Our investment idea this month is Spain based telecommunications giant Telefonica.
We have pitched Telefonica (TEF, Financial) some time ago and in light of the August market turmoil we would like to reiterate our positive outlook for TEF common stock. We are surely aware that TEF common stock is not exhibiting distressed asset characteristics as some of the value pitches here often do. However, TEF has an attractive equity valuation, a double-digit leading dividend yield, consistent earnings, dividend increases over the last couple of years and last but not least, a robust business model with access to above-average growth sources in Latin America.
TEF profile
TEF is a Spanish telecommunications company operating in Europe and Latin America. In Europe the main operating markets are Spain, UK, Germany, Ireland, Italy, Czech Republic and Slovakia. In Latin America TEF is tapping emerging market growth in Argentina, Brazil, Chile, Ecuador, Peru, Panama, Venezuela, Costa Rica, Dominican Republic, Colombia, Guatemala, Puerto Rico (in South America) and the U.S. and Canada in North America. Certainly, the company aims at entering and developing its position in the Spanish and Portuguese speaking markets.
Telefonica is listed in Spain and on major foreign stock exchanges Euronext and NYSE. The ticker symbol on Euronext is TFA and on NYSE TEF. TEF stock is held by three institutional investors: Banco Bilbao 6.28%, pension fund La Caixa 5.05% and Blackrock 3.88%. With 85% free-float TEF is a highly liquid stock.
Competitors
The telecommunication markets in Europe are dominated by a few players with the national telecommunication company in each nation having a strong position in its respective market. Telefonica dominates Spain, Vodafone the UK, Deutsche Telekom Germany, Telecom Italia Italy. The main U.S. competitors are AT&T (T) and Verizon (VZ).
Business
TEF operates in four business segments. The product offering includes fixed telephone, mobile phone, Internet and pay TV services. By far the most dominant line of business is mobile service, with 78% of customers in this segment (15% fixed, 7% Internet, the rest is other). The broadband category within the Internet segment has been posting the highest absolute growth of 37% from 2008-2010 compared to 13% in the mobile service segment. While the majority of subscribers and revenue growth comes from the Latin American markets, we can ascertain that Europe drives the broadband category and Latin America the mobile service category.
Transaction history
An intensive acquisitions strategy from 2005-2007 has led TEF to become the third-largest telecommunications company worldwide after government-controlled China Mobile and UK-domiciled Vodafone Group based on the number of subscribers. To put things in perspective, Vodafone, with its heavy focus on Europe, has around 340 million subscribers; Telefonica, with its focus on Latin America, posts 295 million customers; and AT&T racks up 99 million customers. One hundred and ninety out of 295 million TEF customers are from Latin America. Given that TEF capitalizes on the growth pool in Latin America, whilst Vodafone and AT&T are operating in mostly saturated markets, TEF could in the long term be able to post organic subscriber growth making it the No. 2 in the world after China Mobile.
Margins and earnings contribution
In the first six month of 2011, TEF earned € 30.6bn, which is a 6.3% increase year over year. The aforementioned growth driver has been Latin America with revenue growth of 21%. Forty-five to 46% of revenues, EBITDA and cash flow from operating activities are coming from Latin America, with Brazil being the driving force. Cash flow growth is largest in Mexico with around 30%, Peru with around 25%, Chile 20% and Argentina and Brazil in their high teens. TEF will be relying on the bigger Latin American economies to drive revenue and margin growth going forward.
In addition, these growth rates underline the significant opportunities TEF has at hand to further fund emerging market business expansion and shareholder remuneration. We view TEF’s emerging-market footprint especially attractive given the depth and breadth of access TEF has to these under-developed growth markets and judge the degree of access to be a primary competitive advantage compared to other telecommunication companies.
If we take a closer look at the geographical sales, earnings and cash generation we can identify that TEF is more efficiently generating EBITDA and cash in Spain compared to its other markets. Due to Spain's slowing economy and regulatory challenges the country's contribution to earnings and CF has decreased 6% in the first six month of fiscal year 2011 which we clearly see as a negative. We are convinced, however, that TEF's revenue and earnings challenges in Spain are manageable in nature (view business challenges section below).
