Telefonica Lowered to Neutral

We are downgrading our long-term recommendation on Spanish telecom giant Telefonica (TEF - Analyst Report) to Neutral from Outperform due to difficulties emerging from the depressed domestic market. For the short term (1–3 months), the stock retains a Sell rating with the Zacks #4 Rank.

The weak Spanish market has ended up with customers switching to cheaper offers from Telefonica’s competitors. The economic downturn in that country has been longer than expected and is likely to drag the company’s profits and liquidity.

In addition, the company’s Spanish revenue continues to be affected by the ongoing reduction in mobile termination rates, which is the fee that operators charge each other to connect calls.

Telefonica expects its operating margin to decline slightly over the three-year period (2010-2013) from 38% earned in 2010, but to remain above the mid point of the 30–40% range. Further, the company’s highly leveraged balance sheet, increasing competition (especially in Brazil and UK) and regulatory involvement might limit the upside potential of the stock.

On the other hand, Telefonica continues to sustain its top-line performance in 2011, as the momentum at Latin America and Europe is compensating revenue declines in Spain. Thus, Telefonica is confident that annual revenue will grow at least 1% to 4% through 2013. Latin America remains one of the best performing regions and the principal growth market for Telefonica.

In the recently concluded first quarter, stiff competition in the company’s home market and increased operating expenses led to lower net income compared with the year-ago quarter. However, revenue improved on account of double-digits growth at Latin America and Europe, which partially offset weak operations in Spain.

We believe Telefonica’s strong performance in Latin America, particularly Brazil, increased adoption of mobile broadband and continued investments in the expansion of broadband services (both fixed and wireless) are expected to fuel revenue and earnings going forward.

Telefonica is particularly well positioned in Brazil and Mexico, and is actively gaining market share from its dominant competitor, America Movil (AMX - Analyst Report). Additionally, the integration of  Vivo Participacoes (VIV - Analyst Report) enables Telefonica to offer full competitive bundled services and strengthens its competitive position relative to its rivals.

Further, we are impressed with the company’s healthy balance sheet as well as commitment to generate strong annual revenue and deliver increased shareholder returns. The company reiterated its commitment to pay €1.75 per share as dividends in 2012. Telefonica also plans to distribute at least the same level of dividend in the years ahead.

Given the pros and cons, we prefer to move to the sidelines for now.

Read the full analyst report on TEF

Read the full analyst report on AMX

Read the full analyst report on VIV