The telecommunications and utilities sectors are main drivers of the Spanish blue chip IBEX 35 index, with a combined contribution of 23%. In its recent report on Spain, Goldman Sachs Global Investment Research point out that while the telecoms sector (mainly represented by Telefónica) is very attractive for investors, “looming pressure on returns” is clouding investor interest in the utilities.
So why is Telefónica a good bet? Goldman Sachs believes the company has now become “one of the most compelling” investment opportunities in the European telecom industry. Their opinion is based on the following reasons:
“Improving domestic macro conditions, early investment in fibre-to-the-home and management’s significant restructuring efforts… Our analysts forecast TEF delivering +12% FCF CAGR over the next three years, and with the stock now trading at a 10% 2018E FCF yield, they see valuation as compelling.”
The experts highlight three key ways in which Telefónica has successfully responded to a challenging industry environment: 1) being a pioneer in terms of convergence, which has cut subscriber churn; 2) focusing on cost-cutting, with the workforce in Spain now down 46%; 3) fibre-to-home investment; and 4)disposing of assets, clocking up about €8 billion in total.
So Telefónica is a “leaner and better-invested operator today vs. pre-crisis,” Goldman Sachs says. It flags that against the backdrop of an improving Spanish economy, the company’s prior restructuring efforts “are helping to amplify the FCF expansion opportunity.”
“While Telefónica does face some near-term competitive headwinds in its domestic market, visibility on regulation and returns are higher than in other European countries and FCF growth is also supported by lower restructuring and refinancing costs going forward.”
Turning to the outlook for the utilities, Goldman Sachs note they are cautious about possible “shrinking returns in Spain” due mainly to regulatory constraints. They hold the view that the Spanish regulatory framework will be applied according to the existing law in the period 2020-2025.
They flag three factors which could significantly depress 2020-2025 earnings, noting that these “do not seem to be discounted by the market, given current stock valuations and consensus earnings estimates.”
These three factors are: 1) Grids: low rates mean a signficant drop in 2020-2025 revenues/returns. “Returns in power networks could suffer an around 40% cut (from 6.5% to 4%); 2) Renewables: IRRs could fall by about one-third in 2020; 3) Generation: renewable additions (following recent auctions in Spain) will put pressure on prices. “By 2025, we estimate an about 10% drop in power prices.”
As a result of the above, Goldman Sachs analysts have Sell ratings on Endesa, Gas Natural and Red Electrica.