In addition, earnings growth in Latin America has offset negative growth in Spain in the first six months of 2011 and eventually increased due to Europe's overall growth. It is important to note, that considering the substantial shareholder payouts, TEF will rely more on emerging-market cash generation going forward to fund its shareholder paybacks. The growth trend in Latin America, particularly in Brazil, which is becoming the top revenue-producing country, looks strong enough to assume the company will continue to earn its way into the necessary cash power to facilitate the dividend payments.
Despite the negative effects the Spanish business had on the financials, the group still posted healthy margins as follows: EBITDA margin 37%, EBIT margin 21% and Net income margin 10%.
Business challenges
Cost challenges
With all companies there is consistent capital market pressure on reaching a high level of operating efficiency. TEF is in the process of reducing headcount by 6,500 to address this issue and dis-burden overhead costs.
Regulatory challenges
This is mainly an issue for the European market with its heavy utilization of regulatory measures. As with all regulatory efforts, costs are being generated which first of all have a negative impact on business. It depends on the dynamics of the industry if the companies operating in the industry can effectively pass regulation costs through to their customers in terms of higher prices. Due to price pressures in the telecommunications industry and significant rivalry for customers, telecommunication operators are stuck with these costs, which in the case of TEF come in form of declining ARPU's. ARPU stands for average revenue per user in a given month and is a key performance indicator in the telecommunication industry.
Since regulators have been cutting termination rates (rates that are charged by one operator to another for terminating calls on its network) average revenues per customer are declining. This impact has been quite noticeable in Europe and Spain in particular. Total ARPU is €23.2 for Telefonica Spain (a decline of 9.3% year over year), €23.4 for Telefonica UK (-5.2% year over year) and €13.4 (-9.9% year over year) for Telefonica Germany. Since rates are set by a regulator who is motivated to keep mobile costs low, regulatory interference into the price-setting mechanism will in our opinion continue to be the key driving force affecting revenue generation and profitability measures. Even though this is clearly having a negative impact on the business, in fairness we shall emphasize that this challenge is affecting all industry participants the same way providing a level playing field for all competitors within a given country.
Given TEF’s high returns on shareholder capital in the past we believe the company has the appropriate track record and the skilled management needed to navigate these adverse influences. Given a broader footprint in the emerging markets, TEF should proportionately be less exposed to regulation than its rival companies.
Economic challenges
Even though companies across the spectrum feel the hardening of the economic environment, TEF's business model is a defensive business with revenues and earnings that should substantially be less volatile than those of a more cyclical industry. However, we are not too worried about the global economy. Even if the global economy enters a new recession and share prices become even more depressed than they are now, we are very confident and relaxed with the metrics on which we enter into this investment (see valuation and conclusion).
Shareholder friendly dividend policy
TEF is our favorite telecommunications company in its capitalization class offering one of the highest dividend yields and delivering steady dividend increases over the last couple of years. In our opinion investors focus way too much on capital gains, often in the short run, and sadly neglect dividend payments which research has shown contributes most to the total return investors realize over time. Not only are dividend payments more certain compared to capital gains, they also provide investors with income that can be used for reinvestment, not to speak of peace of mind.
TEF has been paying dividends for 14 years, comprising of annual cash dividends supplemented by stock repurchases. Since 2005 TEF has been accentuating cash dividend payments and scaling back on stock repurchases. In fiscal year 2010 cash dividends amounted to 87% of total shareholder remuneration, with 13% being reserved for share repurchases (from 2006-2009 cash dividends accounted for 65% and stock buyback programs for 35% of remuneration).
TEF has paid out significant amount of dividends both out of earnings and reserves. Total dividends have increased from €0.65 to approximately €1.60 (bases on FY 2011 guidance) more than doubling the 2005 base dividend and posting an average annual dividend increase of over 25% since then. Guidance states that dividends going forward will be paid out of earnings and not be debt-financed.
Valuation and conclusion
Fundamental approach
Dividend guidance suggests that TEF will pay €1.75 in fiscal year 2012. We forecast the fiscal year 2012 dividend to grow at a very conservative 3% rate going forward, which is well below the 25% CAGR for the time period since TEF management adopted a more shareholder friendly remuneration policy. Given the low probability of significant earnings volatility and since dividends have been paid in the past and have have been earned and are aligned with profitability, we can utilize a dividend discount model. Since the business model is less risky due to its defensive characteristics we deem an equity cost of capital between 11-13% appropriate.
