By Ben Strubel of Strubel Investment Management
For our dividend fund we follow the strategy pioneered by Tweedy Browne of buying companies with high dividend yields but low payout ratios. You can read Tweedy Browne’s investing studies here. Telefonica (TEF) is one company we own that fits the bill. TEF offers a current yield of approximately 6% and over the last five years has paid out only an average 41% of free cash flow as dividends.
Telefonica (TEF) is headquartered in Spain and is the fifth largest telecommunications company in the world with 278M accesses (or total connections) as of June 2010. The company has operations in Spain, Europe, and Latin America. Although the company is Spanish, 70% of sales are outside Spain. A detailed overview of Telefonica’s business and growth is shown in Appendix A.
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Many telecom companies in developed markets have taken on the persona of utilities with low growth and modest returns on capital for shareholders. This is logical, since telecoms provide a commodity service except perhaps for temporary exclusivity deals on certain handset models. Telecoms also bear the hallmark of the utility segment because they are usually subject to heavy government regulation as well (mostly regarding interconnection fees). While investors looking for growth might be turned off, those looking for income certainly aren’t as many telecoms have mid- to high-single-digit dividend yields.
A few of the large multinational telecoms stand above their peers because of their growth potential, superior management, and higher returns on capital. One of the standouts is Telefonica.
Almost every telecom company is plagued by declining Average Revenue per User (ARPU). ARPU is one of Wall Street’s favorite methods of analyzing telecoms, but it doesn’t tell the whole story. A better measure of health for telecom companies is Average Margin per User (AMPU) or how much profit the company is making per access. Furthermore, bottom line growth is derived from three parts: ARPU, total accesses, and service mix. Even if ARPU is declining, if total accesses are growing and margins are improving either through cost cutting, efficiency, or the sale of higher value services, then the underlying business can be quite healthy. So let’s look at how TEF fairs in each of these categories.
ARPU and AMPU
TEF’s Average Revenue per User (ARPU) has been declining by about 10% per year. There have been some Latin American countries where ARPU has actually increased. However, on the whole declining ARPU is inescapable.
But TEF’s Average Margin per User (AMPU)1 is increasing. In 2010 TEF had an AMPU of 42.44%, which was its highest in four years. Finally, TEF’s AMPU is well above industry averages and higher than all other major multinational telecoms except China Mobile and America Movil.
1We defined AMPU as the EBITDA/Revenue per average number of access over the period. Average number of access was computed by the simple average of the previous years ending total accesses and the current years ending total accesses.
Service Mix and Total Accesses
Telefonica has seen its total access steadily increase, including growth of 5.14% in the past year. TEF is also seeing a shift away from lower margin services like fixed landlines to higher margins services such as data and pay TV.
Fixed line (including fixed wireless) accesses have steadily declined over the past few years, including a decline of 5.53% this year. This decline, however, is more than offset by growth in all other service types. Mobile grew 7.4%, Internet & Data grew 3.53%, and Wholesale grew 19.3%. Also, high margin Pay TV accesses grew 9.77%.
Europe continues to show slow or nonexistent growth. This will likely continue for some time, since Europe as a whole faces many economic and demographic challenges. Slow growth in Europe, however, has more than been offset by scorching growth in Latin America. This includes double-digit growth in Ecuador (18.5%), Mexico (14.68%), and Brazil (10.24%). TEF has also seen high single-digit growth in the rest of Latin American except for Venezuela and Columbia, which have seen total accesses shrink.
So far so good, total access growth and improving AMPU have more than offset declines in ARPU.
Telefonica has strong management focused on efficiency and shareholder return. This is demonstrated by five-year median operating margins that are greater than all peer companies except China Mobile and America Movil.
Management’s relentless focus on shareholder returns also shows through on the high returns on capital that TEF has earned. Again, only China Mobile and America Movil bested TEF in median five-year Return on Invested Capital (ROIC).
While Telefonica pays out a large dividend, the company appears to be valued fairly based on other valuation metrics. Investors are paying a fair price for a good company.
The following table shows various valuation metrics for Telefonica and its peers.
*Forward P/E used for China Unicom and Verizon
(Source: Capital IQ)
While TEF appears cheap based on P/E, it is fairly valued based on more robust measures such as EV/EBITDA. The most attractive aspect of TEF is the dividend yield, which is approximately 6%. Furthermore, management has announced a €1.75 minimum dividend target for 2012, which equates to a yield of 10% at today’s share price and exchange rate.
Investors in TEF face two prominent risks (a declining euro and ARPU) and a potentially tricky tax situation.
Decline in Euro
Telefonica reports results in euros and pays the dividend in euros. A decline in the value of the euro or a strengthening dollar would have a negative impact for holders of Telefonica’s ADR shares.
Also, TEF must offset declining ARPU through increases in AMPU and subscriber growth. Although subscriber growth has been strong, especially in Latin American and margins have been improving, there is only so much growth and so much cost cutting that can be done. Almost all businesses, especially those providing commodity products such as Telefonica, must revert to median long-term growth rates. Paying too much for the hope of future growth hardly ever works out.
Finally, there are issues relating to the tax treatment of Telefonica’s dividend for ADR holders. There is a separate foreign tax withholding in Spain where Telefonica is based. In general, you can claim a deduction for the withholding tax except in certain tax advantaged accounts (such as IRAs). Before making any investment, however, you should consult a tax professional to determine what the implications may be for your personal tax situation.
Appendix A: Overview of Telefonica’s Operations and Growth
Disclosure: Long TEF, T