Telefonica Trapped With Telecom Italia Faces Writedown

When Telefonica SA (TEF) Chairman and Chief Executive Officer Cesar Alierta told investors in April last year that an alliance with Telecom Italia SpA (TIT) would generate 1.5 billion euros ($2 billion) in cost savings, shareholders in the Spanish telephone operator weren’t warned of the downside.

With consumer spending falling and the two countries among the worst hit by Europe’s debt crisis, Telecom Italia’s stock has since slumped 21 percent, while Telefonica is down 40 percent. Telefonica, set to release earnings this week, may say first-quarter profit was cut by a 400 million-euro charge as the value of its 10.5 percent indirect Telecom Italia holding fell, said Banco de Sabadell analyst Andres Bolumburu.

“The problem with the stake in Telecom Italia is that investors expected the Italian operator to reverse the negative trend in its domestic market and this hasn’t happened,” said Bolumburu. “It could continue to lose value.”

The outlook raises questions as to whether Madrid-based Telefonica, which paid 2.3 billion euros for Telecom Italia shares in 2007, will ever recoup the investment and whether the holding is proving to be a distraction for Alierta as Spain’s largest phone company seeks to halt a slowdown in its domestic business.

Then and Now

Telefonica, Assicurazioni Generali SpA (G), Mediobanca SpA (MB) and Intesa Sanpaolo SpA (ISP), which together own 22.4 percent of Milan- based Telecom Italia through holding company Telco SpA, last week agreed on a 3.4 billion-euro financing package via a combination of bonds, bank loans and capital increase to help repay debt they took out in 2007 for the investment.

Telco now values Telecom Italia at 1.50 euros a share. The stock has been trading below the level since 2008.

Telefonica dropped as much as 2.4 percent and was down 1.5 percent to 10.69 euros at 10:55 a.m. in Madrid. It’s the biggest contributor by index points to the 1 percent decline of the IBEX 35 Index. (IBEX) Telecom Italia slipped 0.8 percent to 83.2 cents on the Milan exchange.

A Telefonica spokesman declined to comment on the valuation of Telecom Italia and whether a writedown is planned this week. In July, Telefonica said first-half profit was hit by a 353 million-euro charge as a result of the declining value of its stake in the Italian operator.

Earnings Estimates

Telefonica’s first-quarter net income probably fell 31 percent to 1.11 billion euros while sales were little changed at 15.4 billion euros, a Bloomberg survey of analysts shows. Telecom Italia may say profit rose 0.5 percent to 552 million euros, according to the average estimate of analysts in a separate survey. Telecom Italia plans to hold a conference call on May 10 to discuss earnings. Telefonica reports the next day.

Telefonica values the Italian holding at 2.15 euros a share, of which 1.80 euros are for the asset and 35 cents for synergies between the two companies, according to Bolumburu. His estimate for the 400 million-euro charge is based on Telefonica cutting the value in line with the other Italian investors, or to 1.50 euros for the asset, plus 35 cents for the synergies.

Speculation about a combination with Telecom Italia has recurred since the 2007 investment, when Alierta beat Mexican rival Carlos Slim to secure a stake in the Italian phone company as was part of Telefonica’s expansion in Europe and Latin America. Alierta has repeatedly said he’s comfortable with the Telco holding, and that Telefonica is focused on wringing savings such as from joint purchasing of handsets and phone- network equipment.

‘Trapped’

Speaking at an investor conference in London on April 13 last year, Alierta forecast 1.5 billion euros in synergies for the three years through 2013, compared with 1.3 billion euros for the previous three years.

“Telefonica is trapped with its Telecom Italia stake as there’s a lot of political involvement and it’s tough to sell it at a decent price,” said Alexandra Delgado, a Lisbon-based analyst at BCP Investimento, who also predicts a writedown. “Both operators still have to deal with problems such as higher competition at their home market, lower profitability and high debt.”

Telefonica reported net financial debt of 56.3 billion euros at the end of 2011. Telefonica will likely increase debt by 277 million euros as it takes part in the capital increase at Telco, Bolumburu said.

Alierta in December cut Telefonica’s dividend forecasts by 14 percent, the first reduction in a decade. He announced 6,500 job cuts last year and has halted major acquisitions. At the same time he has sold non-core assets including a stake in satellite company Hispasat.

Latin America

The weakening business in Spain will continue to drag on earnings and counter gains from Latin America, a region that is now crucial for the operator, Nuno Matias, a Lisbon-based analyst at Espirito Santo said.

In the final quarter of 2011, Telefonica’s operating income before depreciation and amortization climbed 7.9 percent to 3.17 billion euros for Latin America, or 53 percent of the company’s Oibda. Sales advanced 2.5 percent to 7.7 billion euros.

“I expect Latin American growth to be in line with the fourth quarter, although it’s becoming a big concern as well,” BCP’s Delgado said. “If it loses steam the company won’t be able to offset declines in Spain and a slowdown in Europe.”

The operator cut its 2012 dividend forecast to 1.50 euros a share, including 1.30 euros in cash and the rest via buybacks. That compared with a previous forecast for at least 1.75 euros. Telefonica’s 2011 dividend was 1.60 euros.

“Next year, the company is going to be forced to aggressively cut the dividend by 30 percent or 35 percent,” said Saeed Baradar, a London-based analyst at Societe Generale. (GLE) “You have a company with a big pile of debt and facing increasing cash pressure not only from its domestic market but also in Latin American countries including the fixed business in Brazil, and its operations in Argentina and Venezuela.”

To contact the reporter on this story: Manuel Baigorri in Madrid at mbaigorri@bloomberg.net

To contact the editor responsible for this story: Kenneth Wong at kwong11@bloomberg.net

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