These inputs lead us to a valuation range of €17.5-21.9 (or given an exchange ratio of €1 ~ $1.44 the range would roughly be $25.2-31.5). Even with these conservative assumptions regarding dividend growth and equity cost of capital, the current share price of €14.1/$20.3 is a decent 20% discount from our lower range estimated fair value. We like investors use these value estimates as a very rough guide for value indication only, as the nature of the Gordon growth model is to react very sensitively to parameter estimates such as base dividend, growth rate and cost of capital.
Market approach
TEF depicts a couple of attractive metrics that we as value investors highly appreciate: TEF is a stable business with a low trailing P/E of 8.3 and leading P/E of 8.0. Dividend guidance for fiscal year 2011 is €1.60 per share, bringing the current dividend yield up to 11.3%. TEF is expected to pay €1.75 per share minimum in fiscal year 2012 and beyond, driving the leading annual dividend yield to 12.4%. The dividend will be paid in two installments, in May and November. We like to ask our readers to envision that this yield is not being produced by some high-risk mortgage REIT investment but rather an established, solidly financed company with a conservative risk profile and investment-grade rated debt.
We like to remind investors also that the long-term annual return of investing in global shares is between 6-8%, accounting for both dividends and capital gains. With TEF you can lock in a 12% dividend yield alone with the likely prospect of increasing dividends. In addition, you buy a stable, growing business with a great franchise and significant exposure to emerging-market growth (45% of earnings generation in Latin America) at a P/E ratio of 8. In our opinion TEF common stock is a very attractive investment and as investors in a high-dividend stock we couldn't care less whether we are experiencing another recession or not.
Recommended
For everybody interested in a high level, highly interesting finance lecture on TEF we recommend the investor conference presentation from the CSO: Accounting and Cash: Dividends Here! Investor conference, London 13-14 April 2011.
About the author
Christian graduated from university with a master degree in business administration majoring in accounting, tax accounting and organization. After graduating he joined the transaction services department at a Big4 company working on mergers & acquisition deals in Frankfurt, London and Zurich. Christian possesses 12 years of capital market and extensive valuation and research experience. In February 2010 Christian founded Global Value Investors, a research company focused on finding undervalued investments with an emphasis on equity securities. In his monthly research publication he shares his investment ideas with like-minded investors. Currently, Christian manages his own wealth. He is a CFA Level 3 Candidate.
www.global-value-investor.com
We have pitched Telefonica (TEF, Financial) some time ago and in light of the August market turmoil we would like to reiterate our positive outlook for TEF common stock. We are surely aware that TEF common stock is not exhibiting distressed asset characteristics as some of the value pitches here often do. However, TEF has an attractive equity valuation, a double-digit leading dividend yield, consistent earnings, dividend increases over the last couple of years and last but not least, a robust business model with access to above-average growth sources in Latin America.
TEF profile
TEF is a Spanish telecommunications company operating in Europe and Latin America. In Europe the main operating markets are Spain, UK, Germany, Ireland, Italy, Czech Republic and Slovakia. In Latin America TEF is tapping emerging market growth in Argentina, Brazil, Chile, Ecuador, Peru, Panama, Venezuela, Costa Rica, Dominican Republic, Colombia, Guatemala, Puerto Rico (in South America) and the U.S. and Canada in North America. Certainly, the company aims at entering and developing its position in the Spanish and Portuguese speaking markets.
Telefonica is listed in Spain and on major foreign stock exchanges Euronext and NYSE. The ticker symbol on Euronext is TFA and on NYSE TEF. TEF stock is held by three institutional investors: Banco Bilbao 6.28%, pension fund La Caixa 5.05% and Blackrock 3.88%. With 85% free-float TEF is a highly liquid stock.
Competitors
The telecommunication markets in Europe are dominated by a few players with the national telecommunication company in each nation having a strong position in its respective market. Telefonica dominates Spain, Vodafone the UK, Deutsche Telekom Germany, Telecom Italia Italy. The main U.S. competitors are AT&T (T) and Verizon (VZ).
Business
TEF operates in four business segments. The product offering includes fixed telephone, mobile phone, Internet and pay TV services. By far the most dominant line of business is mobile service, with 78% of customers in this segment (15% fixed, 7% Internet, the rest is other). The broadband category within the Internet segment has been posting the highest absolute growth of 37% from 2008-2010 compared to 13% in the mobile service segment. While the majority of subscribers and revenue growth comes from the Latin American markets, we can ascertain that Europe drives the broadband category and Latin America the mobile service category.
