What to Buy: Telefonica SA (Spain: TEF, NYSE: TEF) < USD20

Why Now: Telefonica SA (Spain: TEF, NYSE: TEF) stock has been down-trending since mid-year, brought low as Europe’s sovereign debt crisis has dragged on. This week management essentially rolled back a planned dividend increase for fiscal 2012, with CFO Angel Vila stating, “We set our previous dividend policy back in October 2009 when market conditions were very different from today’s.” The news had a slightly negative impact on the stock, but no analysts covering it changed their opinion.

Telefonica yields slightly more than 10 percent at the projected 2012 rate, which management expects to hold in 2013 as well. It also reiterated previously stated guidance for full-year fiscal 2011 profits and said plans to sell non-core assets, cut debt and boost investment in Brazil by 52 percent were still on target. The company plans to pay EUR1.60 per share in cash dividends and stock buybacks for 2011. That’s just about 6 percent more than the declared rate of EUR1.50 in cash and buybacks for 2012, though the new rate is about 14 percent below the previously declared rate of EUR1.75 per share.

The key is whether the savings–which will be deployed for debt reduction–will allow the company to meet its guidance. We’ll know more when it reports fourth-quarter and full-year earnings, scheduled for Feb. 24, 2012. Meanwhile, Telefonica is a buy up to USD20.

As with all Big Yield Hunting recommendations, Telefonica should only be held in a diversified portfolio by investors who can stomach risk and who have the mental discipline not to average down should the stock fall further.

The Story

It’s a target-rich environment, but there’s not much substance backing many of the high-yields on offer. At the same time, one “falling knife” provides plenty of handle for investors willing to stomach a little more–and a little more direct–European uncertainty. This global telecom–with significant operations in fast-emerging South America–provides plenty of potential for significant upside along with a healthy dividend to compensate while we wait.

David: Well, there seems to be no shortage of 10 percent-plus dividend yields around now. Trouble is I’m not so sure I want to own most of them.

Roger: Nor do I, and neither do most investors, apparently. I’ve never seen so many stocks left for dead.

By the way, before we talk about this month’s pick I think we should discuss some of our previous recommendations in this service. I’m pretty happy with three of the energy producers we’ve gotten people into. AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) had some pretty strong third-quarter results that set a lot of my fears to rest about it being a small company. It’s still climbing something of a wall of worry. But I like that low payout ratio, the lack of near-term debt maturities and the way the stock has stabilized.

BreitBurn Energy Partners LP (NSDQ: BBEP) has been steady, and I liked what management said in its recent conference call about focusing on steady rather than explosive output growth and continuing to raise distributions. Management also owns upwards of 7 percent of the units. And PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) now forecasts 15 percent production growth for next year, which I think surprised a lot of people and has pushed its stock higher despite the overall market turbulence.

On the other hand, I wasn’t at all impressed with the numbers Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF) put up, and I’ve kind of lost any feel for where they’re going. In fact, with these other options around, I’d really rather not own it.

David: I think we really liked it because they seemed to be conservative and always met their numbers. I don’t see that at this point. Shall we consider it a closed position?

Roger: Yes, and no need to be so courtly: Sell Zargon Oil & Gas. Anyone who really wants to follow it can keep tabs through Canadian Edge, or by visiting the company website. But I think swapping proceeds from Zargon into AvenEx, Brietburn and PetroBakken is the way to go.

And as long as we’re slashing, I think it’s time to give up on Alaska Communications (NSDQ: ALSK). The stock wasn’t performing all that well this fall, but I was OK holding it until that third-quarter conference call. You’ve got to hand it to management for being forthright about its challenges. But it really looks like they’re hitting the panic button about Verizon Wireless apparently gearing up to compete in the state.

And I really didn’t like the vague reference to a future dividend cut in the prepared comments, which the executives largely refused to issue clarify when analysts questioned them. I hate taking the loss, particularly before there actually is a dividend cut. But this is definitely a very negative shift in management guidance, and I don’t want to own it either.

David: Agreed. So sell Alaska Communications, too. What about Otelco (NYSE: OTT). They’re in basically the same business, no?

Roger: The market has certainly treated it like a leper. But aside from the fact that the bond portion of the income deposit security matures in 2019 and the shrinking traditional wireline business, it still looks pretty stable.

Cash flow was actually up in the third quarter excluding non-recurring items, and the company is still cutting into its debt. Dividend coverage is still OK at 1.25-to-1, and I don’t see anything to really worsen that ratio. The entire $188.5 million credit line maturing Oct. 31, 2013, is undrawn.

I’m completely against averaging down, but I think the stock’s still a buy for anyone who doesn’t own it, and a good high stakes swap for Alaska Communications.

