News

 U.S. equities ascended relentlessly for almost six months beginning last September. They’ve fallen in each of the past six weeks, however, and volatility has picked up considerably; the Dow Jones Industrial Average is 7.6% below the year’s high, which was set on May 2^nd. Investors’ enthusiasm over Corporate America’s strong financial performance coming out of the Great Recession is now clearly being overwhelmed by anxieties over the host of challenges that have the potential to slow the nation’s economy. The myriad hurdles include: A huge national debt and deficit that will undoubtedly ultimately require spending cuts and tax increases; severe fiscal problems at the state and local levels; unsustainable Medicare, Medicaid, and social Security programs; a housing market slump that shows no signs of ending; stubbornly high unemployment; stagnant wages; and an education deficit. Also disconcerting are the uncertainties associated with the rapidly approaching end to the central bank’s easy (QE2) monetary policy and the potentially disruptive discussions in the U.S. Congress over lifting the nation’s borrowing capacity and cutting spending. Given both the insecurities and the stock market’s extraordinary two-year-long rebound from the lows of March 2009, a period of consolidation seems to be in order. As such, we recommend an equity – Telefonica, S.A. (NYSE: TEF; $23.25) – that should generate solid returns even if our near-term expectations of a generally ragged stock-market performance are realized.

Telefonica is a Spain-based multinational provider of telecommunications services. Its shares, which trade on the New York Stock Exchange as ADRs (or American Depository Receipts), probably offer the richest dividend yield of any large-capitalization issue in the world. The company has a solid track record and its position in many of the fastest-growing economies around the globe suggests that continued prosperity is assured for years to come. That said, investors should note that an investment in an ADR is different from holding a simple domestic equity. The dividend yield, for example, can be difficult to determine precisely, because it is declared (and paid) by the company in one currency but received by the ADR holder in a different currency; the dividend declared and the amount received could vary considerably if exchange rates fluctuate significantly. An assessment of Telefonica is also complicated by its geographic diversification. Revenues are generated in more than a dozen different currencies, all of which are translated back into euros in the company’s financial reports. Translating those results into dollars for U.S. investors can further dilute an understanding of the underlying fundamentals. Therefore, our financial discussion in this report will be largely in euro terms.

A Double-Digit Dividend Yield

Telefonica has paid a dividend every year since 2003, increasing the amount in each of the past seven years. The amounts paid in 2010, 2009, and 2008 were 1.3, 1.0, and 0.9 euros, respectively, distributed in two installments. For 2011, the large telecommunications services provider paid 0.75 euros on May 6^th and has earmarked a disbursement of 0.77 euros for the second half of the year. Moreover, on April 13^th, management reiterated a commitment to distribute a dividend of 1.75 euros in 2012 and at least the same amount in subsequent years. In U.S. dollar terms, ADR holders were paid $1.0733 earlier this month. At the prevailing exchange rate, ADR holders will receive $2.17 this year and $2.50 in 2012, which equates to a year-ahead dividend yield of approximately 10.0%. This is before a 19% Spanish tax on U.S. residents, though, which investors can get reduced to 15% by providing a certificate from the IRS documenting U.S. domicile.

Telefonica is one of the largest companies in the world with a market capitalization of almost 110 billion U.S. dollars. Earnings have comfortable exceeded the dividend payout in each of the past five years, while cash flow has been sufficient to also meet the company’s substantial capital expenditure requirements (10.8 billion euros in 2010). Looking forward, broad geographic diversification, favorable business trends in key markets, and a sharply diminished need for M&A-related funding lead us to conclude that the dividend payout is secure for the foreseeable future; management recently expressed satisfaction with the existing footprint, noting that the dynamics within that footprint are sufficient to provide solid organic growth.

The Company

Telefonica, S.A. is a diversified telecommunications concern, providing a comprehensive range of services – fixed and mobile telephony, internet, data, and entertainment – through one of the largest and most modern networks in the world. Incorporated in 1924 and headquartered in Madrid, Spain, the 284,000 employee-strong enterprise has a dominant or leading position in much of the Spanish- and Portuguese-speaking world. Acquisitions and alliances have also given it a growing presence in Western Europe. As well, it has a 9.9% equity interest in China Unicom, a stake that it has been increasing incrementally over the last several years. Operations in Latin America start in Mexico and extend down through Central America, Colombia, Venezuela, Peru, Chile, Argentina, Uruguay, and, most important, Brazil. In 2010, Latin America accounted for 42.9% of aggregate revenues (40.5% in 2009), while Spain accounted for 30.8% (34.7%) and the rest of Europe 25.1% (23.9%); several minor businesses generated the remaining roughly one percent. Telefonica recently purchased Portugal Telecom’s 50% interest in their Brazilian joint venture, Brasilcel, giving it control of nationwide mobile operator Vivo. The company has a presence in some 25 countries and a customer base, measured in terms of total accesses, of 290.5 million. At the end of 2009, the comparable figure was 264.6 million. (Accesses include fixed telephony, narrowband and broadband internet and data, mobile, and pay tv.)

