There were some bright spots in Telefonica’s (TEF) latest quarter, which saw largely in-line revenue and EBITDA on an underlying basis. Evidently, the increased cost/capex discipline is paying off. However, Telefonica’s financials remain under pressure from a confluence of headwinds – FX, COVID-19, and increased regional pressures (evidenced by the massive Argentina write-down). This adds to the well-known concerns around the balance sheet, as I highlighted in my last article on Telefonica, which I expect will result in a deeper cut to the dividend.

Better-Than-Expected Group-Level Revenues

Telefonica’s FQ3 top-line continues to decline, but the fact the decline was less steep this quarter was a step in the right direction. For the quarter, organic revenue fell -4.3% y/y (narrowing from the -5.6% Y/Y in FQ2), led by resilience in Germany (+0.4% Y/Y) and Telxius (+2.0% Y/Y), along with narrower than expected declines in HispanoAmerica (organic -6.4%). Meanwhile, the UK (-9.5% Y/Y) and Brazil (-2.3% Y/Y) disappointed.

Source: Telefonica FQ3 Financial Report

Encouragingly, Spanish service revenue declines also narrowed, with retail revenues down c. 4.3% Y/Y. I think the strong performance on broadband additions was noteworthy, with c. 37k adds (considerably higher than the c. 8k adds in FQ2), as new customers helped offset declines elsewhere. Convergent ARPU also moves higher to €91.5 YTD (up from the €91.3 in FQ2), with c. 17k convergent subscribers added this quarter.

Source: Telefonica FQ3 Presentation Slides

Slight EBITDA Beat Clouded by One-Offs

Reported EBITDA (or OIBDA as reported by Telefonica) at €2,672 million was a disappointment, however, this was mainly driven by a massive one-off impairment in Argentina of €785 million. Adjusting for the one-offs disclosed by the company (totaling -€833 million), group-level EBITDA on a “clean” basis would have been ahead of consensus expectations on the back of resilience in Germany (+0.7% Y/Y organic), along with narrowing declines at Brazil (-2.9% Y/Y), and Spain (-4.8% Y/Y).

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Source: Telefonica FQ3 Financial Report

Despite the better-than-expected results, weak operating trends remain a concern amid a challenging environment across the entire company’s footprint – Telefonica’s organic EBITDA performance in FQ3 remains the weakest among Europe’s incumbent operators. The resumption of live sports and lower roaming headwinds should help in the near-term, but any improvement will likely be gradual at best.

Optimistic Near to Mid-Term Outlook

Looking ahead, the outlook is for organic operating free cash flow (EBITDA-CapEx) to be “slightly negative to flat,” which compares to the -2.3% Y/Y growth in H1 ’20. Dividends are guided to be €0.40/share, although the company has introduced a voluntary scrip option. As for the medium term, 2022 guidance for organic revenue growth to turn positive seems optimistic. Thus far, management has not furnished any top-line numbers but does expect a c. 2%pt improvement in (EBITDA-Capex)/revenues.

Source: Telefonica FQ3 Presentation Slides

Fiber JV Adds to the Future Capex Needs

In addition, Telefonica (and Telefonica Deutschland) will be pushing forward with its German fiber JV with Allianz. The ownership terms are as follows -Telefonica will take a 40% stake through its infrastructure unit, Telefonica Deutschland a 10% stake, and Allianz 50%. The JV will target over 2 million homes passed in rural and semi-rural areas, creating a fiber network of over 50,000 km.

In conjunction, the total capital outlay will reach €5 billion, with Telefonica equity up to €0.5 billion, Allianz up to €1 billion, and the remainder funded by a subordinated loan structure, along with non-recourse external financing.

Leverage Concerns Weigh on the Dividend Sustainability

Despite the better-than-expected EBITDA and FCF, Telefonica’s net debt remains elevated at €36.7 billion. In the face of a looming recession, FX headwinds, and the ongoing strategic shift, the leverage (c. 3.8x net debt/EBITDA including hybrids and other commitments) is an issue, even more so once we factor in Telefonica’s massive dividend commitment. Add in the already concerning Y/Y EBITDA contraction, and I think the path is clear for a dividend cut.

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2017

2018

2019

2020E

Reported Net Debt to EBITDA

2.7

2.6

2.7

3.0

Net Debt to EBITDA (including hybrids & other commitments)

3.4

3.4

3.4

3.8

Source: Company Data

Thus far, Telefonica has not outright cut the dividend, but it has introduced a voluntary scrip option for its fiscal 2020 dividend.

Source: Telefonica FQ3 Presentation Slides

As the shares are down significantly since the reference date, however, I see the dilution as already equating to a cut. While a dividend cut is not the solution to its leverage issues, it is an encouraging signal of intent. In the near term, my base case is for the DPS to be cut in half to 20c/share (down from 40c/share in fiscal 2020), with the payout relative to FCFE (ex-restructuring costs, hybrids, and spectrum) already set to rise to c.80% in fiscal 2020.

Source: Company Data, Own Estimates

Almost One Year and 60% Later, Telefonica is Still Not a Buy

Following Telefonica’s strategic review last year, I expressed my concerns about the company’s prospects. Since then, shares have declined c.60% and now trade at €2.84/share. However, I remain cautious. Although there were some positives in the FQ3 numbers, COVID-19 and FX headwinds remain, while the massive Argentina write-down underlines regional pressures.

Above all, my primary concern remains the same as last year – Telefonica lacks a clear deleveraging path, and until balance sheet concerns are addressed, I am concerned about the sustainability of the dividend. In the meantime, I would keep an eye out for developments with regard to the 2022 strategic plan, along with potential asset disposals.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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