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Telefonica S.A. (ADR) (TEF), Telecom Italia SpA (ADR) (TI): Expect Better Performance From This Telecom Company

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Telefonica S.A. (ADR) (NYSE:TEF)I have liked Telefonica S.A. (ADR) (NYSE:TEF) for a while. The company is suffering in its home market but is finding growth in emerging markets through its strong presence in Latin America. Most importantly, its European operations should start getting better as the market consolidates and competitive pressures ease. Despite beating market expectations, Telefonica S.A. (ADR) (NYSE:TEF)’s last quarter results still reflect tough market conditions. After the sale of various non-core assets such as the Atento call center business, the group’s top line is expected to decrease by 10.3% in 2013.

Reducing the huge debt pile

Through a number of acquisitions, Telefonica S.A. (ADR) (NYSE:TEF) has built up an unsustainable debt pile that peaked at above $80 billion in 2012. Now, the company is reducing debt by paying off capital with internal funds (it suspended the dividend last year) and through asset sales. As a matter of fact, net debt fell by $2.6 billion over the second quarter to $64 billion, or just below 2.6 times EBITDA. The company aims to keep on reducing debt. According to Telefonica, net debt at the end of the year should be below 2.5 times EBITDA.

Asset sales should keep on helping the company pay-off debt. Last year, Telefonica made some sales such as the aforementioned Atento call-center business. The company also also sold other operations such as 5% of ChinaUnicom, O2 UK broadband, 40% of Telefonica Central America, and 100% of Telefonica S.A. (ADR) (NYSE:TEF) O2 Ireland. I believe other operations might be coming.

The one I have been expecting the most is related to Telefonica S.A. (ADR) (NYSE:TEF)’s investment in Telecom Italia SpA (ADR) (NYSE:TI). The Spanish group needs to take a strategic decision regarding Telecom Italia SpA (ADR) (NYSE:TI): whether to buy out its partners or to sell its 10.4% stake in the company. Since Telefonica is taking debt-off its balance sheet, I do not imagine management thinking of buying out their Telecom Italia SpA (ADR) (NYSE:TI) partners even when many of them are willing to sell.

A combined sale to a third party would be more likely despite Telecom Italia SpA (ADR) (NYSE:TI)’s cheap market valuation (3.3 times EV/EBITDA). If the Spanish company could get 5 times EV/EBITDA, it could bring in more than $1.3 billion to its coffers.

Industry consolidation

Brussels wants to encourage a cross-border consolidation within the industry and Telefonica S.A. (ADR) (NYSE:TEF) is playing its part. Stiff competition and bad economic conditions have been driving up churn and lowering rates to a point that is making companies stop investing as much as needed to keep infrastructure up-to-date. Indeed, very recently, Telefónica, through its German subsidiary, proposed a $10.5 billion deal with the Dutch operator KPN for its German E-Plus unit to create Germany’s largest mobile phone operator.

The combination between Germany’s third and fourth mobile players is creating a company with a market share of 32% and revenue of $10.4 billion. The deal is expected to be closed very soon despite the abstention of KPN’s single biggest shareholder, the Mexican billionaire Carlos Slim, who controls two seats on KPN’s board of directors through America Movil.

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