Today's Buy Opportunity: Telefonica

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Having grown weary of a flat decade in the stock market, investors have jumped back on the dividend bandwagon, clamoring for high yields in safe places. Telecom companies fit this mold nicely, as early investments in infrastructure tend to leave a company with tons of free cash flow, which ultimately ends up in the pockets of shareholders. Over the past year, domestic telecoms like Windstream (Nasdaq: WIN  ) and CenturyLink (NYSE: CTL  ) have held up really well; however, the sovereign debt crisis in Europe has brought down with it foreign telecoms, leaving them priced for perfection.

And there's one company in particular that's positioned nicely to profit from all the EU uncertainty, and that's my "11 O'Clock Stock" pick: Telefonica (NYSE: TEF  ) .

Telefonica fast facts

Market Capitalization

$106.6 billion

Revenue (TTM)

$73.10 billion

Earnings (TTM)

$9.90 billion

Dividend Yield

5.7%

Key Competitors

Vodafone (NYSE: VOD  ) , America Movil (NYSE: AMX  )

Sources: Capital IQ, a division of Standard & Poor's, and Yahoo! Finance. TTM is trailing 12 months.

Fierce competition
Telefonica is a diversified telecommunications provider that has operations in Spain, Western and Eastern Europe, and Latin America. In Europe, the company operates in an extremely competitive environment, where fixed-line telephony is on the decline and wireless penetration rates have reached peak levels. Several large companies, such as Vodafone, Telecom Italia (NYSE: TI  ) , and France Telecom (NYSE: FTE  ) are vying for subscribers in a shrinking pool of potential customers. South of the border Telefonica competes with America Movil, which is already the incumbent Mexican provider. Let's see how Telefonica stacks up against some of its peers:

 

Telefonica

Vodafone

France Telecom

America Movil

Market Cap

$106.6 billion

$126.02 billion

$56.9 billion

$103.0 billion

Forward P/E

9.0

9.8

10.2

12.9

Dividend Yield

5.7%

5.5%

7.7%

0.5%

EBITDA Margin (%)

37.70%

33.20%

35.70%

39.50%

Source: Capital IQ, a division of Standard & Poor's.EBITDA = earnings before interest, taxes, depreciation, and amortization.

Because Telefonica has such a strong presence in its home country of Spain and throughout Europe, it has one of the highest EBITDA margins around. It pays a solid dividend of 5.7% (which it increased six consecutive years) and is trading forward well below its five-year historical P/E of 14.22. Furthermore, out of all the European incumbents, Telefonica seems to have the most growth potential because of its presence and aggressive acquisition strategy in Latin America.

Not the bay of PIIGS!
It's been more than six months since the EU debacle started rippling through the credit markets, and still investors aren't exactly jumping over their chairs to scoop up shares from countries like Greece, Spain, or Italy. And that's one reason why Telefonica is down about 15% so far this year: As a Spanish company, it's been lumped in with the other debt-straddled countries just barely gasping for air. 

But Spain is only one small part of Telefonica, and that's what investors don't understand. The Spanish market accounts for 35% of revenues, while Europe accounts for 25% and Latin America comprises about 40%. Telefonica is the incumbent provider in more than five countries and holds the No. 2 or 3 positions in 10 separate countries. Check out the revenue growth in all three geographical segments since last year:

Source: Company presentations.

As you can see, the downward trend in Spain has already started to reverse course, and revenues in both Europe and Latin America have been on a steady rise so far in 2010. Since the beginning of the year, the company has been able to add 13.4 million subscribers, which is 2.4 times more than in the first half of 2009. Net adds in the second quarter were 4.7 million, which reflects not only an increased commercial effort, but also a decrease in the churn rate, which has dropped to 2.2%.

Another concern of telecom investors is that fixed telephony is declining, mobile penetration rates are high, and average revenue per user (ARPU) has been declining. This is definitely a legitimate threat, especially if companies can't continue to expand market share and add subscribers. Fortunately for Telefonica, the decrease it has seen in fixed telephone lines has been more than offset by growth in mobile, data, broadband, and pay-TV.

By the end of June 2010, Telefonica had seen year-over-year increases of 9.7% to its mobile accesses and 84.6% in mobile broadband accesses. Especially striking was the first half net adds in Latin America, which increased by 71.5%, due primarily to improving trends in places like Brazil, Colombia, Peru, Argentina, and Chile.

In addition, Telefonica recently achieved a pretty significant milestone as it managed to successfully reach an agreement with Portugal Telecom to buy its 50% stake in Brasilcel, the joint venture that holds a 60% stake in Brazil's mobile phone company, Vivo. The acquisition will make Telefonica the undisputed leader of the Brazilian mobile market, which has 150 million cellular users (fifth-most in the world).

The buy opportunity
As I mentioned earlier, Telefonica's stock, in my opinion, has been pummeled unjustifiably this year. Fears of a deep recession in Spain and decreasing opportunities for market expansion have caused investors to overlook several key points that make Telefonica a great purchase.

First, it's one of the most geographically diversified of all the European telecoms, and its recent agreement to purchase Brasilcel only strengthens its opportunities in Latin America. It consistently has the highest EBITDA margins in its European peer group, and its ability to generate gobs of free cash flow enables it to pay a solid dividend, one that it has committed to growing by at least 25% by 2012.

From a valuation standpoint, Telefonica also seems to be very attractive. Using a discounted cash flow model, I assumed very moderate growth, slowly declining margins, and a 12% discount rate; my estimated fair value is in the range of $82-$86. Currently priced at $70, this represents a solid 20% margin of safety. Coupled with a dependable yield, seasoned management, and an ability to increase both the top and bottom line, Telefonica may be the best foreign telecom play there is.

