Telefonica is the most recent addition to the Gracor portfolios. What follows is an outline of the decision structure and a summary of the analysis.
Value investing is based on Benjamin Graham’s work on the principles of investing and investor behavior. I hope that that this posting will help you understand how Gracor applies those principles.
Value Investing vs. Bargain Hunting
It has become fashionable for professional value investors to say that their style is to buy great businesses for 60 cents on the dollar. Really? Granted, this is a marketing statement and not a white paper on the subject, but I believe it is important for you to understand what is missing from this statement.
The missing part is why you are able to buy at such a significant discount? Remember, it is not true that the market randomly coughs up a dollar bill for 60 cents. To get a significant discount, something negative, and typically unforeseen, must occur to scare the market into overreacting.
Before buying such a bargain—even before in-depth valuation analysis—value investors should do the following two things. First, they must understand the nature of the negative event. Second, regardless of the nastiness of the event, they must ensure that the company has the financial and managerial resources to make it through.
What good is the most elegant spreadsheet on the company’s future valuation if it doesn’t recover? As Benjamin Graham put it in his book, The Intelligent Investor, it is not as important for the buyer to be enthusiastic over the company’s long-run prospects as it is for him or her to be “reasonably confident that the enterprise will get along.”
Telefonica vs. Spain
Telefonica’s negative event was the European debt crisis, with Greece being the spark that led to concerns about other European countries, such as Portugal, Ireland, and Spain (hence the rather pejorative acronym, P.I.G.S.)—and, more recently, Italy and France.
To provide a little perspective, since the beginning of this debt crisis the Spanish market has dropped 25%, underperforming the S&P 500 by 37%. Telefonica is Spain’s largest company according to market value, so it has a 20% weighting in Spain’s IBEX-35 stock market index. Thus, it is no surprise that Telefonica’s performance has matched the terrible performance of the Spanish market during the debt crisis.
But what if I told you that Telefonica was only one-third Spanish? If this is true, then perhaps a valid initial hypothesis would be that a matching -37% relative performance is an overreaction by the market. Remember, it is not a bargain if the market corrected properly; it is only a value stock if there has been an overreaction.
As of the end of 2010, approximately two-thirds of Telefonica’s revenues and operating profit came from outside of Spain. Admit it: doesn’t that surprise you?
Telefonica is well known for its presence in Latin America, which accounts for approximately 42% of the company’s revenues and 53% of its operating profit. In Latin America, it has leading positions in Brazil, Argentina, Chile, and Peru. It also has operations in Colombia, Ecuador, El Salvador, Guatemala, Mexico, Nicaragua, and a few others.
Not as well known is the company’s presence in Europe (not including Spain), which accounts for approximately 25% of its revenue and 14% of its operating profits. It has good footprints in the U.K., Germany, Ireland, and the Czech Republic.
This is the data that led me to my hypothesis.
“Get Along” Analysis (Liquidity and Rollover Risks)
To determine whether a big company in an important industry can make it through a negative event, you need to look at the company’s financial statements through the lens of a credit analysis. The point of this exercise is to determine whether Telefonica, in light of the current negative event, still has the financial flexibility to absorb another unforeseen negative event.
Please, this has nothing to do with the current brouhaha regarding the rating agencies and the U.S. downgrade. This is just nerdy debt and liquidity analysis. I will try to keep it pithy.
My analysis shows that Telefonica’s liquidity (cash and cash equivalents) is sufficient to cover debt maturities, capital expenditures, and dividends for at least the rest of this year and probably well into next year. Additionally, it has double that amount in unused committed credit lines, which are not subject to material adverse changes or financial covenants. And yes, that is all net of its acquisition of PT’s stake in Vivo last year.
Telefonica’s rollover risk appears low, considering how debt maturities were dealt with during 2010. Telefonica did a number of transactions in capital markets to cover debt maturities through 2011, so the remaining debt maturities through 2012 are clearly covered through expected cash flow generation even if the capital markets seize up.
After this analysis, I am comfortable saying that even if the European debt crisis worsens, Telefonica has the capacity to deal with the rising costs.
Obviously, none of this matters much if management makes a dumb acquisition. In 2006, they did have trouble with a debt-financed acquisition, but the recovery has gone well and management’s current statements don’t lead me to believe that they will make this mistake again anytime soon.
Valuation via Benjamin Graham’s Two-Part Appraisal Process
- First part of the two-part appraisal process
The first part of the appraisal is what Graham calls “past performance value,” which means mechanically basing the valuation on the company’s past record and assuming that relative growth for the intermediate past will continue in the future. Is it no trickier than applying a P/E to earnings? Not exactly.
First, historical accounting information must be scrubbed (my word). Or, as an old green-shade accountant would tell you, the devil is in the footnotes. Database subscriptions today make it easy to download decades of financial statements, but they might not tell you when a company switched over to IAS GAAP, the short-term effect of exceptional charges, new management’s kitchen-sink quarter, or one country’s legacy thinking about goodwill and its effect on ROE.
To oversimplify this scrubbing process, an experienced eye needs to review the financial history for odd-looking data. Sometimes you find shenanigans, but most of the time it’s Modifying Conventions within the accounting. Either way, the nails that stick out need to be hammered down.
