CHU China Unicom Ltd

Challenged by the weak domestic economy, Spanish telecom giant Telefonica SA (TEF) intends to sell its underperforming assets. The company believes that the divestiture will reduce its debts and win back investor confidence.

During the first nine months of the year, Telefonica generated lackluster revenue in its Spanish division that deteriorated 7% from the year-ago period. Domestic customers are switching to cheaper offers from smaller rivals, resulting in lower revenues and earnings. In addition, the company’s Spanish revenue continues to be affected by the ongoing reduction in mobile termination rates (MTRs), which is the fee that operators charge each other to connect calls.

In Spain, Telefonica is laying off 6,500 employees over the three-year (2011–2013) period to improve its domestic profitability. Additionally, the company is assessing its business to divest non-core assets. The sale will exclude Telefonica’s operations in Germany, Mexico and the Czech Republic, or its 9.7% stake in China Unicom (Hong Kong) Ltd. (CHU).

The asset-light model is expected to strengthen the company’s balance sheet by trimming its debt. Telefonica intends to lower its debt to 2–2.5 times of operating income before depreciation and amortization (OIBDA). As of September, the total debt was €55.4 billion, substantially lower than €55.6 billion at the end of 2010 but higher than €43.6 million at the end of 2009.                                                                                          

Coming to investors’ confidence, we believe the debt reduction might uplift shareholder returns in the future. The company is paying a dividend of €1.60 per share this year and is committed to hiking this to €1.75 in 2012. Telefonica also plans to distribute at least the same level of dividend in the years ahead.

On the other hand, Telefonica Europe is gaining market share from increasing smartphone penetration and data growth. With the launch of 4G Long-Term Evolution (LTE) services in rural Germany, the company is working out deployments in urban areas. Latin America remains one of the best performing regions for Telefonica, particularly Brazil and Mexico. Notably, Brazil is undergoing a slowdown while Mexico is generating lower profits due to MTRs cut.

Going forward, Brazil is expected to become the major source of revenue following the integration of the fixed and mobile businesses. The consolidation of two Brazilian units would generate synergies of €3.7–4.6 billion, up from the previous expectation of €3.3–4.2 billion. With respect to Mexico, Telefonica is gaining market share and expanding its mobile broadband on the back of spectrum wins in 2010.

With assets sales and debt cuts, the company expects revenue to grow 1% to 4% annually through 2013. Telefonica also expects operating margin to decline slightly over a three-year period from 38% in 2010, but remain above the mid point of the 30%–40% range.

We are maintaining our long-term Neutral recommendation on Telefonica. For the short term (1–3 months), the stock retains a Hold rating with a Zacks #3 Rank.

 
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