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Telefonica S.A. (ADR) (TEF), AT&T Inc. (T): Could This Giant Be An M&A Target?

Madrid-based Telefonica S.A. (ADR) (NYSE:TEF), one of the world’s largest Telecom Italia SpA (ADR) (NYSE:TI) companies, has been facing some heavy headwinds. The company’s debt (at almost $70 billion) stands at around 2.7x Telefonica S.A. (ADR) (NYSE:TEF)’s EBITDA, and competion in its home market have been putting pressure on margins and sales. As a matter of fact, for the first quarter this year revenues fell 9% year-over-year (yoy), and the company’s operating income dropped by 18%.

Telefonica S.A. (ADR) (NYSE:TEF)

All of the above being said, the company’s bright spots (such as its strong presence in Latin America) and its cheap valuation, could make Telefonica S.A. (ADR) (NYSE:TEF) an attractive takeover target for a well-capitalized giant such as AT&T Inc. (NYSE:T).

Growth in emerging markets.

Telefonica’s main market is not in Europe anymore–the company’s revenues from its Brazilian branch surpassed those coming from Spain. Sales in Latin American account for over 50% of the group’s total. Telefonica S.A. (ADR) (NYSE:TEF)’s presence in Latin America can only be matched by America Movil SAB de CV (ADR) (NYSE:AMX), Carlos Slim’s telecommunication powerhouse.

In the new continent, prospects are still bright. Telefonica Brasil (Vivo) is growing Average Revenues Per User (ARPU) thanks to smartphone adoption and less tariff competition. Meanwhile, thanks to politically empowered reforms, I would expect a better competitive environment in Mexico (for now just 2.9% of total revenues). Reforms in Mexico should help the company gain market-share from America Movil SAB de CV (ADR) (NYSE:AMX), which still enjoys a monopolistic position in the highly profitable Mexican telecom market.

Italian assets could be sold to facilitate a take-over

Telefonica S.A. (ADR) (NYSE:TEF)’s first quarter earnings surged by 21% yoy. The reason? Last year, Telefonica wrote-off its Italian investments that now are carried in its books at very conservative levels. Telefonica’s investments in Italy are mainly shares of Telecom Italia SpA (ADR) (NYSE:TI).

AT&T Inc. (NYSE:T) or any other bidder could chose to dispose of Telefonica’s 10.5% ownership of Telecom Italia SpA (ADR) (NYSE:TI) in order to make a the takeover more affordable. Of course disposing Telecom Italia SpA (ADR) (NYSE:TI) at the current valuation (3.3x EV/EBITDA and 4.75x P/E) might not be the most shareholder-friendly action, but it could certainly reduce funding needs. I am sure Telefonica S.A. (ADR) (NYSE:TEF) could easily get $1.5 billion for its stake in Telecom Italia SpA (ADR) (NYSE:TI).

Valuation looks compelling

Telefonica trades at 2013 an adjusted equity FCF yield of 13% versus the sector average of 11.6%. Besides, the company also trades at seemingly cheap multiples (4.8x EV/EBITDA and 10.8x P/E). Given Telefonica’s exposure to growing Latin American markets a takeover would make sense, even if the buyer offers a 40% premium to current market prices.