Telefónica (NYSE: TEF) offers a high dividend yield, but dividend coverage could be better relative to earnings. The company also represents an income trap due to weak growth prospects and relatively high valuation.

Company overview

Telefonica is a telecommunications company based in in Spain and offers fixed and mobile telephony, broadband and subscription television services, as well as other technology services such as cybersecurity, big data and cloud solutions.

The current market value is about 25 billion dollars and is traded in the USA on the New York Stock Exchange through its ADR program. The largest shareholder is the Spanish government with a share of about 10%, followed by the Saudi Public Investment Fund with 9.9% and CaixaBank (OTCPK:CAIXY) with about 5%.

Telefonica is the established telecommunications operator in Spain, which remains its largest market, although the company has a diversified geographic presence in Europe and Latin America. In fact, Spain about 31% of its total sales in 2023, followed by Brazil (24%) and Germany (21%), while other markets have a lower weight.

Because the company is relatively large and operates in a mix of mature and emerging markets, particularly in Latin America, Telefonica’s growth prospects are better than those of some European peers. However, investors should be aware that the telecom industry is mature and the long-term growth prospects are not particularly impressive.

In addition, the industry, especially in Europe, is fairly competitive, putting pressure on sales and profits, as there are three or four players in most markets, all trying to gain market share over their competitors. This means that the company’s pricing power can be considered relatively weak, even in markets with a larger market share, such as Spain.

In fact, the competition from Zegona and MasOrange in Spain is quite intense and Telefonica, as the leading player, is the one that may lose the largest market share. In Germany, the business prospects are not much better either, as Telefonica will lose its main customer (1×1) in the wholesale segment by mid-2025, as the German company is in Vodafone’s (VOD) infrastructure, which is having a negative impact on Telefonica’s revenues in the country. On the other hand, the company has better growth prospects in Latin America, namely in Brazil, where it holds a market share of around 39% in the mobile sector with Vivo, making it the market leader in the country.

Despite this, Telefonica’s financial targets are not particularly impressive, reflecting the business headwinds in the coming years. Annual revenue growth is expected to be around 1% for the period 2023-26, and EBITDA should grow by around 2% annually over the same period. This clearly shows that Telefonica’s growth prospects are rather low, while on the other hand, free cash flow generation is expected to grow by more than 10% annually due to the company’s efforts to reduce costs and share the burden of its investments through joint ventures with other partners, which will lead to higher cash flow generation in the medium term.

Financial overview

In terms of financial performance, Telefonica has reported relatively stable performance in recent years, with revenues of around €40 billion per year and EBITDA of around €12 billion annually, representing an EBITDA margin of around 30% in recent years.

As I have already pointed out in previous articles, this company does not compare well to some of its competitors, considering that in terms of growth Deutsche Telekom (OTCQX:DTEGY) has significantly better prospects due to its presence in the US market, while its Dutch competitor is lagging behind in terms of profitability. KPN (OTCPK:KKPNY) appears to be in a better position given its exposure to a concentrated telecom market in the Netherlands.

Although Telefonica is more geographically diversified than most of its competitors, this is not necessarily a positive as the company operates in several difficult markets (Spain, Germany, UK) where no major changes in competitive dynamics are expected in the near future.

Another indication that geographical diversification across several European markets does not necessarily create added value is what is happening at Vodafone. The company has struggled for many years to achieve positive business developments in Spain and Italy and in recent months has decided to divest its operations in both countries.

For this reason, I do not believe that Telefonica’s geographical diversification represents a competitive advantage, as synergies between the different markets are quite low and macroeconomic conditions in Western Europe are generally similar. Thus, geographical diversification does not seem to create much added value in the long term.

Against this backdrop, it is not surprising that Telefonica reported a relatively weak operating performance in 2023. Revenues increased by only 1.6% year-on-year to €40.6 billion. Operating profit was €2.6 billion, a 36% year-on-year decline, impacted by higher costs and losses on equity-accounted investments. The bottom line was negative last year, recording a loss of €574 million (compared to a profit of more than €2.3 billion in 2022).

