Upside potential for Telefonica of 12.7%, below the rest of the telcos

Alphavalue | Between May 2017 and September 2018, Telefónica´s shares have fallen -37.5% before recovering +20% in the last three months.

Telecommunications companies recovered during the recent global market sell-off: their high yields (reasonably secure thanks to the FCF) attracted investors, while indications of corporate movements have been reanimated by the recent decision in favour of the merger between Deutsche Telekom (add, Objective Price 17.6 Euros) and Tele2 (reduce, Objective Price 109 SEK) in the Netherlands. However, the Spanish company remains 25% below where it was eighteen months ago and continues being one of the shares with the worst performance in the sector together with Telecom Italia (buy, Objectice Price 0.84 eurod) during this period.

We see an upside potential at six months of +12%, in reality below the average of +20% for the telecommunications sectors as a whole. The difference is explained basically by Telefónica´s high level of indebtedness.

In any case, Telefónica could claim one of the most international profiles with more than 70% of its business abroad, being a reference point in Spanish and Portuguese speaking markets. This impressive global position has given the group modest organic growth in sales in constant change in recent years, but not in the terms published: in 2017 sales grew organically by 3.4% yoy, but remained stable in published terms (currency exploited a 10% hole in sales in euros in Brazil and 15% in the rest of Latin America). As for 2018, Telefónica has published fairly correct results for the first 9 months in organic terms (with sales and Ebitda growing +2.2% and 3.8% respectively yoy), but the continued deterioration in the Brazilian real and the collapse of the Argentine peso have been brutal. The reported figures have been impacted (sales and Ebitda finally fell -8% and -2% respectively yoy, with a negative currency impact of -17% in Brazil and -25% in the rest of Latin America). In effect, going to Spanish and Portuguese speaking markets was as inevitable as too easy to not be risky.

Telefónica decided in 2017 to cut its dividends to strengthen its balance sheet and accelerate its organic deleveraging, maintaining, however, an attractive level of remuneration for its shareholders. The dividend was 0.4 euros/share in 2017 (compared to 0.55 euros/share in 2016 and 0.75 euros/share in 2015). It should be pointed out that the debt level of the group is already not so concerning. It is situated at 44.25 bn€ at the end of 2017 (adjusted for current financial assets), with a fall of -4.35 bn€ due to the generation of free cash flow (2.8 bn€) and the close of the sale of 40% of its infrastructure subsidiary Telxius (1.3 bn€). At the end of September 2018, The net debt was 42.65 bn€, thanks to the generation of free cash flow and the sale of 10% of Telxius. The net debt now is 2.75X Ebitda, an acceptable level for a telecommunications company. It is worth recalling that the Brasilian and German subsidiaries which are listed are not indebted, and therefore the debt servicing appears to be a Spanish and Latin American (not counting Brazil) effort.

In short, Telefónica is in a unique Spanish position, a high potential in Brazil, a call option in Argentina, and perfectly solid and competitive assets in Germany and the UK. It adds a 5% yield to “pay” its patience. It is not Telia, but possibly more attractive than a Deutsche Telekom dependent on the US. The valuation ratios imply a constraint greater than the debt burden (valuation EV/Ebitda) for an upside potential of +12.7%.