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Morningstar | Telefonica Generates Solid Organic Revenue Growth, Hurt by Foreign Exchange; Shares Undervalued

In the first quarter, Telefonica once again reported solid organic revenue growth (+3.8%), but saw this gain negated by currency movements. Thus, reported revenue declined 1.7% year over year. The culprits were primarily the Brazilian real, and the Argentine peso. Our full-year revenue growth projection of 0.7% assumed weaker currencies, but not this much. However, we don’t expect any significant changes to our EUR 13 per local share fair value estimate. Our narrow moat rating remains intact, and we believe the shares are significantly undervalued.

In its home country of Spain, revenue grew 0.3% as success in selling converged services more than offset declines in single service products. The firm’s convergent customer base grew 4% to 4.6 million and now includes 92% of its TV base, 89% of its broadband base, and 84% of its consumer wireless contract base. Additionally, average revenue per user improved 0.6% to EUR 88.20. We expect convergence will increasingly drive Telefonica’s revenue growth as it reduces future incentives.

Telefonica performed particularly well in the U.K. where revenue grew 5.3%. Including wholesale customers, the firm’s wireless subscriber base gained 2% to 32.7 million. However, the majority of the revenue increase was driven by an 18.7% jump in handset sales that carry low margins. Thus, its EBITDA margin in the country actually declined 0.5%. While we are pleased with the top-line increase in the U.K., we would like to see less emphasis on handsets to generate growth. (For information on Telefonica’s German and Brazilian subsidiaries, please see our notes on Telefonica Deutschland, and Telefonica Brasil dated 5-9-19.)

The weak U.K. EBITDA margin flowed through to the whole company, which generated an EBITDA margin of 31.1%, excluding leases, versus our full-year projection of 32.5%. However, the first and fourth quarters historically produce lower margins, so we anticipate better results in the next two quarters.

In the hispam sur region, Telefonica grew revenue 15.2% in local currency, but it dropped 12.1% in euros. This was primarily from Argentina that saw 40% revenue growth in pesos, but a 28% decline in euros. Argentina had shown signs of stabilising at the end of 2018 but was hit by a fresh round of devaluation in the quarter. In most of the region, Telefonica suffered small wireless and broadband subscriber losses, which led to revenue declines of 2.9% and 1.7% in Chile and Peru, respectively, in local currency terms.

In the hispam norte region revenue grew 1.2% as Mexico’s revenue improved for the first time in five quarters and the recovery in Colombia continued. We expect this region to outperform the south for the rest of this year.