Summary

• 95 years old Spanish telecommunications company Telefonica is a market leader in its main geographies in Europe and Latin America. It serves around 370M accesses worldwide.
• Dividend is attractive with yield over 9%. However it is not sustainable at present.
• Sales have trended down since 2016 and are down 11% last year mainly due to the impact of the pandemic and currency exchange rates.
• The company is highly indebted and takes measures to reduce a debt. The debt is almost 10% lower over year due to divestments and M&A activity.
• Telefonica is heavily undervalued by our stock evaluation method as investors discount for risks it bears.

Dividend    Revenue    Profitability    Financial Strength    Investment Case

Multinational telecommunications company Telefonica (TEF) operates in 14 countries and is present in 33 countries. It provides fixed and mobile phone, broadband, internet, data traffic, Pay TV and other services. Telefonica has the following brands:

The company has the following four key divisions:

• Spain – 32% of total revenue in 2020. Telefonica is the leading operator by accesses in Spain.
• The United Kingdom – 7% of revenue. Joint venture Virgin Media O2 UK is one of the largest businesses in the UK.
• Germany – 18% of revenue. The third largest telecom in Germany.
• Brazil – 18% of revenue. The leading operator by accesses in Brazil with over 95M accesses.

Also Telefonica has Hispam division which generated 21% of revenue in 2021. It consists of the operations in Argentina, Chile, Colombia, Ecuador other countries and has multi – country operating model. It reduced its exposure to Hispanoamerica through the sale of Telefonica Costa Rica division.

The remaining two divisions are:

• Telefonica Tech helps B2B customers by developing Cloud, Cybersecurity, IoT and Big Data services.
• Telefonica Infra – develops the company’s infrastructure.

The company has 4G coverage for over 90% of population in its main markets. It works to deploy innovative and more efficient networks based on fiber and 5G. 5G in Spain is available to 80% of the population. 100% of fibre optic coverage in Spain is to be achieved by 2024.

In 2020 the company created a 50/50 joint venture with Liberty Global in the UK by combining O2 Holdings and Virgin Media, UK. Telefonica. In June 2021, Telxius Telecom, owned by Telefonica, completed the sale of its towers divisions (almost 31K towers) to the American Tower Corporation in Europe and Latin America for 7.7 billion euros. The proceeds were used to reduce the debt.

Banks BBVA, Caixabank and Blackrock each have close to 5% stakes in Telefonica.

   Dividend

Dividend	Dividend Yield	5Y Growth	PayOut Ratio
EUR 0.35 per share	8.35%	-7% per year	25%

Telefonica has been paying the same fixed dividend of EUR 0.4 per share over the past several years including 2020. In 2020 it was scrip dividend (shareholders had a choice of either receiving a cash dividend or the equivalent in additional shares). Over 60% of shareholders choose to receive new shares of Telefonica. That means that Telefonica ends up with larger number of shares thus reducing shareholder value. In 2021 dividend is EUR 0.35 per share and it is script dividend again.

The company used to have high payout ratio historically. In 2021 it is low however, 25%. So the dividend is covered by earnings for now. A voluntary scrip dividend provides the company with financial flexibility. However the company’s debt is high and funds are needed to handle it. So we could assume that dividend will not increase in the coming years.

   Revenue

Revenue	5 Years Growth	Revenue growth in 2020	Company Outlook 2022
EUR   39.28B	-5.5% p. a.	Total sales                       -8.8% By divisions: Spain                                 0% United Kingdom             -60% Germany                          +3% Brazil                                -7% Hispam                           +5.5% Telxius                              -2%	N/A

Revenues have trended down since 2016. In 2021 Telefonica reported revenue was almost 9% lower over year while organic growth was higher by 2%. Revenues decreased mainly due to the deconsolidation of the UK business impacted by joint venture VMED O2 UK and the sale of the towers division of Telxius. Organic growth was supported by higher handset sales and service revenues. Performance by business divisions was as follows:

