Telefonica in Neutral Lane

We are maintaining our long-term Neutral rating on Spanish telecom giant Telefonica (TEF - Analyst Report) following fiscal 2011 earnings results. Telefonica outperformed its peers in 2011, with industry leading profitability, improving margins and increasing returns to its shareholders.

Moving through this year, Telefonica’s main purpose is to enhance the overall revenue with continued focus on fixed and mobile broadband growth as well as strong commercial activity across all markets. The increased adoption of mobile broadband in its high-end smartphones -- especially Apple Inc.’s (AAPL - Analyst Report) iPhone -- is driving market share improvement amid stringent regulatory conditions. The company expects revenue to grow 1% to 4% and predicts its operating margin to remain above the mid point of the 30–40% range annually through 2013.

In addition, Telefonica is restructuring its Colombian business as well as assessing its business to divest non-core or underperforming assets. The company recently announced the sale of its 13.23% stake in satellite operator Hispasat SA. These actions will win back investor confidence and would uplift shareholder returns in the future. Further, Telefonica intends to bring down its debt by at least €1.5 billion this year, which will be equal to 2.35 times of OIBDA compared with 2.63 times at the end of 2011.

Though the company’s 2011 earnings outpaced the Zacks Consensus Estimate, it fell on a year-over-year basis, mainly due to weak Spanish operations and higher operating costs. Spain is not working in favor of Telefonica.

The company is exposed to increased churn rates (customer switch) and lower Spanish revenue due to the ongoing reduction in mobile termination rates(MTRs), which is the fee that operators charge each other to connect calls. Further, the economic downturn in that country has been more than expected and is likely to drag the company’s profits and liquidity.

Moreover, Telefonicaremains challenged by the slowdown in Brazil and growing competition from France Telecom S.A. (FTE - Analyst Report), Vodafone Group Plc (VOD - Analyst Report), China Mobile Ltd. (CHL - Snapshot Report) and America Movil S.A.B. de C.V. (AMX - Analyst Report).

For the short term (1–3 months), the stock retains a Hold rating with a Zacks #3 Rank.