Telefonica Remains Neutral

We are maintaining our long-term Neutral recommendation on Spanish telecom giant Telefonica (TEF - Analyst Report). For the short term (1–3 months), the stock retains a Hold rating with a Zacks #3 Rank.

We believe continued investments in the expansion of broadband services (both fixed and wireless) are expected to offset some of the difficulties emerging from the depressed domestic market.

The weak Spanish market has resulted in customers switching to cheaper offers from Telefonica’s competitors. The economic downturn in Spain has lasted longer than expected, taking a toll on 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 through 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 and regulatory involvement might limit the upside potential of the stock.

On the positive, Telefonica continues to sustain its top-line performance in 2011, as the momentum in Latin America and Europe is compensating for 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 for Telefonica, especially Brazil.

Brazil is expected to become the major source of revenue following the integration of the fixed and mobile businesses. The consolidation of two Brazilian units Vivo Participacoes and Telecomunicacoes de Sao Paulo SA (VIV - Analyst Report) would generate synergies of €3.7–4.6 billion, up from the previous expectation of €3.3–4.2 billion.

Telefonica Europe is gaining market share from increasing smartphone penetration and data growth. The company continues to prepare the ground work for future growth by improving network capability to support mobile data services.

In the first half of the year, stiff competition in the company’s domestic market and increased operating expenses led to lower net income compared with the year-ago period. However, revenue improved on account of double-digit growth in Latin America and Europe, which partially countered the weak operations in Spain.

Read the full analyst report on TEF

Read the full analyst report on VIV