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On Jan 8, 2014 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 the 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 #3 (Hold).

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 continuous launch of high speed data services will aid the company in satisfying data-hungry customers. The company wants to further monetize data by leveraging from its LTE network.

Initiatives like removal of handset subsidies and network sharing agreement will lead to handset subsidies. 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.

Telefonica continues to lead the Brazilian market by expanding its LTE network and fixed broadband services. The company is focused on adding high value customers, thus improving its ARPU prospect. 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. Telefonica is also increasing its foothold in other regions of Latin America and planning to share its network with various Mobile Virtual Network Operators (MVNOs) in Mexico.

However, Spain remains a troubled market for Telefonica and despite its gradual recovery, the lingering effects of the Euro-zone crisis continue 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. Further, weakening of Latin American currencies, particularly Brazilian real, remains a near-term concern for Telefonica.

Other Stocks

Among other stocks, Hawaiian Telcom Holdco Inc. (HCOM - Snapshot Report), Level 3 Communications Inc. (LVLT - Snapshot Report) and BT Group Plc. (BT - Snapshot Report) are better placed. HCOM and LVLT hold a Zacks Rank #1 (Strong Buy), while BT carries a Zacks Rank #2 (Buy).

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