David: There are a couple of others that bother me somewhat. I understand why Capital Product Partners LP (NSDQ: CPLP) has been hit. Everyone’s worried about tankers, and no one’s paying attention to management’s reaffirmation of the dividend, or the fact that it relies on long-term contracts and can weather a weak spot market. I saw where they just signed a long-term contract at an above market rate; that’s always a very good sign.

But what about Superior Plus Corp (TSX: SPB, OTC: SUUIF)? Management actually did cut the dividend by about 50 percent.

It’s still yielding over 10 percent, but doesn’t that undermine the case for owning it?

Roger: First, I like your reasoning on Capital Product Partners, and I think people should stick with it, with the caveat, of course, that you should never, ever average down.

Superior, though, I think we should also keep.

The reason is this: Management cut the dividend because it no longer expected a big earnings recovery in 2012, given economic uncertainty. But the “reduction” in guidance basically means they’re expecting 2012 to come in flat with 2011, mainly a range of CAD1.55 to CAD1.90 per share based on adjusted operating cash flow, their primary metric.

That’s a very conservative assumption for all Superior’s businesses, and it will free up funds to basically zero out any debt coming due before the end of Dec. 2012.

I don’t like the dividend cut any more than you do. But the stock didn’t do much after the cut. It was expected. And management has shown it will push the payout back up when conditions allow.

I still think this is a double-digit stock sometime in the next 12 to 18 months, though again no one should average down if they’re in at a higher price. We have a new recommendation every month. That’s where readers ought to put new money.

David: Speaking of this month’s pick, what are you looking at?

Roger: Wait a sec. There are still three other picks to talk about and for brevity’s sake, I’ll just come out with it. I don’t think anyone should invest new money in Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF), The Data Group TSX: DGI-U, OTC: DCPIF) or FP Newspapers Inc (TSX: FP, OTC: FPNUF). Neither has cut dividends yet. But my guess is both of them will sometime in the next 12 months.

Chorus’ problem isn’t in its numbers but Air Canada’s (TSX: AC/A, OTC: AIDIF) attempt to tear up its cost sharing contract. I just have no feel for how ongoing arbitration comes out, though I think a lot of bad news is already priced in.

FP had what I thought were atrocious numbers. A cut is definitely already priced in, and management has shown itself to be incremental in its moves and supportive of dividends.

But again, I don’t want anyone buying more of it, no matter how aggressive they are.

Data Group Income Fund (TSX: DGI-U, OTC: DGPIF) is also apparently covering distributions with cash flow, but they really have me confused about their corporate conversion plans and what they’ll do with the dividend afterward.

Again, you’re pricing in a lot of bad news with a nearly 20 percent yield, but I wouldn’t put more into this one.

David: I can’t argue with what you’re saying about Chorus and FP, which looks increasingly like one of those print companies that will be driven out of business eventually by the Internet.

But I disagree on Data Group. I think they do have a sustainable business model, and, though I can’t vouch for what management will decide for the dividend or the conversion, I think the numbers do support the current payout.

Roger: OK. I’ll go along with that. And by the way, if it doesn’t work out readers should blame me first for going along with you.

David: Speaking of moving things along, are you finally ready to talk about this month’s pick?

Roger: Telefonica SA (NYSE: TEF).

David: Wait a minute. First, it’s in the Utility Forecaster Portfolio. Second, don’t they break your rule of staying clear of companies cutting their dividend until there are obvious signs of recovery?

And lastly, I just remembered one past Big Yield Hunting pick you left out, France Telecom (NYSE: FTE). Isn’t one European telecom enough to have on the books, given the disaster unfolding there?

Have you taken leave of your senses?

Roger: Probably. This is not an easy market. But let me explain.

I don’t make a practice of using portfolio picks from other advisories in Big Yield Hunting, mainly because this service takes risks UF, for example, typically will not. I do have a group of Growth Portfolio Aggressive Holdings in that advisory–with a very low weighting, by the way–which actually have a pretty similar high stakes objective. Not all have monster yields.

Telefonica is obviously an out-of-favor stock now trading at a three-year low. But it’s an appropriate investment for those who can take on some risk for the promise of greater rewards, just as all of those Aggressive Holdings are.

David: What about the dividend cut? Isn’t that an automatic disqualifier?

Roger: Normally when a company cuts its dividend I advise “sell.” In fact, I’ve been burned for not doing so on several occasions.

Dividend cuts are definitely a disqualifier for any candidate for conservative income investment. But there are a few very important factors that make Telefonica different.

First, most of this “cut” isn’t really a reduction at all, just a cancellation of plans to raise the dividend. In 2009 Telefonica announced a series of dividend boosts, the last an increase to an annualized rate of EUR1.75 per share for 2012. The company’s cash dividends in calendar 2011 were EUR0.77 paid Nov. 7 and EUR0.75, paid on May 6. It still actually plans one more dividend boost to a payment of EUR0.83 cents sometime in early 2012, before the “cut” takes effect.

