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One Telecom Trade to Consider
Posted by: fedezaldua (IP Logged)
Date: October 21, 2013 09:59AM

Despite its high leverage and its troubles at its home market, I have liked Madrid-based Telefonica (TEF), which is held by Charles Brandes and David Dreman - for over a year now. The reason was simple: My estimated value for Telefonica was well below its stock's price. The value of its Latin American operations (over 50% of the company's top-line) provided some support for the company's profitability level while its strategy of cutting debt through asset sales (such as the sale of its O2 UK broadband business and 40% of Telefonica Central America) was working even better than I had initially expected. Apparently, the market recognized Telefonica's value since the shares are up by 30% year to date. As a direct result of the surging stock price, Telefonica's price is not as attractive as it used to be. The company now trades at 10.8% 2014 adjusted equity free cash flow yield and 5.7 times EV/EBITDA.

A Deal with Trans-Atlantic Consequences

Overall, I still think the ultra-competitive European telecom sector still trades at a cheap level. Above all considering the up-and-coming consolidation process that should help ameliorate the sector's competitive landscape. As a part of the aforementioned consolidation process, Telefonica has acquired control of Telco, which is Telecom Italia's (TI) major shareholder. This would give Telefonica de-facto control of Italy's former telecom monopoly.

This move will surely trigger some trans-Atlantic transactions. For example, Telecom Italia controls TIM in Brazil and Telecom Argentina (TEO). Both companies (TIM and Telecom Argentina) compete with Telefonica's businesses in such countries. Hence, the straightforward result from Telefonica's recent move on Telecom Italia should be the forced sales of Telecom Italia's businesses in Latin America. According to Credit Suisse's analysts, Telecom Italia, which is currently generating as much as 28% of its EBITDA in Brazil and Argentina, could get more than $12 billion for its Latin American operations. This could actually be a good thing for shareholders. The huge cash inflow should help Telecom Italia reduce its $36 billion debt pile and push down the company's gearing to 1.7 times EBITDA from the currently high 2.5 times EBITDA. The cash could also help the Italian company to make very much needed infrastructure investments in its home market.

Proposed Trade

Given current market prices, I would sell my position in Telefonica in order to build a long position in Telecom Italia. Clearly, the company's situation in its home market is not an easy one. The company's top-line is expected to decrease by 10% year-over-year in 2013 and the strategic steps the company will be taking are not clear following the recent departure of its former CEO, Franco Bernabe.

That said, the competitive situation in the Italian telecom market should ameliorate going forward and the company trades at an adjusted equity FCF yield of 16.6% and 2014 4 times EV/EBITDA. This price level, which is a significant discount to European peers, should discount most of the risks Telecom Italia should face in the near term future. Besides, I would not rule out the possibility of a full-blown take over of Telecom Italia by Telefonica in the next 12 to 36 months.

Guru Discussed: Charles Brandes: Current Portfolio, Stock Picks
Stocks Discussed: TEF, TI, TEO,
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