its results, as many EU telcos do, using OIBDA and revenues, both of which are seeing 3Q22 performance. The company is on track to deliver a solid full-year guidance here, managing macro challenges and working with a streamlined, lean operating model with a solid OIBDA margin - and this margin is stable despite cost headwinds.
It's "home markets" are seeing growth and reinforcement.
Telefonica IR (Telefonica IR)
And its internet/fiber pushes are contributing to growth as well. Results came in with almost 4% top-line growth with positive numbers across most segments, and a growing bottom-line, with 3.1% YoY organic OBIDA growth. The company's net debt, which has been a thorn in its side for years, is down. Telefonica has managed to deleverage to 2.52x despite the M&A and generated almost €2.5B worth of free cash flow in 9M22, which marks a YoY increase of 68.2%.
An amazing amount of growth, if I do say so myself.
TEF is a play on cellular and broadband/fiber both from a B2C and B2b perspective. The combinations of the following factors are no longer just non-recurring, it's becoming part of an improving trend:
- OIBDA growth, organic
- Revenue growth
- Delevering
- Fundamentals
- FCF improvements
As long as these improvements keep coming in, it's my stance that the company will start seeing improvements in its valuation as well. The company received a significant €1.3B tax refund, which is going to enhance the 4Q22 FCF and increase the net debt reduction that the company has been going for here. I don't view it as completely insane that we might see net debt approaching 2x for 2023.
TEF IR (TEF IR)
Inflation is real even for Telefonica, of course - but the company is pushing it with pricing increases, strong B2B trends, Tech revenue, and the fact that its CapEx peak is behind it.
You might remember this because I've been talking a lot about it when it comes to Orange too - how one of the main advantages is that Orange has front-loaded its CapEx for years. TEF has been doing the same. They're reaping the rewards now, because unlike other telcos with CapEx still at 16-17% of revenue, their own numbers are towards 15% or even below, which is a much bigger deal than it might sound like.
One of the main reasons we buy TEF is the massive dividend. The dividend alone can be pretty much what makes this investment outperform a poor market. The company has reiterated 2022 guidance at the following level, and it has also confirmed the company dividend for the fiscal.
TEF IR (TEF IR)
Since crashing to the €3-€4 level when I started writing more about the company, I've been pushing for this dividend, which is now a confirmed €0.3/share split into two payouts. That means that the dividend, which is covered and confirmed, now comes in at 8.35% for the native - a really solid high one.
When it comes to Telcos, we want to check churn numbers, earnings trends, and margins to spot any oddities or worrying trends. I personally believe there are no such worries for TEF. Margins in its home markets are solid - down a bit, but nothing to really raise eyebrows given inflationary pressures. 37% including CapEx isn't really bad.
Net ads are also showing positive growth, and several environments, such as Virgin Media O2 in England, are even showing massive growth in terms of OIBDA.
TEF IR (TEF IR)
You can see similar trends in Brazil as well, which is also by the way leading the charge in margins at over 43% with CapEx. That's numbers you don't see every day for a Telco - it's among the class-leading here in this aspect.
Like some Telco, TEF has also added a Tech-oriented growth engine, which is really pushing it in terms of revenues. We're up to €1B for the 9M22 period, and this is part of what's being argued as VAP/VAS for the B2B segment.
Then there's T2 Infra, which is its own argument, and one I like a lot.
TEF IR (TEF IR)
Telefonica on a broad basis and from a high level has many options to leverage and see profits from a near-class leading portfolio of attractive telecommunication infrastructure assets and services. The company's P&Ls have turned around, and have gone from a one-time thing to basically become a pattern, as I see things.
The company is managing the inflation and macro well enough by sustaining its revenue and hitting targets, and I don't see massive deterioration in any of its segments - or outside, never-before-mentioned risks.
Then there's the best part.
Telefonica - The valuation
Telefonica has some issues - there remains no doubt about that. That's why I'm also not at a 5% portfolio stake, but lower at around 2%. However, at this level, I'm willing to swallow a BBB- for a market-leading Telco in several areas.
The problem with the company's valuation is that the historical discount is very much based on how poorly the company has performed historically - which I no longer believe to be the case for the next few years. While I don't see Telefonica massively outperforming, I do believe that the company should be allowed a segment-relevant P/E multiple.
You can look at revenue multiples, EBITDA multiples, P/E, and FCF - in every single metric, there is only one company that comes close to the discount of TEF - Orange. It's no fluke that I mention these two in the same breath more than once.
If we look at every single other European Telco, the company is being pushed at around half those multiples. If you look at Telus (TU), the same is true - it's half its revenues, less than 60% the EBITDA multiple, and a third of the FCF multiple of the Canadian peer.
Now, there's some logic to discounting Telefonica - but not as much as this.
Let's re-establish a few facts about buying Telefonica here.
1. We're potentially buying the stock at an extremely pressed valuation.
2. The dividend is safe, and has recently been re-confirmed, even if it is currently.
3. The likelihood of a complete collapse of Telefonica's operations is slim-to-none - the company is growing, not failing.
4. At current valuations, even an essentially flat EPS for years would result in annual returns of over 8%, thanks to the dividend. That's where my minimum level lies, more or less.
In my first article on Telefonica, I wrote this.
The upside here is that many of these changes I demand are already ongoing. Debt will be reduced. The company is expanding and improving. Trends are most certainly positive. The asset base is absolutely solid, and the markets where the company operates combine an appealing mix of established western markets, with emerging markets that have growth potential not found in home markets. I would also argue that the company is currently well-managed.
(Source: Telefonica Article, Seeking Alpha)
You may notice that many of these things I forecasted back in 2021 have already come to pass, right?
Well, that's why I'm actually glad we're seeing such a massive dearth of valuation and logic here. It enables me to buy - and do so at attractive overall levels.
The average street targets for this company haven't changed much in the last year. 26 analysts follow the company, and 12 of them are positive at this time. They believe in a range from €2.5 up to €6.4/share, with an average of €4.5, which implies an upside of at least 25% at the current valuation. That's lower than the 36% of my last article, but the company has also outperformed the market since that time - so that's not strange.
I believe that eventually, that discount will end, and when it does, I firmly believe I will be on the right side of the equation to see returns of over 15% per year, with a 3-year total RoR of close to 55% for this company - and that, to me, is good enough to invest a decent amount of cash in.
I'm still not shifting my previous share price target for Telefonica - I remain at a "BUY".
My previously-adjusted PT for the company was €4.9/share. I'm increasing that to reflect outperformance and the improved outlook, to €5/share.
This forms the basis of my continued Telefonica Thesis.
Thesis
My thesis for Telefonica is as follows:
- The currently cheapest telco major in all of Europe, and one that warrants individual attention and consideration, even with everything that's happening here.
- There are reasons for the valuation, but I view those reasons as unfairly discounting the fundamental advantages of the company. We can heavily discount the cash flows, assets, and multiples, and still, come out with higher targets than the market is giving us for Telefonica.
- I view this one as a "BUY" with a €5/share price target.
Remember, I'm all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
It bears mentioning that we have BBB- here, but this does not take away from this valuation. I like what I see here, and remain very positive.
The company discussed in this article is only one potential investment in the sector. Members of iREIT on Alpha get access to investment ideas with upsides that I view as significantly higher/better than this one. Consider subscribing and learning more here.
