Friday, June 01, 2012
TMM were looking at the Ibex again and the slotting thereof and wondering – just where does this end? Looking at its components we see the following.
33.5% consists of banks which are part of the sovereign/financial system #REF loop that has been covered extensively elsewhere. 10.7% is Inditex, which judging from what the Mrs Macros have to say is not having any problems anytime soon and trades as such. Then, there is Repsol which has been receiving the gaucho grill, a bunch of utilities and Telefonica. As Telefonica is by no means small we thought we’d discuss it in detail.
Telefonica is big telco that derives its income from a great many places – not least of all Latin America. As you can see below it is primarily a Latin American business and by all means should be able to get by in a deflationary domestic episode pretty well given that the Spanish business consists of a moribund fixed line business and a mobile business which is growing, but not growing anything like Latin America.
So why does Telefonica’s equity and its longer dated USD bond performance look like this?
The way to look at Telefonica in TMM’s opinion is to break it up into its various business and look how it is funded. Firstly, lets look at the Spanish business in light of the serious risk of having hard currency debt (Euros) and the risk of having to move back to a local currency at what TMM estimate would be a 15-20% devaluation. Surely this is unprecedented, right?
For those with a sense of history there have been Telcos that have lived through massive devaluations and there is no better example than Telecom Argentina. As can be seen below a 70% devaluation and an 80% drop in operating income in hard currency terms tends to lead to bad stuff – like bond defaults.
Bondholders did ok even here though as you can read here. Recoveries were 85-90c which is pretty remarkable and the equity was largely OK as can be seen below. In Telefonica’s case, bondholders would likely go for the equity so the emerging market equity wrangle probably doesn’t work here. Nonetheless, this is a lot of asset recovery for a 70% devaluation, so why is Telefonica looking so distressed when it would face, at worst, a 20% devaluation?
TMM think they have the answer and as per usual it’s in the cash flow statement. Telefonica is the first company they have seen that thinks it’s a good idea to increase leverage in a financial crisis which is, you know, kind of odd if not crazy. Note the amount of cash being ripped out of this company by creditors and equity holders per year. It is not small. 100% of cash from operations plus cash from financing is being pulled and there appears to be a large shift in the lender base.
With regards to which creditors are stepping in and stepping out Telefonica looks like it is the usual story in Europe – bank balance sheets out (revolvers, term loans) retail and real money investors in (bonds and notes). No surprises there.
What is surprising are the dividends which keep increasing per share as can be seen below, along with the buyback – who owns this company anyway and thinks it’s a good idea to lever up in the teeth of a crisis?
These guys. When you are a cash cow and your lenders are distressed and also your biggest shareholders, you are going to be under pressure to pay out a lot of dividends to them, pay back a lot of loans to them and try and issue a lot of bonds to other people.
The problem of course is that this strategy is the quintessence of short term greed. BBVA and Caixa may need that money yesterday but it is not in the interest of the other 89% of Telefonica’s shareholders to pay out 7.5bn of dividends, equal to a third of OIBDA when credit markets are saying “no mas”. Not least of all when Telefonica looks cheap – really cheap – compared to regional peers and its listed Brazilian subsidiary looks the same since everyone expects them to sell of more of the crown jewels to keep a couple of banks afloat for a few months more.
TMM took a pivot table of Telefonica’s debt to work out what needs to be done here. It is shown below:
Telco’s tend to fund themselves in local currency where they can to avoid a mismatch of funding and income, though in Telefonica’s case there is a lot more Euro borrowing at the Spanish holding company than would be justified by OIBDA in Spain. At present there are about 14bn of bank borrowings in Euro which TMM presume sit mostly with their Spanish lenders / shareholders. TMM think this has got to go and be replaced by funding matched to income, likely in BRL. Note that this is a large sum, some 16bn but it is only two years of dividends and buyback, both of which could be suspended immediately if management worked for anyone but a couple of Spanish banks. TMM think that if Telefonica paid these down, replaced some Euro borrowings with BRL and left about 14bn of EUR bond and note debt on ~4bn of Europe it would be hard to argue that Telefonica has a problematic balance sheet or one with major exposures to a currency union breakup.
But in the interim, TMM see headlines like this about them selling off their German unit and think this is mad and bad and it is high time someone did something about it.
In the interests of disclosure - yes, TMM do own some of this stuff! Finally we apologise for the blurriness of some of those screen shots. At the moment that's the best we can do.