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Dear readers/followers
To say that Telefonica (NYSE:TEF) is my "best" or most qualitative telecommunications investment would be a bit of an overstatement and exaggeration. I would say that Telefonica has been a decent investment, with a good yield, and good further potential for outperformance. It's important to understand here that different investments I make have different goals and overall targets for how they are positioned in my portfolio.
Telecommunications are investments that are primarily income-oriented to me. Their inherent stability makes them good for this because dividend cuts in this industry are relatively rare. Those that do them, such as AT&T (T) and Telia (OTCPK:TLSNY) are companies where I typically become more careful. I own only a very small position in T, and Telia has since then turned around, making for a more interesting investment once again.
So Telefonica's lackluster 3-month performance since my last article, which you can find here, is not really a problem to me. Of course, I would have preferred it to move up more, but the thing with value investing is that it's usually inherently slow - until it isn't. It's not uncommon for these investments to trudge along for years at a time, only to then suddenly "bounce up". This trend can also be viewed in this company's share price development, with small bounces followed by small dips as investors sell and take home profits. I'm taking a longer view than this.
Let's look at the company's results.
Telefonica - Upward potential materializing further
As I said in my last article on Telefonica, the upside here is a combined potential EBITDA growth, low churn rates overall, and expansion of its growing 5G coverage. FCF is expected to increase at a double-digit rate, which means the materialization of a high return potential and even a better multiple of this happens.
This is what I continue to base my positive thesis for Telefonica.
And since my last article, the company has actually moved forward quite a bit, and 2Q24, which are the results we're going to look at here, are non-trivially improved. The company is seeing accelerating top-line growth in all main markets, meaning Spain and Germany, with record pushes to customer levels in the Brazilian market. While obviously volatile, this market remains at a core position for the business, and I do not view it as "negative" in the least.
The company is reporting 1.2% revenue growth, driven not only by B2C but also B2B, with good EBITDAaL less CapEx growth of 11.5%, with a solid-if-still-low CapEx/sales ratio of 12.1%. To put this one into context, it's lower than most of the European majors. It's definitely lower than some of the Scandinavian ones, some of which are over 15%. So Telefonica has this well in hand (or, in another interpretation, is "underinvesting", but I don't believe this to be the case).
Like most Telcos, Telefonica is continuing to shut down its legacy networks and fields, and it's on track with Millicom (TIGO) for a transaction in Colombia to create a FiberCo stake, which will go some way to monetize more of the company's assets. It's also fully on track to deliver on 2024E results. Good momentum is definitely a thing here, and I frankly do not fully understand why the company hasn't risen higher on the back of results such as these.
Telefonica IR (Telefonica IR)
The company's cutting and carving in, among other things, legacy, with 4,300 accounts in Spain closing, which results in lowering CapEx intensity even from the currently low levels. The number of fiber connections is rising, with 2.3M increasing on a quarter-on-quarter basis, with increases in 5G coverage in its main markets. The company, on the top line and from an overview perspective, definitely seems to be doing things "right" here.
In fact, not a single one of the country's national operations actually did "poorly" this quarter.
Telefonica IR (Telefonica IR)
And the company is, as you can see, sticking to what it "said" it would be doing. This is impressive as well. Churn is sub-1% for its main markets, and have been for over a year. The continued showcased growth confirms the positive thesis for the company here. In its main markets, such as Spain, the company has a near-unassailable position. Furthermore, it's also expanding into wholesale, which is securing future cash flows and margins.
Telefonica IR (Telefonica IR)
If the company then also secures value through a sale of a FiberCo stake, the company may further and meaningfully reduce its leverage/debt load, which would improve metrics even further and support higher multiples in terms of valuation.
That's where I currently want to see companies like these. I want to see them improving their leverage, and I want to see them making moves that improve profitability and margins. What I don't want to see is senseless investments into things that are more uncertain, say content creation or content "portfolios", but thankfully, this company has not done this.
