Telefonica Downgraded

Telefonica Downgraded

Telefonica Downgraded

We are downgrading our recommendation to Underperform from Neutral for Telefonica (TEF), the largest telecom carrier in Spain and Latin America. Currently the stock has Zacks #5 (Strong Sell) Rank. We think Telefonica's fight with Portugal Telecom (PT) for the full control of its Brazilian wireless joint venture, Vivo Participacoes (VIV) may push the share price downward.

Portugal Telecom's board and shareholders refused the Telefonica bid to buy the remaining control (50%) of Vivo, with support from the Portuguese government. According to the government, Vivo is crucial to the growth prospects and development of Portugal Telecom. Exclusive control of Vivo will enable Telefonica to merge the entity with its Brazilian fixed-line voice and broadband unit Telesp (TSP), which is struggling to perform. This will make the combined entity a full-service operator offering competitive bundled (fixed-line and wireless) services.

While Telefonica continues to lead the Brazilian wireless market, the carrier is exposed to increased competition. France-based media company Vivendi SA, which has purchased the controlling stake in the Brazilian telecom operator GVT Holding, poses as an emerging threat. Moreover, Telefonica's biggest rival in Latin America, America Movil (AMX) is reportedly integrating its Brazilian wireless and wireline assets. By combining Vivo with its Brazilian fixed-line business, Telefonica would be in a stronger position to compete with America Movil.

Telefonica is being forced to reduce mobile and broadband internet rates due to increased competition in the domestic market with other operators gaining traction, impeding average revenue per user and top-line sales retention. Moreover, the company's Spanish revenue continues to be impacted by the reduction in mobile termination rates and a soft economy. The company's Spanish revenues declined 5.7% year over year in the most recent quarter.

We also remain cautious about the company's expansion activities as many back-to-back acquisitions give rise to integration risks. The company's highly leveraged balance sheet (debt to equity ratio of 2.4 at the end of the most recent quarter) also remains a cause for concern. Telefonica continues to operate with a high debt level and a net debt position that increased 4% sequentially to 45.3 billion (US$62.9 billion) as of the end of the first quarter.

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