Next, I will discuss the more mechanical application of a P/E to earnings.
For the P/E, I looked at the data available for the 20 years before the 2008 global meltdown. Telefonica was trading in a P/E range from a low of 10 to a high of 22 (excluding the nutty Tech Bubble period). Since the meltdown, it has broken below that floor and traded between 8 and 9 times earnings three times. For this central value exercise, I decided on a P/E of 15-16.
For the company’s earnings, I averaged the EPS for the past four years and got $2.50. Remembering this is the mechanical part, but more on this $2.50 later.
Applying a 15 P/E to that EPS, I got a value of $37.50, and $40.00 with the 16 P/E. Lo and behold, the $37.50 valuation is right in the middle of a long-term chart of the stock’s trading range (I like congruency). Interestingly, the highest price Gracor paid for Telefonica was $21.36, a 43% discount on the $37.50 valuation.
- Second part of the two-part appraisal process
The second part of the appraisal is where knowledge and experience are applied to decide whether modifications should be made to the above valuation due to new conditions that are expected in the future. Right away, I focused on growth, margins, and—the biggie for Telefonica—technology risk.
In order to get right to the technology risk, let me just say that the first two factors are standard congruency checks. Is the growth congruent with the P/E multiples? Are the margins congruent with the EPS used? If the margins are on the high side, then the earnings need to be normalized. Have the growth and margins affected each other in an unsustainable way that needs to be normalized?
There is a specific issue in the equity account of Telefonica that I have worked with for at least a decade. It has to do with Spanish managers’ (CEOs, CFOs, etc.) long-held desire to be conservative regarding goodwill on their balance sheets. At this time, I don’t believe this has a material impact on the valuation.
- Technology risk
Technology risk is the biggie for all telecom companies, and Telefonica is no different. This risk can be defined as the differences between legacy depreciation charges imbedded in the financial statements and the reality of future capital expenditures (capex). It is certainly not a new risk, but it is the biggie and has been for at least a decade.
A simple example that’s closer to home is Verizon’s decision to lay fiber to every home (FIOS). If cheaper wireless broadband technology develops during Verizon’s depreciation time frame, then Verizon will have wasted a lot of capex.
There are two factors critical to the assumptions regarding technology risk: next generation fixed networks and broadband-enhanced mobile. In terms of fixed networks, around the world, copper is still king. The move toward fiber will be necessary to remain competitive, and fiber is capital-intensive. In terms of mobile, it’s all about fourth generation wireless standards, or 4G (also known as LTE, long-term evolution).
Moody’s has done good work on this “capex” issue for the telecommunications service providers. Its findings show that growth pushed by smartphones, etc., will increase the capex/revenue ratio up from the current average of 15% to 18% in the next three to five years. Remember, the profitability of that investment is the second issue; the first issue is who has the capital to invest. Moody’s also stated that it found that a majority of the companies in this industry have little room in their rating categories for debt-financed capex growth.
Telefonica is different. It not only has the financial capacity for the upcoming increase, it has also been able to achieve better growth than its peers with below average spending. Its capex/revenue has been approximately 1% below the industry average.
A fundamental principle of Benjamin Graham’s work on value investing is that no one can predict the future, but we can protect against it. Predicting the efficacy of the future capex/revenue spending of an industry exposed to this much technology is folly. There is a much greater chance of falling victim to a self-deceptive overconfidence bias than there is that we will get usefully precise numbers!
- Protection against the future in this valuation
First, the above “get along” analysis tells us that the company has the financial flexibility to compete against its rivals if more capital investing is necessary. Second, I have used a conservative average EPS for the last four years: $2.50. Considering both the company’s growth in revenues per share during that period and its recent acquisitions, I could build a pro forma case for a bigger number. The important point is not to get excited and pay up for prospects and promises of the future. Third, the P/E of 15-16 that was used is a long-term average P/E for the market in general. Considering the growth prospects for the industry and the majority of Telefonica’s markets, it could be argued that this is a conservative P/E.
Finally, and most importantly, the protection against the future lies in the size of margin of safety. To put it differently, buying a dollar bill for 60 cents is a huge margin of safety for a company of this size and scale that is in an important and growing industry, has a good operating track record, and possesses its current financial strength and liquidity.
Benjamin Graham never said that one should only buy with a 40% margin of safety (60 cents on the dollar). Rather, this was a metaphor used by Warren Buffett in his 1984 speech, “The Superinvestors of Graham-and-Doddsville.”
The closest Benjamin Graham came to this was when he spoke about buying secondary companies with an “indicated value of at least 50% more than the price.” Mathematically turned on its head, this would be a 33% margin of safety or 67 cents on the dollar.
Telefonica is no secondary company, and we still bought it at a price better than the metaphorically-mixed-up “60 cents on the dollar.”
Truthfully, I don’t believe Benjamin Graham would demand that big a margin of safety for Telefonica. But Mr. Market was offering, so I took it.
Postscript Warning on Dividend Yield
Telefonica’s dividend yield is eye-popping and misleading. At the very least, Spain’s 19% foreign withholding tax cuts it down substantially. That tax is withheld at the source and, from what I have read, it is very tricky to recover. Please consult with a tax adviser! Additionally, the dividend yield to you will be affected by the euro/dollar exchange rate.