If there is one metric Telefonica (NYSE:TEF) is known for, it is its high debt level. For this matter, it holds the record among European peers as pictured below, with its debt to equity ratio being 158%, except for Deutsche Telekom (OTCQX:DTEGY). However, driven by its American subsidiary T-Mobile (NASDAQ:TMUS), the German telco (telecom operator) exhibits year-on-year revenue growth of 7%.
Therefore, for European telcos which have been facing revenue stagnation for some years, it is not only about reducing debt but also about promoting growth, which may seem to be a challenge. However, as this thesis will elaborate on, Telefonica has been using a capital-light growth strategy that is working, and in a sustainable way.
I start by elaborating on the reasons why this type of growth should be prioritized in the current macroeconomic environment.
European Telcos facing Low Growth and High Debt
Whether it is through investments in new projects or inorganically through acquisitions, a strategy to advance growth through debt in the highly competitive European telecom industry is not sustainable for three reasons.
First, European mobile broadband consumers derive less value from connectivity than their American counterparts as telcos in the U.S. invest 50% more per capita in mobile networks. As a result, European consumers pay relatively less, by two times according to the charts below. Worst, with the focus being on price rather than on value in Western Europe, there are even price wars or aggressive price cutting as part of the sales effort, which is bad both for sales as its results in lower ARPU but also reduced profit margins for telcos.
Second, there is competition with telcos seeing hyperscalers landing on their turf to poach away their most profitable clients. Thus, companies like Microsoft (NASDAQ:MSFT) are signing in more of telcos enterprise customers as part of hybrid cloud projects. These are attracted by the OPEX charging model whereby they only pay on a pay-per-use basis. Well, telcos have fought back by evolving their IT divisions into Techno (technology operator) like for example "Telefonica Tech", but competition is tough against the scale and easy-to-use features of hyperscalers.
Third, high debts are also not sustainable given that interest rates are going up pretty much everywhere as central banks worldwide hike interest rates in order to combat inflation. This implies higher borrowing costs with the pill likely to be hard to swallow for highly leveraged companies. In this case, Telefonica paid $1.546 billion as net interest expenses on debts of $57.3 billion in 2021, which, nonetheless, is down from $1.6 billion in 2020 when debts were $68 billion.
Going forward, leverage should continue to decrease due to Telefonica's approach to implementing projects involving a shared investment or capital-light strategy as I will show later, but for the time being, I elaborate on the most recent of them pertaining to fiber.
The Capital-Light Strategy
The Spanish group, through its infrastructure subsidiary Telefónica Infra, has reached an agreement with Liberty Global (LBTYA) and InfraVia Capital Partners to establish a joint venture focused on the deployment of fiber to the home in the United Kingdom.
Now, most European governments have been prioritizing fiber development since early 2021 as part of the Covid-induced digital transformation trend. For this purpose, compared to mobile cellular networks which can carry 5G signals, with download speeds of up to only 20 Gbps, you can easily reach practical speeds of 5 times more.
Furthermore, in order to migrate from limited-speed copper-based internet to broadband fiber, UK's telecom regulator Ofcom introduced a policy to encourage more than two-thirds of UK properties to choose fiber instead of remaining stuck with copper. Interestingly, the regulator encouraged more players to compete with BT (OTCPK:BTGOF), the incumbent, for the fixed wholesale market as part of this accelerated FTTH deployment network to cover up to 7 million premises by 2026. Add this to Virgin Media O2's (VMO2) fiber upgrade project, and this leads to about 23 million premises, or just 2 million short of BT's Openreach by December 2026. For investors, VMO2 was formed in June 2021 as a 50:50 JV between Liberty Global's and Telefónica's U.K. businesses.
Another important point is that Ofcom will not introduce price controls until April 2026, which is good for the profitability side of things considering competitor BT's strong presence in this field with the main broadband network in the country. At the same time, partnering with InfraVia will enable Telefonica to save considerably, as it will cost about GBP 1.4 billion, and this spread over several years, while the total investments amount to approximately GBP 4.5 billion.
Furthermore, the amount of debt incurred for the copper replacement project will be offset to a large extent through the Telefónica deal to allow additional partners in its Spanish rural fiber business. For this purpose, the operator has agreed to sell 45% of its Bluevia rural fiber business to a consortium formed by the infrastructure fund Vauban Infrastructure Partners and Crédit Agricole Assurance, for an amount of 1.01 billion euros.
Previously, the operator has closed similar agreements to give access to financial partners in its fiber divisions in different markets including Germany, Brazil, and Colombia with KKR (KKR) as per the table below.
The above table also shows that the JVs where Telefonica is involved is not only limited to the European market but have more of a global orientation, due mostly to the group's presence in Latin America.
Reduction in Capex-to-Sales and Debt Levels
These partnership deals for fiber connectivity involve a relatively small amount of capital expenses and one may be tempted to think that these may not be sufficient to drive revenue growth. However, these costs certainly add up to have an effect on the group's capital expenses, but in a more optimal way to generate sales, as measured by the Capex to Sales ratio as per the chart below.
This chart effectively shows that the Capex being utilized by Telefonica relative to the sales figures it generates has declined after reaching a peak in the first quarter of 2021. In other words, it was using $0.18 of Capex for every dollar of sales generated in 2021 compared to $0.13 in 2022, signifying that its capital-light strategy is functioning. Equally, important, the debt level is gradually being reduced as shown in the chart below.
Furthermore, in a high-inflation and recession-prone environment where deal-making (M&A activities) has collapsed because of so much uncertainty and also because of regulatory scrutiny, Telefonica's strategy also makes a lot of sense. Thus, project-based partnerships are not scrutinized by regulators in the same way as M&As.
Valuations, Risks, and Key takeaways
Now, this growth strategy is also attractive as less Capex spent means more free cash flow being generated. Viewed from this perspective, the trailing Price to Cash flow of 2.19x is undervalued relative to the communications sector by over 70% as pictured below. Adjusting for a 25% upside, Telefonica should be valued at $4.94 (3.95 x 1.25) based on its current share price of $3.95.
This represents a moderate price target.
The reason pertains to downside risks in a market mostly guided by revenue growth, instead of looking at how it is being achieved. In this case, Telefonica's quarterly sales are on a downtrend as evidenced in the chart below and this could continue for some time before it stabilizes. Therefore, the stock should be volatile when financial results are announced.
Another issue is the red warning sign displayed about dividends likely to be cut. For this purpose, the stock scores a Dividend Safety Score of "F", which according to SA's statistics collected for the past 11 years points to a high possibility (64.4%) of dividends being cut. However, in case the telco continues along the capital-light path, there are fewer chances of reduction in free cash flow, which in turn implies that the dividends will be maintained.
Finally, this thesis shows that Telefonica's capital-light strategy indeed works, namely in reducing capital expenses and debts. On the other hand, it should take more time to bear fruits on the revenue front, but, with more governments throughout the world prioritizing fast internet through fiber, Telefonica's global presence in 12 countries should help it clinch more partnership deals, implying more revenues together with an improvement in its market share.