Zacks_Analysts' Blog : Telefonica Downgraded to Neutral - Analyst Blog

We are downgrading our long-term recommendation on Telefonica (TEF), the largest telecom carrier in Spain and Latin America, to Neutral from Outperform. Currently, the stock has Zacks #2 (Buy) Rank for the short term (1–3 months).

We believe the successful acquisition of the full stake in Telefonica’s Brazilian wireless joint venture, Vivo Participacoes (VIV), has already been largely priced in. Thus, there is now limited upside to the stock in the near term. However, we believe Telefonica is benefiting from the increased adoption of mobile broadband in its high-end smartphones (especially iPhone), which has strengthened its cellular revenue base and is driving market share improvement amid stringent regulatory conditions. This may lead to outperformance by the stock.

In the first nine months of 2010, revenue and earnings were higher than the year-ago levels. Despite fragile Spanish operations, revenue growth in Latin America led to strong results in the period. Notably, earnings per share more than doubled year over year in the third quarter of 2010 and net income trebled from the year-ago level. Third quarter profit was led by the company’s acquisition of the remaining 50% stake in Vivo from Portugal Telecom (PT).

Vivo’s full stake will further promote diversification and increase Telefonica’s exposure to the growing Brazilian market. The acquisition of Vivo makes Telefonica the leader in the Brazilian telecom market. Telefonica merged Vivo with its Brazilian fixed-line voice and broadband unit Telesp (TSP), which is struggling to perform.

While Telefonica’s Spanish revenues continue to be affected by the reduction in mobile termination rates and a soft economy, we believe the company’s dominant position in the Spanish telecom market, attractive growth prospects in Latin America, its strengthening position in the Brazilian market and healthy dividend payouts make it attractive for investment.

Telefonica continues to lead the Brazilian wireless marketamid intense competition. France-based media company Vivendi SA, which has acquired the controlling stake in the Brazilian telecom operator GVT Holding, poses as an emerging threat. Telefonica’s biggest rival in Latin America, America Movil (AMX) is also reportedly integrating its Brazilian wireless and wireline assets. Nevertheless, by combining Vivo with its Brazilian fixed-line business, Telefonica is in a stronger position to compete with America Movil.

Accordingly, we are cautious about the company’s highly leveraged balance sheet, increasing competition and regulatory involvement, all of which may limit its upside potential in the long term. In the short term, Telefonica has an upside potential on increased adoption of mobile broadband, which is expected to fuel earnings.