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"11 O'Clock Stock" is sponsored by Motley Fool Stock Advisor. The Motley Fool will wait at least 24 hours after this publication before purchasing shares of Telefonica. To see an FAQ on "11 O'Clock Stock," click here.

Jordan DiPietro owns shares of Telefonica. America Movil is a Motley Fool Global Gains recommendation. France Telecom is a Motley Fool Income Investor selection. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (46)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 09, 2010, at 11:12 AM, MarketBob wrote:

    Jordan, thank you for your article. Seems like you know your way in the telecom market (see your other article, 7 High-Flying Telecoms).

    Would it be possible to do a follow-up with some of the more 'obscure' but high-yielding stocks, mentioned by Jfarina1976 (see top 250 on http://www.dividend.co.nr )?

    Best,

    Bob

  • Report this Comment On August 09, 2010, at 11:23 AM, TMFPhillyDot wrote:

    If anyone has any questions about Telefonica, I'd be happy to answer them.

    Thanks for reading!

    Foolishly,

    Jordan (TMFPhillyDot)

  • Report this Comment On August 09, 2010, at 11:26 AM, TMFPhillyDot wrote:

    @MarketBob,

    It would definitely be possible to research some of the more obscure telecoms. Why don't you let me know specifically which one's you are interested in.

    Thanks!

    Jordan

  • Report this Comment On August 09, 2010, at 4:46 PM, TMFMMTInvestor wrote:

    Jordan,

    Check out the very end of the 11 o'clock stock video on the homepage. Hilarious. Was that an intentional mini blooper reel?

    Scott

  • Report this Comment On August 09, 2010, at 4:50 PM, TMFPhillyDot wrote:

    @sjf2005,

    Lol. Yes, it was intentional to leave it in there, but the blooper was definitely not intentional! We thought it would be funny to show the behind-the-scenes footage at the end!

    Thanks!

    Jordan (TMFPhillyDot)

  • Report this Comment On August 09, 2010, at 7:22 PM, goldengirl2362 wrote:

    Hi Jordan,

    Is there a tax withholding on US bound dividends?

    Thank you ,

    Linda

  • Report this Comment On August 10, 2010, at 8:19 AM, energysystems wrote:

    Linda,

    Spain has a 19% dividend withholding tax as of 01-01-2010.

  • Report this Comment On August 10, 2010, at 8:43 AM, rockbox64 wrote:

    Telefonica is a great buy it has committed to boost it already high dividend and is also, after the Vivo acquisition, can certainly also be considered a growth stock, which a lot of the local high yielding telecoms aren't. AND its already beaten down. It almost seems to good to be true. And we all know about opportunities that seem to good to be true. I own TEF in my SEP because I wanted telecom exposure and foreign exposure. I bought it for the above reasons and diversification purposes also. Its also one of my only 7 CAPS picks. Good luck all!

  • Report this Comment On August 10, 2010, at 9:32 AM, DRovito wrote:

    Hello Jordan. I'm interested in TEF, as I've witnessed the proliferation of its brand and expansion of its operations over the last twenty plus years. But I have a few questions. First, will the acquisition of Vivo from PT cause share dilution? Second, when you mention the 5.7% DIV, due toi the Spanish withholding tax, the NET DIV proceeds will be closer to 4.6 %, while Vodafone's 5.5% DIV would be exempt from any withholding, correct? Finally, is TEF planning an incursion into the US market or other markets? I look forward to hearing fro-m you. Thanks for your time.

  • Report this Comment On August 10, 2010, at 10:39 AM, TMFPhillyDot wrote:

    DRovito,

    Thanks for the interest in TEF.

    1) I do not believe that the acquisition of Vivo from PT will cause any share dilution. To read the press release from TEF, check out their website: http://www.telefonica.com/en/shareholders_investors/html/not...

    2) Off hand, I am not positive about VOD's dividend policy, but you are correct that TEF's dividend is decreased by Spain's withholding tax, which is 19%. However, per their annual report, if you provide U.S. residency documents, you are only subject to a 15% tax.

    3) As far as I know, I don't think they have any plans to venture into the U.S. markets. They are trying aggressively to attack the low-end of the German market in addition to grabbing more market share in Eastern Europe.

    Thanks!

    Foolishly,

    Jordan (TMFPhillyDot)

  • Report this Comment On August 17, 2010, at 9:33 AM, wolfhounds wrote:

    I have a small comment on the dividend yield for U.S. taxpayers. Any foreign tax withheld is eligible for the Foreign Tax Credit making the yield whole. If you are reinvesting, however, only the net distribution is reinvested.

    Good article.

  • Report this Comment On August 18, 2010, at 7:48 AM, bigkansasfool wrote:

    I'm not a big fan of purchasing a telephone company that is in fierce competition. In fact, I think that's crazy. If I want a foreign telephone company I think I'd go with mexican TMX. I realize that land lines are decreasing, but I still prefer a monopoly with a moat over a hugely competitive market.

  • Report this Comment On September 15, 2011, at 7:40 PM, joaquingrech wrote:

    As a spaniard, who has own telefonica for a long time, I can tell you one thing... not as good business as it seems.

    I think they are cheap now, but they cut recently DSL prices by half, which will give a nice haircut to the earnings.

    In latin america, the situation is similar. Competition is fierce on telecoms. Just check the graph for TEF, you'll see not much movement for a couple of years... similar to MSFT.

    It does have a nice dividend though.

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