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Morningstar | Currency Weakness Hit Telefonica Hard in 2018; Shares Significantly Undervalued

Currency movements hurt Telefonica’s 2018 results more than we had anticipated, but current exchange rates remain near those we had already assumed for 2019. Thus, we don’t anticipate significant changes to our 2019 expectations or our EUR 13 per local share fair value estimate. Reported revenue fell 6% year over year, versus our expectation of a decline of 3%. However, revenue grew 2% on an organic basis. While organic revenue guidance for 2019 is for 2% growth, we are modeling a reported decline of 4% due to recent currency declines. Our narrow moat rating remains intact, and we believe the shares are significantly undervalued.

In its home country of Spain, Telefonica continues to improve its convergent position. Its convergent base grew 4% year over year to 4.6 million and now accounts for 91% of its pay TV customers, 88% of its broadband subscribers, and 84% of its wireless contract customers. In total, those converged customers subscribe to 22.2 million accesses and generated an average revenue per user, or ARPU, of EUR 88.2 ($98.2) per month, an increase of 2.5% from a year ago. Telefonica recently launched its O2 brand in Spain as a lower-price offering, which we expect will help motivate more of its prepaid customers to move to a converged package. This transition and recent price increases should drive higher ARPU and revenue in 2019 and beyond.

The firm’s operations in the U.K. had a strong fourth quarter, with reported revenue growing 6.7%, benefiting from currency movements in the quarter, but reported revenue for the year only gained 3.8%, as it was hurt by currencies. Growth was driven by 2% wireless subscriber growth, including wholesale accounts, to 32.6 million. Additionally, handset and other revenue jumped 14.3%, though this tends to be volatile. That said, we expect Telefonica to grow its U.K. subscriber base and revenue in pounds. For results in Germany and Brazil, please see our notes on Telefonica Germany and Telefonica Brasil, respectively.

The big currency hits were in Brazil and Argentina. In Brazil, organic revenue growth was 0.3% for the year, but moved to a reported decline of 15.8% after the currency hit. Argentina was even worse, with organic revenue growth of 26.2% plummeting to a reported drop of 33.8%. However, both the Brazilian real and the Argentine peso have shown some stability recently. Thus, drops of that extent shouldn’t continue in 2019. In the Hispam Sur segment, revenue grew 9.6% organically, but due to Argentina fell a reported 18.8%. From a subscriber basis, wireless customers declined 1% to 13.7 million as prepaid customer losses more than offset postpaid subscriber gains. We anticipate continued organic revenue growth in 2019, but reductions in reported terms.

The Hispam Norte section reported much smaller currency hits, but weaker underlying results as well. Organic revenue declined 1.2% year over year but fell 5.9% in reported terms. However, the more interesting issue with this division is the ongoing divestitures. Telefonica agreed on Feb. 20 to sell its operations in Panama, Costa Rica, and Nicaragua to Millicom, while it agreed last month to sell its operations in Guatemala and El Salvador to America Movil. It is also rumored to be looking to sell its operation in Mexico. The fact that Telefonica wrote off all of its Mexican goodwill in the quarter, we believe provides credence to the rumor. These deals will increase Telefonica’s focus and free up some cash for further debt reduction. We would be particularly happy to see Mexico sold, as the business has struggled to generate much cash flow despite having 27 million customer accesses. We think the value of the Millicom deal at 6.9 times EBITDA also highlights the value of Telefonica’s stock, which is underappreciated by the market.

Finally, Telefonica reported an adjusted EBITDA margin of 32.0% for the year. While this was below our projection of 32.7%, it was a solid improvement over the 31.1% of 2017. We expect there is room for additional margin expansion.