2nd UPDATE: Telefonica Net Profit Falls As Margins Drop

Telefonica SA (TEF) posted Friday a 1.9% decline in first-quarter net profit, missing analysts' expectations because of lower margins and surging operating expenses, in a sign that troubles in its Spanish home market remain a headache for the company.

Spain is still Telefonica's largest single market by revenue, so the company was hit hard by continued tough economic conditions in the country. Madrid-based Telefonica, Europe's second-largest telecommunications company by market value after U.K.-based Vodafone Group PLC (VOD.LN), said revenue rose 11% to EUR15.44 billion, slightly below expectations, with sales in Spain down 5.6%.

This was offset by a 26% jump in revenue from Telefonica's Latin American division, although that result was flattered by the full consolidation of Brazilian mobile-phone provider Vivo Participacoes SA (VIV, VIVO4.BR), which it took over last year in a complex deal with former partner Portugal Telecom (PT).

Net profit fell to EUR1.62 billion from EUR1.66 billion in the same period last year, below expectations of EUR1.72 billion. Operating expenses rose 13% to EUR10.18 billion, with personnel expenses also up 13%.

First-quarter operating income before depreciation and amortization increased 9% to EUR5.57 billion. Telefonica's Oibda margin, its most closely watched performance measure, fell to 36.1% from 36.7%.

"The Latin American and European operations continue to perform well, but Spain shows no signs of recovery yet," Investec Securities analysts said in a note to investors.

Following the results, Investec lowered its target price for Telefonica shares to EUR17 from EUR18.96, noting that they may be traded at some discount to fair value due to Spain's economic problems. Earlier Friday, Spain posted 0.3% quarterly economic growth in the first quarter, well below the euro zone's 0.8% average, evidence that domestic demand, which was formerly the main growth engine, remains subdued after the country's 2008 property crash.

"We suspect the Spanish issues and macro crisis across Euroland will continue to weigh on this one for a bit longer," Investec added. It also reiterated its Telefonica rating at hold.

At 1007 GMT, Telefonica shares traded down 0.5% at EUR16.89, in line with the wider Spanish market. They have been one of the worst performers in the blue-chip IBEX-35 index since January, rising 4% compared with a 5.9% rise in the index.

This is partly a consequence of Telefonica's poor results for the fourth quarter last year, which also showed higher expenses and margins under pressure.

Looking to improve profitability, Telefonica has already said it may cut its Spanish staff by 20% in coming years--a measure that has been roundly criticized by local politicians, as the country faces its highest unemployment rate since the mid-1990s, at just over 21%.

-By David Roman, Dow Jones Newswires; +34 91 395 8127; david.roman@dowjones.com

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