A History of Strong Growth

Revenues have increased steadily over the years, compounding at a roughly 10% annual rate in the past decade. Acquisitions have certainly been a factor, but so has organic growth, which has derived from the combination of technological advances and expanding prosperity around the world, which, in turn, is partially attributable to the dramatic improvement in telecommunications infrastructures in the emerging economies. Telefonica’s top-line advance has been relatively modest the past four years, however, as competitive pressures, economic downturns, and austerity measures in Spain and many other parts of Europe have partially offset the vitality in Latin America. In 2010, for example, revenues in Latin America increased 13.3% (to 26.0 billion euros), but contributions from Spain were down 5.0% (to 18.7 billion euros). Overall, revenues increased 7.1% (to 60.7 billion euros), with organic gains of 2.4% and exchange rates adding 2.2 percentage points. Growth in earnings per ADR, meantime, have outpaced revenues by a healthy margin, fueled by the benefits of operating leverage, cost-containment measures, and stock repurchases (about 12% since the end of 2004). Net income and per-ADR net increased 30.8% and 31.6% last year, respectively, to 10.2 billion and 2.25 euros. These figures are inflated by a 3.8 billion euro nonrecurring capital gain, though.

Revenues were up 10.8% in the first quarter of 2011, with almost 71% of the 15.4 billion euros coming from outside of Spain. Top-line contributions from Latin America increased 26%, helped in part by the consolidation of Brasilcel. Europe segment revenues rose 8.4%, also supported by acquisitions, but the Spanish operation continued to suffer from macroeconomic weakness, with revenues falling 5.6%. Net income contracted modestly, slipping 1.9% to 1.6 billion euros. Looking forward, we expect revenues to approximate 64.5 billion euros in 2011 and 66.0 billion euros in 2012. Earnings per ADR were 0.36 euros last quarter, essentially flat with the year-earlier tally. Profits should rise in the coming quarters, as recent acquisitions are better integrated and the operating overhead is reduced further, but the full-year total will undoubtedly fall moderately below the 2.25 euros earned in 2010, absent the capital gain that inflated last year’s results. We think the company will earn 1.85 to 1.90 euros per ADR in 2011 and about 2.05 in 2012. That said, overall underlying fundamentals remain positive, particularly in Latin America, and core earnings should continue to trend upward. Indeed, there remain ample growth opportunities in mobile broadband and fixed broadband access, given the proliferation of improved internet devices (smartphones and tablets), social networking, and shrinking handset prices, which also serve to reduce subsidy expenses for the service providers.

A Solid Balance Sheet

At the end of 2010, Telefonica carried a debt burden of 61.1 billion euros, including 9.7 billion in short-term debt, reflecting an aggressive dual-pronged (acquisitions and capital investments) growth strategy. Any concerns about financial leverage are mitigated by annual cash flow that should total at least 18 billion euros annually for the foreseeable future, however, plus an equity base of 31.7 billion euro that’s buttressed by broad diversification. Moreover, since the M&A program has been largely completed, management can focus on generating organic growth, improving margins, and strengthening the financial structure.

The Final word

Like most telecom stocks, Telefonica shares fell sharply in the early years of the last decade. They have performed well since bottoming in late 2002, though, providing both solid capital gains and above-average dividend income. Valuations, meantime, have fallen to historically low levels, as earnings growth outpaced the price advance. The price/earnings ratio is in the single digits, where it has been for most of the past three years. By contrast, the p/e averaged around 24.5 in the preceding 10 years, ranging from a low of around 12 to a high close to 50. Given both the size of the company and relative maturity of the telecom industry, earnings growth in the next decade is likely to be well below the rates achieved in the past decade. Therefore, a significant expansion in the multiple seems unlikely. Importantly, however, a falling valuation, dividend increases, and a weak dollar have pushed the dividend yield to historically high levels. Given the company’s huge cash flow, the payout is probably sustainable, strongly suggesting that TEF ADRs will be rewarding even without meaningful share-price appreciation.

In closing, we would reiterate the following risks: The telecommunications industry is highly competitive and Telefonica, with its presence in a large number of Latin American countries, is subject to myriad geopolitical uncertainties. The company's financial results are also subject to potentially large fluctuations in exchange rates, as are the dividends received by U.S. investors.