Beyond its size, which provides Telefonica with scale by spreading its fixed costs over a large number of subscribers, we like the company’s move into converged services, bundling fixed-line services with broadband, pay television, and wireless telephony. The company has been the leader in this movement, which positions it well to benefit from this momentum-building trend.
We believe Spain is the country furthest along in this transition, mainly driven by Telefonica. The company has also led the way in laying fibre in order to increase broadband speeds. Its fibre network in Spain now passes in excess of 15 million premises, which is significantly more than the 2017 objectives of its competitors, Vodafone and Orange , in the country. We believe Telefonica’s positioning in Spain sets it up for continued long-term growth.
Beyond Spain, we believe the acquisitions of E-Plus in Germany and GVT in Brazil strengthen Telefonica’s operations in those countries. In Germany, Telefonica is now the largest wireless operator by number of subscribers, and in Brazil, it has the ability to transport its converged strategy from Spain throughout the whole country. Both acquisitions also provide significant cost-cutting opportunities.
While we would like to see the company sell its U.K. operation in order to exit a more competitive market and reduce debt, this is still a good business. Market rival BT appears to be moving more slowly to convergence than we’d expected after its acquisition of EE, which provides more chances for O2, a Telefonica unit. We also believe the company has other options to reduce its debt, though none are as easy as selling this asset. In the rest of Latin America, outside of Mexico where America Movil dominates, Telefonica continues to perform strongly. It is well positioned, and we don’t see this changing.
Bigger Scale Means Better Profitability
Telefonica is one of the largest telephone operators in the world, with total fixed and wireless telephony, Internet, pay-TV, and wholesale accesses of 347.1 million. It dominates its home country of Spain with market shares of about 60% in fixed-line telephony, 44% in broadband, and 31% in wireless telephony. In many Latin American wireless markets, it is in a duopoly with America Movil; it has 186.6 million wireless customers in this region alone. The large market shares that the two operators control make it difficult for a new entrant to gain enough scale to compete profitably. Despite Spain’s weak economy and Telefonica’s reduced revenue there, its margins in the country, at around 41%, are among the highest in Europe. In addition, the company’s size allows it to get better pricing on handsets and equipment than smaller operators. Telefonica can operate at a lower cost than its competitors and take more profits to the bottom line, which we think provides the company with an economic moat. However, we are concerned about the sustainability of these advantages for 20 years and thus think the moat is narrow rather than wide.
We do think Telefonica has a positive moat trend. Europe is moving toward a converged market of wireless and fixed-line telephony, broadband, and pay television. Spain is the furthest along in this progression, and Telefonica is the leading player there. We expect convergence of wireless services to reduce churn, increase margins, and increase revenue over time. The company is also leading Brazil in this direction. It is already having success in selling quad-play packages in the state of Sao Paulo, where it owns the incumbent fixed-line operator as well as the largest wireless operator; with its acquisition of alternative telecom carrier GVT, it can offer a similar product across most of the rest of Brazil. It is also dealing with its weakness in the rest of Europe after acquiring E-Plus from KPN , which makes it the largest wireless operator in Germany and gives it the necessary scale to compete with Deutsche Telekom and Vodafone. To further focus on areas where it has a competitive advantage, Telefonica has sold its operations in the Czech Republic and Ireland. While EU regulators killed the company’s attempt to sell its U.K. operation to CK Hutchison, this business continues to perform well. Telefonica is now set for improving margins and returns on capital.
Currency and Competitions Are Risks
Latin American currencies are notoriously volatile. This was a major problem in 2001-02 and has been again recently. The company has virtually eliminated Venezuela’s revenue; it is now using an exchange rate of VEF 697 to EUR 1, compared with 6.3 a few years ago. Other currencies in Latin America dropped significantly during 2014 and 2015, with the most important being the Brazilian real, which fell 35% in 2015. Telefonica has also moved beyond its traditional Spanish- and Portuguese-speaking markets and in doing so has added further political and economic risks as well as increasing leverage on the balance sheet from acquisitions. The company has been on a buying spree and risks overpaying for additional acquisitions similar to Vivo or overleveraging its balance sheet.
Competition is increasing in all of Telefonica’s markets, which could impede the company’s ability to boost its margins. Unlike the majority of those in continental Europe, the cable TV industry in Spain has been competitive for years, offering high-speed Internet access and telephony. With Vodafone’s acquisition of Ono, the largest cable operator in Spain, and Orange’s purchase of Jazztel, an alternative carrier, competition in the country could increase even further. The current credit crisis is also hurting Telefonica’s performance and until recently had pushed up interest rates in Spain. With the EU regulators preventing Telefonica from selling its U.K. business, it is offering its dividend in scrip form to save money. If investors don’t voluntarily take up the scrip dividend and the company can’t reduce its debt, management might decide to reduce the dividend in the future.
Reducing debt remains a primary goal of Telefonica, which one of the most leveraged phone companies in Europe. In February, Telefonica announced that it had agreed to sell up to 40% of its tower business to KKR for EUR 1,275 million. We expect the company to use the proceeds from this sale and its free cash flow to reduce debt. It could make additional small acquisitions, but we don’t think it will make any more large ones until it has achieved significant debt reduction. Despite the large debt position, we think the amount is manageable for such a large company with relatively steady cash flows. Maturities are nicely staggered over many years, so no single year is a major concern for refinancing. However, Telefonica is more concerned about rollover risk than some other incumbent European telecom operators, given that its headquarters are in Spain and its debt rating faces pressure from the weakening Spanish sovereign credit ratings.