Telecom Italia's High Dividend Yield, Cheap Valuations Make It A Buy

| About: Telecom Italia (TI)
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Telecom Italia (NYSE:TI) reported its half-yearly results last month, and despite the slightly disappointing results, the stock has done well since the earnings release, gaining almost 27%. In a previous report on TI, we suggested a long position on the stock based on its exposure to high-growth markets. We reiterate our previous stance, despite the economic turmoil in the region, and cooling growth in Brazil. We believe the recent steps taken by the company regarding its debt reduction and disposal of its media division will enable TI to focus on its core competences. Since our last report on the stock, it is up almost 20%, and we believe the current cheap valuations and a high dividend yield still provides a good entry point.

The company has been under immense pressure as of late to cut its debt. Telecom Italia had a total long-term debt of approximately 35 billion Euros, with a debt-to-equity ratio of 180% as of the most recent quarter ended June 2012. This has become the topic of discussion for the company, especially after TI posted weaker-than-expected results in its domestic operations. The company's operations in Italy deteriorated in the wireline and wireless businesses, both reporting over a 3% decline in revenues, due to a reduction in revenues from both its consumer and business segments. The deterioration was also seen across its metrics, with average revenues per user dropping by 10% in the first half of the year and the churn rate increasing by over 1%. However, because of the company's geographical diversification, it was able to recover from domestic losses after stronger performance in other regions, all of which generated revenue growth in the first half.

However, the company has reiterated its previous stance that it will be able to achieve its debt reduction target without cutting its dividends. The stance can be validated by the company's recent results, which show that the level of debt has declined, and it is on track to achieving its target of adjusted net financial debt of approximately 27.5 billion Euros till the end of financial year 2012. As of the end of the first half, it has reported a debt of 30.7 billion Euros.

Another important development for TI, which has been taken rather well by the market, is the company's decision to spin off its fixed wireline business, which has been suffering at the hands of wireless substitution for quite some time now. Results have been disappointing as well, with a consistent decline in voice traffic and fixed network connections seen across most regions. However, the possible spinoff of its traditional landline business will give the company some capital to aid in its debt reduction policy, which has been haunting investors. In the first quarter, the company's CEO, Franco Bernabe, said that the company was seriously thinking of disposing off its fixed line network, and the major reason cited was debt reduction. According to various estimates, the network is worth somewhere between 9-to-15 billion Euros, and the possible spinoff may occur by the end of the year.

In another development, the company has decided to dispose of its media division and is actively looking for bidders. There were talks of Mediaset being a potential buyer of its television channels and broadcasting frequencies, but now it has dropped out of the bidding process. TI's management has confirmed that non-binding offers will be received by September 24. It seems the company is serious about its debt, and if it does get rid of its fixed line network, as well as find a buyer for its media division, it will come closer to achieving its debt reduction target.

The company has confirmed that it will continue its current dividend payments, after it recently cut dividends. As far as the company's ability to sustain its payout is concerned, it has historically generated stable operating cash flows. In 1H2012, the company paid total cash dividends of almost 1 billion Euros, while generating 4 billion Euros in operating cash flows, which indicates that the current payout is very much sustainable. The stock currently offers a dividend yield of 5.3%, which is well supported by its operating cash flow yield of 70%.

The stock looks cheap based on its valuations. It is trading at 0.5 times its sales, at a discount to the industry multiple of 0.9x, as well as Telefonica (NYSE:TEF)'s 0.8x. On a forward P/E basis, TI looks cheap as well, currently trading at 5 times its earnings, as compared to TEF's 7.5x.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Telecom Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.