Telefónica will buy the Telco shares of its Italian partners (Assicurazioni Generali, Mediobanca and Intesa Sanpaolo) by subscribing to two capital increases. The first one for $437 million and a second one for $155 million. In addition, the Spanish company will own an option to buy the remaining 30% of Telco since January 2014.
Most probably, Telefonica will exercise its call option and buy full ownership of Telco. After all, there are some early signs of a turnaround in the operating momentum for Telefonica and the de-levarage plan is up and running, ready to beat most investors' expectations. Moreover, Telefonicas has already been making bold moves to consolidate the European telecom sector such as its takeover of E-Plus, KPN's German unit.
On the other hand, we have Latin America. The regions is the biggest source of income and growth for Telefonica and Telecom Italia. That said, regulators will not likely let Telefonica achieve mobile consolidation in Brazil and Argentina by taking control of Telecom Italia, which owns 67% of Tim Participacoes (TSU) and controls Telecom Argentina (TEO) through Nortel Inversora (NTL).
Telefonica's move into Telecom Italia could trigger a sale of Tim and Telecom Argentina. According to Sanford C. Bernstein analysts, TIM could be sold to Brazil's other operators such as America Movil (AMX), SAB or Portugal Telecom (PT). According to those analysts, TIM could fetch up to $15 billion. This would mean that Telecom Italia could “take home” over $10 billion from the Brazilian deal alone. According to my own estimates, Telecom Argentina could be sold at a valuation of $5.5 billion. This would mean that Telecom Italia could take home an extra $2 billion. Since Telecom Italia's net debt is at around $35 billion, the sales would represent 34% of the company's total net debt pile. This cash amount could be used to reduce debt and invest in the local business, which is certainly in need for further investments.
What Should You Do?
I think you should go long Telecom Italia, considering its possible full takeover of Telco or even Telecom Italia by Telefonica. Not only a full sale of Telco would lead to a price premium, but any move that leads to the sale of Brazil or Argentina could likely be value creating for Telecom Italia's shareholders. In addition, the Italian telecom company is among one of the cheapest stocks in the European telecom sector. Telecom Italia trades at 18% 2014E adjusted equity FCF yield, versus its sector's average of 10.5%. Charles Brandes seems to believe Telecom Italia and Telefonica are both well undervalued since he holds both names in his portfolio.