The Case for Telefonica

Author's Avatar
Jun 01, 2012
Article's Main Image
“Buy low and sell high” is the standard advice of any value investor. It can also be remarkably hard to put into practice.

You see, we humans are herd animals, and we tend to think and act as groups, particularly during times of stress. Call it the primal human instinct to seek strength in numbers.

Unfortunately, while this instinct may ensure our survival during times of war or natural disaster, it handicaps us as investors. When we see others panicking we too sell in fear or stand paralyzed in indecision at exactly the time we should be buying with both fists.

All of this is a lengthy introduction to the subject of this article, Spanish telecom giant Telefonica (TEF, Financial).

Telefonica has had a rough year. The price of its U.S.-listed ADR are down nearly 70% from their pre-2008 highs. The domestically traded shares have fared slightly better due to the lack of currency movements, but results have been dismal nonetheless.


Spain’s crisis has become Telefonica’s crisis. As the most liquid stock in the Spanish stock market, Telefonica has become a proverbial punching bag and an outlet for traders wanting to short the embattled eurozone country.

To be fair, some of the stock price punishment is justified by Telefonica’s decaying business in its home market. With nearly one in four Spaniards unemployed, some are looking to cut corners by downgrading to cheaper cell phone plans or switching to cheaper rival carriers. The rough economy has also accelerated the decline in the domestic fixed line business, both residential and corporate. After all, Spanish companies are not in need of new desk extensions when they are laying off personnel still.

Telefonica’s high debt level — which would likely have gone unnoticed in less volatile times — is also a point of concern and led the company to make significant changes to its dividend policy. I’ll elaborate more on that shortly.

Adding insult to injury, in late May Telefonica lost its long-standing title as Spain’s most valuable company, losing the top spot to fashion retailer Inditex (OTC:IDEXY), which owns the Zara brand.

Alas, it seems that when it rains, it pours.

Despite the difficult conditions at home, I consider Telefonica an incredible buy at current prices. In fact, I believe that Telefonica is priced to deliver some of the highest total returns of any large-cap company in the developed world over the next decade.

My bullish case rests primarily on two arguments. First, Telefonica, though domiciled in Spain, is not really a Spanish company. Only 28% of its revenues come from Spain, with another 25% coming from other European countries, primarily the United Kingdom and Germany.

At 46%, nearly half of the company’s revenues come from the fast-growing markets of Latin America, which — unlike Europe — are still unsaturated markets for mobile phones in general and more lucrative smart phones in particular.

So, while Telefonica is domiciled in Spain — and trading at a crisis valuation of just six times forward earnings —Telefonica cannot legitimately be called a “Spanish” company. It is a “backdoor” play on rising incomes in Latin America — what I like to call “Emerging Markets Lite.”


My second reason for liking Telefonica is the company’s long history of generously rewarding its shareholders in cold, hard cash. Telefonica is committed to paying its shareholders a handsome dividend, and at current prices the shares are some of the highest-yielding shares anywhere in the world.

This requires a little explaining, however. In December, Telefonica cut its dividend for the first time in a decade, citing a desire to reduce the company’s debt burden. Telefonica also partially replaced its cash dividend with a share dividend; more on that in a moment.

Under more normal circumstances, Telefonica’s high level of debt (its debt/equity ratio is over 200%) would not be cause for alarm for a company with utility-like consistency. Much of Telefonica’s debt was accumulated during the buying binge that created its Latin American empire — the company’s future. Cash might have gotten tight for a couple quarters, but the debt would not have represented a threat to the company’s continued existence.

Of course, these are not normal times. Though I believe Spain will muddle through with a little help from the European Central Bank, there is the legitimate possibility that Spain could have a financial sector meltdown and that such a meltdown would effectively lock Spanish companies out of the capital markets. Telefonica did not want to find itself in the position of having to roll over its bonds at a time when the markets were having convulsions.

In any event, Telefonica has gone a step further, pledging to raise cash by spinning off its German division and some Latin American assets in stock market listings. The Financial Times estimates the German unit to be worth as much as €9 billion, which would make a significant dent in its €57 billion debt load.

The Latin American assets — which, as I said, represent the future of the company — are worth far more; the Financial Times estimates them to be worth at least €40 billion in total.

The selling of Telefonica’s German business makes all the sense in the world. Germany is a saturated market with little room for growth, and the country’s demographics are appallingly bad. Selling the business will not have any adverse impacts on the company’s long-term prospects.

Latin America is a different story, however. Management is not stupid, and they certainly will not jeopardize the company’s future by selling off key growth assets. That said, there are plenty of non-core assets that could be easily jettisoned — call centers and fixed-line assets, for example.

The dividend for 2011 was €1.60 euros per share, of which €0.77 was paid in cash in November of last year and the remainder paid in May as a mixture of cash and stock. The dividend for 2012 is expected to be €1.50, though the composition is still somewhat vague. In management’s own words, “The remuneration mix (dividend, share buyback or the combination of both) will be decided considering market conditions and investor preferences at that time.”

If May was an indication of things to come, the November dividend could be something along the lines of a 50/50 split between cash and stock dividends with (possibly) the option for investors to choose.

It is odd that management lumps in share repurchases with the dividend, though I consider it largely a moot point. If the company is trying to conserve cash, then I don’t see share buybacks being large enough to significantly affect returns.

At Telefonica’s current price of €8.94, there are different ways we can interpret the dividend yield (I use euros in my calculations, but the ratios works out the same in dollars for investors in the U.S.-traded ADR). Taking the €1.50 at face value would give you a dividend yield of 17%. Assuming that the cash portion is only half that amount, you still get a cash yield of over 8%. And I should be clear that, at least for growth investors, a stock dividend is preferable to a cash dividend. You get the same benefits of a dividend reinvestment plan but without having to pay taxes on the dividends.

In any event, the stock dividend is merely a short-term tactical move to allow the company to conserve cash during a volatile time in Europe’s capital markets. Once the eurozone is stabilized, I expect Telefonica’s dividend policy to return to something a little more orthodox.

The Elephant in the Room

The open question, of course, is “What happens to Telefonica if Spain leaves the eurozone?”

Before I answer that, I should point out that I would consider a Spanish exit to be out of the question. Spain’s entire post-Franco identity has centered around being “more European,” and there is no significant political constituency advocating an exit. It’s simply not going to happen.

Still, it is not out of the question that the eurozone will come unraveled around Spain. If we have a true eurozone meltdown, then Telefonica’s shares will take a severe hit. Remember, during the 2008 U.S. meltdown, virtually every stock cratered, not just the banks at the center of it.

I should also reiterate that I consider such a scenario unlikely. I expect to see some pretty dramatic intervention by the ECB before conditions get much worse than they are today.

Bottom line: The eurozone crisis has created a phenomenal opportunity to buy one of the finest international telecom companies in the world at a price we might not see again in our lifetimes. At six times earnings and an expected dividend of 8 to 17%, Telefonica is one of the best values on the market today.

Disclosures: Sizemore Capital is long TEF.

4 / 5 (19 votes)