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On Oct 8, 2013 we maintained our Neutral recommendation on Spanish telecom giant Telefonica (TEF - Analyst Report). Over the long term, we expect the company to benefit from its strategic measures in the European markets and continuous expansion of LTE network in Latin American markets. However, effects of reduction in mobile termination rates, increased commercial expenses, heavy network investments and a highly leveraged balance sheet could damage the company’s prospect. The company currently carries a Zacks Rank #2 (Buy).

Why Maintained?

We expect Telefonica to deliver strong revenues and profits from increased commercial activity, faster adoption of smartphones, expansion of mobile broadband services and cost-cutting initiatives.

Telefonica Europe continues to gain market share from increasing smartphone penetration and data growth. Affordable tariffs along with contiguous launch of high speed data services will aid the company to satisfy the data hungry customers. Additionally, affordable tariffs along with contiguous launch of high speed data services will aid the company to satisfy the data hungry customers. Movistar’s Fusion, which is an integrated telecommunication product, continues to gain market traction and remains one of the main growth drivers for the telecom behemoth.

Latin America, in particular Brazil, remains one of the best performing regions for Telefonica. The company expects to lead the Brazilian market by expanding its LTE network and fixed broadband services. In addition, it is also in the process of launching a network virtualization test. Telefonica has taken several growth initiatives to grab the opportunities in the digital world. The company has formed several collaborations to enhance its digital presence.

Spain remains a troubled market for Telefonica and despite its gradual recovery the lingering effects of the Euro-zone crisis continues to affect its performance. Implementation of MTR (mobile termination rate) in Mexico will affect the company’s revenues in the Latin American country while LTE deployment and enhancement of distribution channel will thwart its balance sheet position.

Despite continuous offloading of its non-core assets and debt cuts, Telefonica has one of the highest debt levels within the industry. A highly leveraged balance sheet weakens the company’s earnings growth prospect.

Other Stocks

Among other stocks, TIM Participacoes S.A. (TSU - Snapshot Report), Portugal Telecom SGPS S.A. and BT Group Plc. (BT - Snapshot Report) look attractive. TSU holds a Zacks Rank #1 (Strong Buy), while PT and BT carry a Zacks Rank #2.

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