Transaction history
An intensive acquisitions strategy from 2005-2007 has led TEF to become the third-largest telecommunications company worldwide after government-controlled China Mobile and UK-domiciled Vodafone Group based on the number of subscribers. To put things in perspective, Vodafone, with its heavy focus on Europe, has around 340 million subscribers; Telefonica, with its focus on Latin America, posts 295 million customers; and AT&T racks up 99 million customers. One hundred and ninety out of 295 million TEF customers are from Latin America. Given that TEF capitalizes on the growth pool in Latin America, whilst Vodafone and AT&T are operating in mostly saturated markets, TEF could in the long term be able to post organic subscriber growth making it the No. 2 in the world after China Mobile.
Margins and earnings contribution
In the first six month of 2011, TEF earned € 30.6bn, which is a 6.3% increase year over year. The aforementioned growth driver has been Latin America with revenue growth of 21%. Forty-five to 46% of revenues, EBITDA and cash flow from operating activities are coming from Latin America, with Brazil being the driving force. Cash flow growth is largest in Mexico with around 30%, Peru with around 25%, Chile 20% and Argentina and Brazil in their high teens. TEF will be relying on the bigger Latin American economies to drive revenue and margin growth going forward.
In addition, these growth rates underline the significant opportunities TEF has at hand to further fund emerging market business expansion and shareholder remuneration. We view TEF’s emerging-market footprint especially attractive given the depth and breadth of access TEF has to these under-developed growth markets and judge the degree of access to be a primary competitive advantage compared to other telecommunication companies.
If we take a closer look at the geographical sales, earnings and cash generation we can identify that TEF is more efficiently generating EBITDA and cash in Spain compared to its other markets. Due to Spain's slowing economy and regulatory challenges the country's contribution to earnings and CF has decreased 6% in the first six month of fiscal year 2011 which we clearly see as a negative. We are convinced, however, that TEF's revenue and earnings challenges in Spain are manageable in nature (view business challenges section below).
In addition, earnings growth in Latin America has offset negative growth in Spain in the first six months of 2011 and eventually increased due to Europe's overall growth. It is important to note, that considering the substantial shareholder payouts, TEF will rely more on emerging-market cash generation going forward to fund its shareholder paybacks. The growth trend in Latin America, particularly in Brazil, which is becoming the top revenue-producing country, looks strong enough to assume the company will continue to earn its way into the necessary cash power to facilitate the dividend payments.
Despite the negative effects the Spanish business had on the financials, the group still posted healthy margins as follows: EBITDA margin 37%, EBIT margin 21% and Net income margin 10%.
Business challenges
Cost challenges
With all companies there is consistent capital market pressure on reaching a high level of operating efficiency. TEF is in the process of reducing headcount by 6,500 to address this issue and dis-burden overhead costs.
Regulatory challenges
This is mainly an issue for the European market with its heavy utilization of regulatory measures. As with all regulatory efforts, costs are being generated which first of all have a negative impact on business. It depends on the dynamics of the industry if the companies operating in the industry can effectively pass regulation costs through to their customers in terms of higher prices. Due to price pressures in the telecommunications industry and significant rivalry for customers, telecommunication operators are stuck with these costs, which in the case of TEF come in form of declining ARPU's. ARPU stands for average revenue per user in a given month and is a key performance indicator in the telecommunication industry.
Since regulators have been cutting termination rates (rates that are charged by one operator to another for terminating calls on its network) average revenues per customer are declining. This impact has been quite noticeable in Europe and Spain in particular. Total ARPU is €23.2 for Telefonica Spain (a decline of 9.3% year over year), €23.4 for Telefonica UK (-5.2% year over year) and €13.4 (-9.9% year over year) for Telefonica Germany. Since rates are set by a regulator who is motivated to keep mobile costs low, regulatory interference into the price-setting mechanism will in our opinion continue to be the key driving force affecting revenue generation and profitability measures. Even though this is clearly having a negative impact on the business, in fairness we shall emphasize that this challenge is affecting all industry participants the same way providing a level playing field for all competitors within a given country.
Given TEF’s high returns on shareholder capital in the past we believe the company has the appropriate track record and the skilled management needed to navigate these adverse influences. Given a broader footprint in the emerging markets, TEF should proportionately be less exposed to regulation than its rival companies.