• Spain – Revenue was almost the same as last year. It was supported by handset revenues of the new Fusion portfolio with several devices as part of packages. Movistar Prosegur Alarmas was launched offering clients an installation of alarm which is connected to an alarm reception center and other systems. Also Movistar Health offered online medicine service allowing users to connect to a primary care doctor 24/7.
• United Kingdom – Revenue decreased by 60% impacted by the change in the scope of consolidation. Excluding that the revenue is down by 7% impacted by the pandemic related restrictions in the UK. Revenue of VMED O2 UK amounted to EUR 7.2B.
• Germany – Revenue was higher due to the increase in revenue in both the mobile and the fixed businesses.
• Brazil – Revenue decreased by 7% mainly due to the depreciation of Brazil real (-9%). In organic terms revenue is higher by 2%.
• Hispam – Revenue was higher by 5.5%. The effect of hyperinflation in some countries (+4.2%) was offset by the foreign exchange impact (-4%). Both mobile and fixed business revenues were higher over year. Organic growth was 5% per year.

New products, sales of bundled packages, prudent M&A activity should support future revenue growth of the company.

   Profitability

Profit	5 Years Growth	Net Profit Margin	ROE	Company Outlook 2021
EPS EUR 1.38 Net Profit EUR 8.14B	27% p. a.	8.5%	20.5%	N/A

Operating income in 2021 jumped by 228% to EUR 13.586 over year but organic growth was only 5.6%. It was impacted by one-off events such as capital gains from setting up joint venture VMED O2 UK and the sale of towers of Telxius Group. Also Telefonica increases efficiency through digitalization and automation of operational processes. EPS has been in strong downtrend in recent years. However it jumped to EUR 1.38 in 2021 from EUR 0.24 per share the year before.

The average over the last 5 years EPS is EUR 0.58 per share. As there are high swings in the level of profitability we could assume that EPS would reach that average level in the next 5 years.

   Financial Strength

Company Capital Structure

In EUR B

Year	2019	2020	2021
Equity	17.118	11.235	22.207
Cash & cash equivalents	6.042	5.604	8.58
Debt including lease	59.59	55.714	50.365
Net Debt (as defined by the company), incl leases	45.123	41.697	34.112
Debt/Equity	348%	496%	227%

The company is highly indebted. However in 2021 Telefonica managed to reduce the debt substantially using proceeds of the sale of towers divisions in Europe & Latin America and other M&A activity. At the end of the year operating cash flow is 26% of the debt and operating profit to interest payments stands at 6.7x. Both measures allow the debt to be manageable. The net financial debt without leasing has been down over years.

The company has long term credit rating BBB- with stable outlook from S&P. Refinancing activity allowed to extend average debt life at lower interest rates. The company aims to reduce debt further through organic deleveraging.

   Investment Case

The estimate of future stock price and investment returns based on P/E ratio

Assumptions of dividend and EPS growth over the next 5 years
Dividend is assumed to be at the same level, EUR 0.35 per share in the coming years. Then the total dividend income over the next 5 years would amount to EUR 1.75. We could assume EPS of EUR 0.58 in 5 years as discussed earlier.
Projected stock price
Average P/E over the last 5 years (15.9) multiplied by EPS in 5 years = 15.9x EUR 0.58 = EUR 9.22.
Future Returns Based on the Assumptions
Stock price upside potential                                      132%    from the current price EUR 4.19 Overall return on investment*                                   176% Compound Annual Return on Investment                23%

*- Includes the expected dividend income over the next 5 years and dividends are not reinvested.

Telefonica operates in large markets and has high quality networks. The demand for data connectivity is increasing and the company could benefit from it. The stock price is in long term down trend and the above calculations indicate that the stock is substantially undervalued. The most recent performance shows signs of improvement. However it remains to be seen whether Telefonica is able to turn around its performance in the near future and support its stock price.

Disclosure:

I have no position in the stocks mentioned in this article and do not intend to initiate any position within the next 72 hours.

 

Notes

Data source – the company’s financial reports and presentations. Source of pictures – the company website unless otherwise stated. Colored circles next to headings mean an author’s evaluation of the relevant performance criteria of the company: green means positive, yellow neutral and red negative evaluation. There are many ways to estimate the future stock price. We use only one of them, the one based on P/E ratio. All estimates made in the article are for the informational purposes only. No taxation, brokerage fees and other expenses related to investing are considered in the estimates. The estimates are the result of the rule of thumb assumptions and the real outcome might differ materially from those estimates. As the future unfolds, macro events, not mentioned in the article, could impact the company fundamentals. Use the information in the article only as a starting point for your own due diligence.