However, these results were significantly affected by a one-off effect, namely the impairment of the goodwill of the British joint venture (VMO2), in which Telefonica holds a 50% stake, for almost €3.6 billion, which had a negative impact on the company’s balance sheets of around €1.8 billion. Adjusted for this effect, Telefonica’s net profit would have been around €1.2 billion, still a sharp decline compared to the previous year.

In the first half of 2024, operating performance differed little from the recent past. In the second quarter of 2024, Telefonica’s revenues increased by 1.2% year-on-year to €10.2 billion, driven by growth in several segments. Geographically, Brazil was the biggest growth driver (+3.3% year-on-year), while Germany and the UK performed weaker, reporting stable revenues compared to the same quarter last year.

Its EBITDA increased by 1.8% year-on-year to €3.2 billion in the quarter, representing an EBITDA margin of 31%. This is a positive result given the inflationary environment and cost pressures that Telefonica managed well and protected its profitability. However, due to lower revenues from the VMO2 joint venture, net profit fell by 3.3% year-on-year to €447 million in the second quarter of 2024, which is not particularly impressive.

For the full year, the company has kept its guidance unchanged and expects revenue and EBITDA growth of 1-2%. This figure is quite low and reflects the various business challenges, which include strong competition and the company’s lack of pricing power. These factors have structurally affected the company’s business in the past and are not expected to change significantly in the near future.

In fact, according to analysts, Telefónica’s future growth is expected to be very subdued. Revenue is expected to reach around €41.9 billion by 2027 (compared to €41 billion in 2024) and EBITDA to fall to €12.8 billion (compared to €13.2 billion in 2024). This shows that the company’s financial situation is not expected to improve significantly in the coming years.

Regarding the balance sheet, Telefonica has been trying to reduce its debt ratio in recent quarters. The goal is to reach a net debt to EBITDA ratio of between 2.2 and 2.5 by 2026, which is an acceptable debt position compared to other telecom companies. However, the current debt ratio is 2.8, which is quite high and shows that Telefonica needs to reduce its debt in the future, as it does not expect much EBITDA growth in the medium term.

This means that a large part of the organic cash flow generation is likely to be used to reduce debt, even if Telefonica wants to maintain an attractive dividend in the future.

The current annual dividend is €0.30 per share, with the dividend being paid semi-annually, resulting in a dividend yield of 7.4% at the current share price. This is quite attractive for income investors, but the sustainability of the dividend is not great considering that the payout ratio based on forecast earnings per share for 2024 is almost 100%, which is clearly a very high payout ratio.

On a cash flow basis, the coverage is better, as Telefonica’s cash outflow related to dividend payments is around €1.8 billion per year, while free cash flow was €2.3 billion in 2023 and should increase to around €3 billion by 2026. So, although Telefonica’s dividend coverage could be better in terms of earnings, I do not expect a dividend cut in the near future. The stock market seems to be OK with this, as the current consensus is for an unchanged dividend of €0.30 per share over the next few years.

In terms of valuation, Telefonica currently trades at 11.8 times forward earnings, which represents a premium to its historical valuation of 10.1 over the past five years. Compared to its peers that also have low growth prospects, such as Orange (ORAN), BT Group (OTCPK:BTGOF) or Vodafone (VOD) this also appears to be a high valuation considering that comparable products trade on average at less than 9 times earnings.

Diploma

Telefonica has very weak growth prospects and no competitive advantage in the telecoms industry. In addition, its valuation is not particularly cheap compared to its closest competitors. Although the company offers a high dividend yield, its coverage based on earnings could be better and the prospects for dividend growth are low. Therefore, Telefonica does not seem to be a good income investment in the long term. I think KNP is a much better income investment in the European telecoms sector, as I have previously discussed here.