The FCF improvement I spoke about last article, that one seems all but confirmed now with the 1H24 results. The phasing is fully aligned because even if you don't see the significant improvements here, due to how the company (and other Telcos) work, the company's FCF is always back-end loaded in terms of its fiscal year. So for this quarter, the company once again confirms that FCF is expected to grow by double-digits and that the expectation for FCF CAGR between 2023-2026 is expected to be upwards of 10%+ growth per year.
Fundamentally speaking, the company is very conservative in terms of leverage - perhaps one of the most conservative Telcos out there already. Despite dividends and investments in the T.DE stake to over 96%, the company is at less than 2.8x net debt/EBITDAaL which comes to under €30B debt net. And because the company has cash liquidity of over €18.9B, this is very comfortable, especially considering an interest rate on average that's already down from 3.8% to 3.58% for its debt, with no significant maturities this year.
The key point to recall here going forward is that we have short-term thesis materialization. What I mean by this is that every single metric that the company said it would achieve for the short-term, it has been achieved, and it's on track to achieve every single one for the full year as well.
Telefonica IR (Telefonica IR)
For this reason, I continue to expect the company to perform well, and I say that my expectations even have been fulfilled - with more upside to come going forward.
Let's look at company valuation.
Telefonica Upside - Some room left, and double-digits potentially there
We do have a BBB-rating at this time still, but this is only a small drawback to an otherwise solid company because we also do have a respectable yield from Telefonica at this time at 7.1%. There are higher ones, but it's certainly not the lowest either - especially when we consider the YoY EPS improvement of over 250% on an adjusted basis (a reversal from negative), and the following improvements at the high single or double digits for earnings as well. Take a look below.
Telefonica Valuation/Earnings (F.A.S.T graphs)
My stance continues to be that a company such as Telefonica should trade at between 12-14x P/E. This brings a low-end RoR at a forecasted 12.5x P/E at around 12% per year at this point, up to almost 18.5% per year at 14.5x P/E, inclusive of dividends. This is a good enough upside to where I continue to say that my long-term PT for Telefonica is $5 for the TEF ticker, and where I say that there's a continued potential double-digit upside - my requirement for investing (with a clear preference for 15% or above per year).
Telefonica as a company has long failed to meet targets. It's part of its accuracy profile, with a 66% failure to forecast properly with a 10% margin of error (Source: paywalled F.A.S.T Graphs link).
The NYSE TEF ticker, which is the one we cover here, has an average PT of $4.8 from analysts, with both analysts covering the company at either a "Buy" or an outperform rating. To find more data and conviction we can go to the native ticker, which is also TEF, but on the Madrid stock market. Here we find an average share price of an equivalent of $4.6 from 23 analysts, with most analysts currently at "Hold". I view this hold as being the favored approach due to planned asset sales coupled with some previous and historical volatility. As such, I understand it.
It's too far to say that Telefonica is 'cheap' here - because it really cannot be called cheap at this juncture - but it's at an attractive price with a decent enough upside to where you can make a rate of return that is above the market average, inclusive of the company's attractive dividend.
But there are better investments here.
Risks to the positive thesis are a lower-than-expected valuation due to asset sales, which might happen, as well as the company going back to underperformance, which would not be a strange thing viewed from a historical lens. However, the company does have an appealing set of structural changes which it has done since then.
For that reason, it's as follows.
The company does represent a "Buy" here - my PT hasn't yet been reached, and I continue to see double digits. For that reason, I give Telefonica the following price target and thesis.
Thesis
- Telefonica is currently one of the cheapest telco majors in all of Europe, and one that warrants individual attention and consideration, even with everything that's happening here - and even with the valuation now being higher than prior.
- I've updated my thesis and pricing for the considerations, including the company's asset sales and strategies.
- 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 - it's slightly lowered, owing to some asset sale plans and other moves, but still at a very considerable upside from here on and forward.
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. I just don't consider it "cheap" any longer - but it's still attractive.
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.
