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Morningstar | Telefonica Reports Solid Underlying Results; Overwhelmed by Foreign Exchange; Shares Undervalued

Telefonica reported solid organic third-quarter results that were overwhelmed by negative currency movements. However, we expect to maintain our EUR 13 per local share fair value estimate and narrow-moat rating. We believe the shares are significantly undervalued. The firm's reported revenue fell 7.9% year over year. However, in local currency terms, revenue increased 2.7%, which was sufficient for management to upgrade its local currency revenue guidance to around 2% for the year from around 1% previously. While we realize the reported numbers matter, we don’t believe the market is giving the company credit for the underlying turnaround it is making.

In its home country of Spain, Telefonica's revenue growth was minimal, but it had strong subscriber growth that should help next year. The firm's "Fusion" service, which is its converged product, grew its customer base 4% to 4.6 million, and its average revenue per user 1.8% to EUR 89.20 ($101). Fusion customers now include 90% of its pay-TV base, 87% of its broadband base, and 83% of its mobile contract base. Additionally, Telefonica continues to move its broadband subscribers on to its fiber-to-the-home, or FTTH, network, which now passes 20.8 million premises. Telefonica in Spain has been the poster child for convergence and we expect that to continue.

In the U.K., Telefonica reported strong revenue growth in pounds of 7.9%, which still was up 7.4% in euro terms. However, a good portion of the growth was from handset revenue, which jumped 23.3% and tend to be volatile. Still mobile service revenue growth was a solid 3.6% as customers continue to upgrade from prepay to contract, which tend to have higher ARPUs. We expect this trend to continue.

Telefonica continues to also control its costs, which led to an EBITDA margin of 34.5% versus our full-year projection of 32.7%. However, the fourth quarter historically has lower margins, so we expect the full year to be closer to our estimate.

Revenue growth in Latin America was strong in local currency terms, but very weak in euro terms. In Telefonica’s Hispam Sur region, local revenue growth was 11.2%, but sales plummeted 32.3% in euro terms primarily because of the Argentine peso. Like in the U.K., the wireless operations saw a movement from prepay to contract customers, which helped ARPU growth. Currency movements also hurt the firm’s Brazilian operations. For more on Brazil and Germany, please see our separate notes on Telefonica Brasil and Telefonica Germany.

However, in the Hispam Norte region, currency movements were minimal and reported revenue grew 0.3%. Telefonica’s operations in Colombia and Ecuador performed particularly well with organic revenue growth of 7.8% and 7.2% respectively. The Colombian operations are also benefiting from convergence with 8% growth in its wireless subscriber base and a 27% jump in its broadband base. We believe this region shows the possibilities Telefonica has long term when currencies stabilize.