Telefonica to Exit Chinese Assets

Spanish telecom giant Telefonica S. A. (TEF - Analyst Report) plans to sell almost half (4.56%) of its stake in China's second largest mobile operator China Unicom (CHU - Analyst Report).

Telefonica will sell 1.1 billion shares for a total of €1.13 billion ($1.4 billion). The transaction, awaiting approval from antitrust regulators, is expected to complete by the end of next month. Following the sale, the company will retain a 5.01% stake in China Unicom.

The divestiture is a part of the company’s efforts to increase its financial flexibility. Telefonica operates with a high debt level of €57.1 billion as of March 2012 versus €56.3 billion at the end of 2011 and €55.6 billion at the end of 2010. In addition, the company was compelled to plan such a move after Standard and Poor downgraded its credit rating last month. The company is also facing the threat of a Moody’s downgrade if its debt position does not recover.

According to a Bloomberg report, Telefonica’s market share has plunged about €50 billion over the last 18 months. Telefonica is underperforming in its home market and woes are getting deeper with the unresolved Euro-zone crisis. Additionally, Telefonica is exposed to increased churn rates (customer switch) and lower Spanish revenue due to the ongoing reduction in MTRs, which is the fee that operators charge each other to connect calls.

Further, 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) added to its concerns.

Apart from divesting its Chinese assets, Telefonica is taking various efforts to reduce its debt. Late last month, the company announced its intention to sell its stake in its German unit, O2 Germany, through public share offerings, for €9 billion. Additionally, the company is looking to sell some assets in Latin America through public offerings. Latin American operations include the two largest markets Mexico and Brazil, which are healthy contributors to the company’s revenue and earnings.

Besides, Telefonica is restructuring its Colombian business and announced the sale of a 13.23% stake in satellite operator Hispasat SA in February this year.

We believe this asset-light model would strengthen the company’s balance sheet by trimming its debt. These would lead to a €1.5 billion debt reduction this year, which will be 2.35 times of OIBDA compared with 2.63 times at the end of 2011. Such actions will also help in winning back investor confidence and would uplift shareholder returns in the future.

We are maintaining our long-term Neutral rating on Telefonica. But for the short term (1–3 months), the stock retains a Zacks #4 (Sell) Rank.