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We recently profiled TEF and had mostly good things to say about the company. Although a Spanish company, Telefonica does significant business in Latin America. Slow or negative growth in its home market and in Europe can be offset with higher growth from emerging markets. Additionally, telecom services are viewed by many as a necessity. Expensive bundled services may not be in high demand, but basic cell phone service is now a must. The utility-like nature of the business and generous dividend payout make TEF look attractive, especially to investors seeking income.
The problems with Europe are well known by now. Many EU currency union nations are unable to finance themselves and in return for various “bailouts” they are required to undergo austerity which is crippling their economies (both in the public and private sectors). Even countries that have not yet been forced by the ECB, EU and IMF “troika” to implement austerity measures are beginning to do so voluntarily, ostensibly to maintain market confidence.
At first glance it might seem like to an investor the worst problem in Europe is just austerity and the near certainty of a coming recession. But a more sinister problem lurks below the surface. In its current form the EU currency zone is unworkable. The ECB must be involved in the debt issuance of member nations for the union to work. This could take multiple forms such as capping interest rates, guaranteeing the debt, or providing per capita fiscal transfers. The EU has a currency union but must also make provisions for a fiscal union if the grand Euro experiment is to work.
Countries like the United States, U.K., and Japan which issue debt securities in their own currency have no funding issues. Instead government spending and deficits are only limited by inflation. That is why despite a large deficit the United States has no problem funding government expenditures and the Federal Reserve’s control of the interest rate can keep rates from rising. Just look at Japan, with a debt to GDP ratio of well over 200% Japan still pays record low interest rates. In contrast Euro currency users function more like a state government. Most US states have balanced budget amendments and state debt to GDP ratios range from 3% to 20%. Unless Euro currency users were to reduce their debt and deficit levels to that closer to US states ECB involvement will be needed.
Germany continues to remain dead set against ECB involvement. There have even been multiple ideas floated for a smaller version of the EU currency union, a split in two, or even rumors of Germany leaving. Anything it seems to avoid involving the ECB as the ultimate fix. While Germany happily stood by while the crisis consumed the other members it has now reached Germany’s doorstep in the form of a recent German bond auction that was well below expectations. Despite this fact Germany continues to remain stubbornly opposed to the required solution.
The threat of a disorderly or even orderly break up remains the biggest threat to any company carrying large amounts of Euro denominated debts on its books.
Imagine a disorderly breakup of the union, or Spain leaving, or the EU leaving Spain. What would happen to Telefonica’s bank deposits? What currency would they be in? Would the debt still be in Euros and if so how difficult would it be for Telefonica to acquire the Euros needed to pay off the debt.
For a highly levered company like Telefonica these are important questions.
Telefonica Debt Profile (2010 20-F)
Non Current Debt (EUR): 51,356M
Euro denominated debt (EUR): 34,549M (after affects of hedging)
Underlying debt
Floating rate notes (EUR): 8,575M
Fixed rate notes (EUR): 21,870M
While a disorderly default would wreak havoc on many companies, those with significant Euro denominated deposits and Euro denominated debts would be hit the hardest.
Telefonica does business in Germany, the Netherlands, Ireland, Slovakia, and the Czech Republic. Should any of those countries cease using the Euro currency it could have a profound impact on Telefonica.
Additionally Telefonica is party to many derivatives transactions particularly interest rate swaps and foreign exchange rate options. These derivative transactions have been entered in to for both hedging and trading purposes. The full list can be found near the bottom of Telefonica’s 20-F.
Some gurus seem to still see value in Telefonica. As of 9/30/11 Bruce Berkowitz, Brian Rogers, and David Dreman had bought TEF, but only in small amounts.
Disclosure: No positions
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The real risk I see is the slow down or recession in European countries, and Euro could be a driving factor here.