Economic challenges
Even though companies across the spectrum feel the hardening of the economic environment, TEF's business model is a defensive business with revenues and earnings that should substantially be less volatile than those of a more cyclical industry. However, we are not too worried about the global economy. Even if the global economy enters a new recession and share prices become even more depressed than they are now, we are very confident and relaxed with the metrics on which we enter into this investment (see valuation and conclusion).
Shareholder friendly dividend policy
TEF is our favorite telecommunications company in its capitalization class offering one of the highest dividend yields and delivering steady dividend increases over the last couple of years. In our opinion investors focus way too much on capital gains, often in the short run, and sadly neglect dividend payments which research has shown contributes most to the total return investors realize over time. Not only are dividend payments more certain compared to capital gains, they also provide investors with income that can be used for reinvestment, not to speak of peace of mind.
TEF has been paying dividends for 14 years, comprising of annual cash dividends supplemented by stock repurchases. Since 2005 TEF has been accentuating cash dividend payments and scaling back on stock repurchases. In fiscal year 2010 cash dividends amounted to 87% of total shareholder remuneration, with 13% being reserved for share repurchases (from 2006-2009 cash dividends accounted for 65% and stock buyback programs for 35% of remuneration).
TEF has paid out significant amount of dividends both out of earnings and reserves. Total dividends have increased from €0.65 to approximately €1.60 (bases on FY 2011 guidance) more than doubling the 2005 base dividend and posting an average annual dividend increase of over 25% since then. Guidance states that dividends going forward will be paid out of earnings and not be debt-financed.
Valuation and conclusion
Fundamental approach
Dividend guidance suggests that TEF will pay €1.75 in fiscal year 2012. We forecast the fiscal year 2012 dividend to grow at a very conservative 3% rate going forward, which is well below the 25% CAGR for the time period since TEF management adopted a more shareholder friendly remuneration policy. Given the low probability of significant earnings volatility and since dividends have been paid in the past and have have been earned and are aligned with profitability, we can utilize a dividend discount model. Since the business model is less risky due to its defensive characteristics we deem an equity cost of capital between 11-13% appropriate.
These inputs lead us to a valuation range of €17.5-21.9 (or given an exchange ratio of €1 ~ $1.44 the range would roughly be $25.2-31.5). Even with these conservative assumptions regarding dividend growth and equity cost of capital, the current share price of €14.1/$20.3 is a decent 20% discount from our lower range estimated fair value. We like investors use these value estimates as a very rough guide for value indication only, as the nature of the Gordon growth model is to react very sensitively to parameter estimates such as base dividend, growth rate and cost of capital.
Market approach
TEF depicts a couple of attractive metrics that we as value investors highly appreciate: TEF is a stable business with a low trailing P/E of 8.3 and leading P/E of 8.0. Dividend guidance for fiscal year 2011 is €1.60 per share, bringing the current dividend yield up to 11.3%. TEF is expected to pay €1.75 per share minimum in fiscal year 2012 and beyond, driving the leading annual dividend yield to 12.4%. The dividend will be paid in two installments, in May and November. We like to ask our readers to envision that this yield is not being produced by some high-risk mortgage REIT investment but rather an established, solidly financed company with a conservative risk profile and investment-grade rated debt.
We like to remind investors also that the long-term annual return of investing in global shares is between 6-8%, accounting for both dividends and capital gains. With TEF you can lock in a 12% dividend yield alone with the likely prospect of increasing dividends. In addition, you buy a stable, growing business with a great franchise and significant exposure to emerging-market growth (45% of earnings generation in Latin America) at a P/E ratio of 8. In our opinion TEF common stock is a very attractive investment and as investors in a high-dividend stock we couldn't care less whether we are experiencing another recession or not.
Recommended
For everybody interested in a high level, highly interesting finance lecture on TEF we recommend the investor conference presentation from the CSO: Accounting and Cash: Dividends Here! Investor conference, London 13-14 April 2011.
About the author
Christian graduated from university with a master degree in business administration majoring in accounting, tax accounting and organization. After graduating he joined the transaction services department at a Big4 company working on mergers & acquisition deals in Frankfurt, London and Zurich. Christian possesses 12 years of capital market and extensive valuation and research experience. In February 2010 Christian founded Global Value Investors, a research company focused on finding undervalued investments with an emphasis on equity securities. In his monthly research publication he shares his investment ideas with like-minded investors. Currently, Christian manages his own wealth. He is a CFA Level 3 Candidate.
www.global-value-investor.com
