Spain's largest mobile network provider, Telefonica (NYSE: TEF ) , has fallen on hard times. Low-cost competition and a brutal local economy conspired to destroy the company's earnings power:
TEF EPS Diluted TTM data by YCharts
So in an effort to conserve resources, Telefonica zeroed out its double-digit dividend yield overnight. That move was not popular with Telefonica's shareholders, who had come to view that stellar dividend as an income-producing personal piggy bank. But this little piggy went to market and won't be back until the back half of 2013.
So the telecom's cash flows don't have to support a dividend policy that cost $3.7 billion in fiscal 2012. This gives Telefonica a chance to pay off some of its stunning $72 billion in long-term debt. High debt levels are nothing new for companies in the capital-intensive telecom industry -- next-door neighbor France Telecom (NYSE: FTE ) owes $42 billion, for example, and our own Verizon (NYSE: VZ ) is in the same ballpark -- but Telefonica's borrowing habits take it to the next level.
This one goes to 11!
Let's put Telefonica's debt load into perspective.
Verizon's total debt matches up against 57% of the company's equity, showing how Big Red's loan-fueled capital investments have resulted in tangible assets. British rival Vodafone (Nasdaq: VOD ) buckles a bit less under its loan papers, with a debt-to-equity ratio of just 44%. France Telecom is worse off, with more loans than assets, but Telefonica blows them all away: The debt load is 160% larger than the total shareholder equity.
So Telefonica came up with a plan to unlock some hidden equity and ease the debt burden a bit further: Let's sell stock in some of our international operations!
The first such partial spinoff is Telefonica Germany, which runs services in Germany under the O2 brand.
The unit collected $6.5 billion in 2011 revenue, with a strong 22.8% OIBDA profit margin (operating income before depreciation and amortization, a variant of EBITDA, or a rough approximation of cash flows). So Telefonica is hardly getting rid of a cash-burning loser. According to the IPO prospectus, the company "aims to increase the profile and market awareness of one of its most attractive assets."
The sale is expected to move some $1.6 billion of investor money into Telefonica's tumbleweed-haunted coffers. The company will sell about 260 million shares on the Frankfurt market, keeping 77% of the German unit's shares to itself. This is a common way of managing spinoff operations, because it offers the best of both worlds: Telefonica still controls the newly created market entity and hopes to make more money on follow-on share sales if the stock gains in value.
Moreover, the German operation is sitting on enough tax credits (related to mobile radio license purchases more than a decade old) to run tax-free for about three years. That's a very compelling reason to lead off Telefonica's deleveraging efforts with an IPO in this particular market.
Looking ahead, Telefonica has hinted at similar share-based sales in other markets, chiefly in Latin America.
That market as a whole has grown to about half of Telefonica's total sales and profits. Latin America remains a key growth driver for the company, led by strong smartphone sales in the region under the Vivo and Movistar brands. Smartphone users under Telefonica Brazil are tripling year over year right now. The Brazilian division sports 76 million mobile customers and about triple the revenue of that German unit, and OIBDA margins stand at a fantastic 36%.
If Telefonica truly wants to monetize its "finest assets," the Brazilian market would be a great place to start. If the German sale is worth $1.6 billion up front, a 25% sale of Telefonica Brazil at similar price-to-sales levels should bring in nearly $5 billion. And as I said, this market offers more growth and fatter margins than Germany and should be worth more to investors.
It'll take several IPOs of the German magnitude to really make a dent in Telefonica's massive loan balances, but you gotta start somewhere.
Is it time to take action yet?
I like the two-pronged debt-reduction plan. A series of partial spinoffs will unlock value in a very direct way, and Telefonica may very well be worth more than the sum of its parts.
The stock looked cheap even while dividend yields hovered in double-digit territory, and it got even cheaper when the payouts were slashed. Remember that the debt-reduction plan is aimed at bringing those payouts back next year, and then factor in the idea that the smartest investors buy while others are panicking, and it's hard not to see a compelling value in this stock.
TEF P/E Ratio TTM data by YCharts
Patient investors may want to wait until Telefonica's management commits to a couple of juicy mini-IPOs, or at least until Oct. 30, when we can gauge the German market's reception of Telefonica's first baby. I started a bullish CAPScall on Telefonica this summer, and it's beating the market so far. But I think Telefonica's best days lie ahead, and I expect great things from this pick over the next few years.
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