But the rate paid this year is only slightly more than the EUR1.50 now planned for 2012, though the lower number also includes stock buybacks. There’s a huge difference between that kind of cut and the type forewarned by, for example, Alaska Communications.

Yes, Europe’s recession is having an impact on revenue, particularly in Spain. But the company’s overall forecast for 2011 is unchanged, and its new guidance for 2012 really isn’t all that different from what it was before. The weakness in Spain is being offset with cost cutting and growth in Latin America, which was 47 percent of revenue in the third quarter. The business model is under pressure from the global economic crisis, but it’s still sound, and this company is going to still be here when Europe eventually stabilizes. In fact, it’s likely to be larger and more dominant than ever as it grows in Latin America and its rivals in Europe are marginalized by tough conditions.

The third thing that makes Telefonica’s situation very different is, despite having a high level of debt, there are no near-term credit pressures. Paying less out in dividends will provide some funds to further reduce long-term indebtedness. So will sales of “non-core” assets, such as Mexican wireless towers to American Tower Corp (NYSE: AMT) announced this week.

In other words, this company is facing about the toughest conditions imaginable and is adjusting its plans. But it isn’t faltering. Even after the cut the dividend will still be well over 10 percent and the stock is trading for less than five times cash flow. That’s very cheap for a company that’s still quite dominant in all of its key markets.

David: Apparently a lot of analysts agree with you. I note 24 have “buy” recommendations. I also see, however, that 14 have “holds” and eight “sells.”

And that none changed their minds after the dividend cut. This still looks like a bull-bear war.

Roger: And the bears thus far are winning. The same is true of the other European telecom we’ve talked about in Big Yield Hunting, France Telecom, though the sentiment is slightly less bullish with 16 “buys” versus 18 “holds” and eight “sells.”

Look, everyone knows Europe has sovereign debt problems that are a threat to spread to the credit markets, even if there is an agreement to save the euro. Everyone knows the eurozone economies are probably going to suffer because of it. In fact, there’s a near unanimous consensus the Continent is going to suffer a bad recession in 2012.

And everyone knows European telecommunications companies are going to feel some of the pain if that happens, despite providing an essential service in rising demand.

Would I own Deutsche Telekom (Germany: DTE, OTC: DTEGY)? Absolutely not. But that’s mainly because the US government is refusing to let it exit T-Mobile USA with a reasonable return, and it’s going to pay a price for that by lacking funding to compete in Europe.

Neither France Telecom nor Telefonica have that kind of risk. But as long as Europe is still under pressure, their stocks are going to be lumped in with the rest, and they’re going to sell cheap. France Telecom, for example, trades at just 2.5 times cash flow and less than five times free cash flow.

David: Cheap stocks can stay cheap for a long time.

Roger: Agreed. I also think there’s some dividend risk with both of these stocks at the company level. And don’t forget they’re priced in euros and pay dividends in euros, a very weak currency of late.

But let’s not lose sight of one thing: Expectations are what drive the prices of stocks. All a company has to do in the long run is just beat those expectations and its stock is going higher. I defy anyone to find a group of stocks that are guaranteed to be there when this crisis is over that carry such low expectations.

I might also point out that Telefonica stock had a lot of insider buying in 2011. That certainly didn’t stop it from falling sharply this year. But it does make me a considerably more confident when management is putting its money where its mouth is.

David: So what kind of upside do you expect?

Roger: Verizon Communications (NYSE: VZ) trades at 12 times cash flow. That’s well more than twice Telefonica’s valuation. Is it worth that much more? Only if one assumes that Telefonica is growing half as fast. The irony is exactly the opposite is true. In fact management says revenue in Spain has actually bottomed and will rise next year.

By the way, my opinion is Verizon is also undervalued. But I think, in any case, Telefonica’s New York Stock Exchange (NYSE)-listed American Depositary Receipt should trade in the mid-20s.

David: What about downside?

Roger: You still have several analysts saying that Telefonica is going to have to cut its dividend again. Not surprisingly they’re getting a lot of airtime now. If they’re right, this stock will go to the low teens in US dollar terms, and we may see it crack EUR10 on the downside. The stock could also slide a bit further in the next couple days, as news sometimes travels slowly.

My feeling, though, is the weak hands have been chased out of this stock for the most part. Interestingly, it’s only 30 percent held by institutions. That means there are a lot of patient individuals holding, which is often a tough group to shake out. And let’s not forget very low expectations are also the best possible downside protection.

David: Should people buy in Spain or with the ADR?

Roger: I think NYSE-listed ADR is are fine for US investors. It’s plenty liquid for one thing, which means we can get in and out if needed. I wouldn’t use a stop loss on this position. Rather, the exit point should be if there’s a real reduction in guidance and dividends.

What we saw this week doesn’t qualify.

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < CAD10.30, USD10
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD18
• December 16, 2011: Telefonica SA (NYSE: TEF)–Buy < USD20

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)