Telefonica, S.A. (NYSE:TEF) operates as a telecommunications company. The firm also supplies services in the areas of cybersecurity, Internet of Things (IoT), big data, and the cloud in addition to mobile and fixed telephone, broadband, and pay television. There are two reasons why I am bullish on TEF. First and foremost, I think the recent inflection in Spanish service growth can be sustained (at higher profitability), which would warrant a re-rating of TEF (or give support at the current levels). Second, I contend that it is noteworthy that TEF has a history of successful disposals. I still think there's a good chance to streamline things given how many assets are up for grabs. I recommend a buy rating for TEF stock.
Years of revenue decline have plagued the Spanish market due to the prevalence of low-cost challengers that have taken market share through aggressive pricing in the mobile sector, and in the fixed sector, where easy access to a low-cost fiber network has hindered operators' ability to monetise their services. Recent price increases by major Spanish players like Orange, Masmovil, and Vodafone give me hope for the market's future success because they show that there is some sanity emerging at the premium end of the market. The price increases across the TEF base that occurred in January 2023 can, in my opinion, be expected to persist if this trend continues. This is supported by data showing that in 4Q22, after three years of declines, Spain's service revenue growth began to inflect as a result of a rational market supporting strong volumes and pricing. With January churn at TEF being lower than it was in 4Q22 (FY22 earnings call), I continue to believe the Spanish market is more rational. However, I should point out that competitive pressure will continue to limit price increases to some extent. In terms of pricing and competitive pressure, MVNOs like Digi continue to be among the most aggressive players in the market.
My second divergent view is that the expansion of TEF's service revenue will be accompanied by higher profits. First, the negative effects of rising energy prices in Spain appear to have dissipated, and the company's lower exposure to wage costs than peers should allow EBITDA growth acceleration. In addition, by 2023, TEF anticipates having 70% of its energy secured at competitive prices similar to those seen before the conflict between Russia and Ukraine. This gives me further confidence that we will see an inflection in margins coming this year. Although there are cost savings related to fiber, I believe the impact will be less felt since TEF has achieved approximately 80% fiber coverage in Spain, the company is already experiencing the advantages of having a lower cost base for its fiber infrastructure compared to its old network. As the company maintains its current multi-network and multi-exchange operations, I anticipate further positive cost trends. As the number of exchanges is rationalized and the legacy network is turned off, TEF should reap additional benefits.
If we revisit the results of the fourth quarter of 2022, I think that the positive Spanish EBITDA, inflation data in the Spanish market, confirmation of wage inflation, and changes in revenue from handsets are important additional pieces of information. I draw attention to the fact that 4Q22 saw a return to growth in Spain alongside a profit beat before the price increase took effect. Lower energy prices drove much better-than-expected national inflation in Spain, which suggests the tailwind TEF will experience on Spanish energy costs in 2023 could be even stronger.
Simplification & M&As
In my opinion, TEF's recent achievements in M&As suggest a desire to streamline its portfolio. Investors are questioning whether TEF will divest other assets, including Cornerstone, TEF Tech, Nabiax, and Hispam. The way I see it, divestitures have the potential to greatly reduce TEF's debt and streamline their operations, leading to a potential increase in their stock valuation. Although my primary focus has been on the benefits of divestitures, I recognize that management may also consider acquisitions to enhance their presence in important European markets and technology. Acquiring additional assets could be a viable option for TEF to expand its rural network in Spain in a cost-effective manner, as opposed to investing in capital expenditures.
Here is a simple model to illustrate the upside for TEF simply from an earnings perspective (without assets disposals). I would expect TEF to continue growing at low-single digits given its large size but margins to continue expanding to previous highs of 35%. With these assumptions and a 6x forward EBITDA valuation, we could see a 60% upside or 17% IRR over the next 3 years. Now, suppose TEF were to sell some assets and use it to delever its balance sheet (current ~3x net debt/ebitda to low 2x), I believe we could see an increase in valuation to high-single digits (where peers are). This would further improve the upside profile for TEF.s
The competition in Spain could be more severe than expected. I think the rationalization of the Spanish market is happening now that different players are raising prices. It is possible that earnings forecasts and valuation could be jeopardized if this positive momentum were to deteriorate. Although price hikes have been announced, they may eventually cause customers to churn. The earnings forecast is at risk if churn is higher than expected.
I am bullish on TEF and maintain my buy rating. There are a couple of reasons for my positive outlook. Firstly, the recent inflection in Spanish service growth is sustainable, which could lead to a re-rating of TEF or support at current levels. Secondly, I anticipate that the expansion of TEF's service revenue will be accompanied by higher profits. Thirdly, TEF has a history of successful disposals, and there is potential for further divestitures, which could reduce debt and streamline operations, leading to an increase in stock valuation. TEF's recent achievements in M&As also suggest a desire to simplify its portfolio, which could further improve its valuation. Overall, with these positive factors in mind, I believe that TEF offers a strong upside potential for investors.