1. Telefónica (Madrid: TEF), rated a BUY by AlphaValue
Worries over peripheral Europe cannot simply be swept away, however much the politicians try. Ten years’ worth of Greek, Portuguese and Irish debt are not to be sniffed at. Spanish bonds may have escaped a hammering for the moment, but not so the stockmarket. Spain’s IBEX 35 index of leading shares has underperformed the FTSE 100 by 25% since early 2010. Take Telefónica, the nation’s former telecoms monopoly, for example. Traders have used its shares, representing over 15% of the index, as the easiest and most liquid vehicle to short the market – and in turn created a buying opportunity.
Although telecoms companies might have lost some of their allure over the years, they are still relatively defensive, offering utility-style returns and juicy dividends. This is because most of the heavy lifting – in terms of building the necessary networks in the West – is complete, thus facilitating strong cash flows. Better still, the incremental cost of supporting new subscribers is low. So extra subscription revenues drop largely to the bottom line. That’s great news, given the immense popularity of mobile broadband on smartphones and tablets. Both are helping to lock in punters on longer contracts.
For the time being, though, investors seem to be only concerned with the negatives – especially on Telefónica’s home turf, where it makes 35% of earnings before interest, tax, depreciation and amortisation (EBITDA). Here, first-quarter revenues fell by 5.6% and operating profits declined by 15% as customers switched to discounted offers from smaller rivals. But management is cutting costs to protect margins, with about 6,500 redundancies expected in 2011 – equivalent to 20% of local staff.
More important to me, though, is what is happening abroad. First-quarter data traffic in Telefónica’s UK business (O2) rose 45% with associated revenues up 35%. Germany is also holding its own. Even more impressive was the eye-popping 26% jump in Latin American sales to €7bn (45% of EBITDA).
With the overseas divisions progressing nicely, it shouldn’t take much of an improvement in its domestic unit to give the stock a lift. For 2011, I am forecasting turnover and EBITDA of about €64bn and €23.5bn respectively, with a closing net debt of €55bn. Consequently, I would value the group on a blended 6.5 times EBITDA multiple, which, after adjusting for the debt, generates an intrinsic worth of about €21.50 per share.
In terms of the risk, there’s no doubt the industry is being impacted by cut-throat competition, lower termination fees and deregulation. Additionally, gearing needs to be watched (net debt is 2.4 times EBITDA), particularly as contagion fears in peripheral Europe could push up its cost of capital.
That said, the board is adamant this will not affect the dividend, and has even promised to hike the payout by 14% in 2011 to €1.60 per share (a 9% yield) and increase this again to €1.75 for the following two years. That means dividends could total about €5.10 per share from 2011 through 2013, or 30% of the share price. AlphaValue has a €23.40 price target, and second-quarter results are scheduled for 28 July.
Rating: BUY for the income at €16.50
2. 3i (LSE:iii) rated a BUY by Evolution Securities
We could soon see a nasty spike in inflation in Europe if Greece defaults on its debt and exits the euro. To protect against contagion, I suspect that the European Central Bank will have to flood the financial system with liquidity, and push up inflation. If so, wealth preservation will be key – and one ‘store of value’ is cheap equities. Why not buy a company that also owns a basket of other companies? Consider 3i, for example.
As Europe’s largest listed private-equity house, it aims to snap up distressed assets at rock-bottom prices. Over time, it improves profitability at the firms it buys before later flogging them off for a healthy profit. For instance, last week 3i sold its 70% stake in Alo for £240m – a manufacturer of front-end loaders for agricultural tractors. This unit was valued in the books at £129m in March, so the uplift in net asset value (NAV) should be £90m (or 8p per share).
All told, the chief executive, Michael Queen, believes 3i can generate average returns of 15% per year across the economic cycle, despite only achieving 10.6% in 2010. This shortfall was caused by a robust performance in continental Europe (51% of portfolio) being offset by a £198m impairment on its stake in UK outsourcing specialist Enterprise. Nonetheless, the net asset value (NAV) rose 9% to 351p per share, and the dividend was hiked up by 20%, as the organisation’s diversification strategy began to bear fruit. Assets under management also jumped 32% to £12.7bn.
Elsewhere, a new subsidiary was formed – 3i Debt Management – following the acquisition of Mizuho Investment Management for £18.3m. The unit boasts £3.4bn of assets under management. Queen plans to further beef up this area as the new Basel III banking regulations are likely to lift trading.
In relation to risks, 3i is in essence a geared play on the equity markets. That reflects both the debt carried in its portfolio along with its own £522m of net borrowings. This double leverage means results tend to be affected negatively during a downturn, but positively when sentiment ticks up. Another risk to consider is its wide selection of non-quoted investments, which are something of an unknown quantity for outside investors.
All the same, the shares trade at a hefty 25% discount to my fair value of around 360p per share. That’s a fact not missed by the directors, with the chairman, chief executive and finance director all piling in after the May results at prices ranging from 272p to 292p. Moreover, at these historically cheap levels, there may even be an outside chance of an opportunistic takeover approach. The next update is scheduled for the company’s annual general meeting on 6 July. Evolution Securities has a price target of 370p.
Rating: BUY at 270p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. See
www.moneyweek.com/PGI
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