Crisis Measures

Why Telefónica’s debt is a grave European problem

October 9, 2012
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Euro Crunch
October 9, 2012
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Telefónica’s Montjuïc Communications Tower in BarcelonaFlickr user Jaume Meneses

In 2009, Spanish telecommunications giant Telefónica, boosted by exclusive contracts to sell the iPhone in several countries, issued bold predictions about its future earnings. And investors, expecting a strong recovery in Europe, drove the stock back up to near pre-crisis levels.

Three years later, Telefónica is laden with one of the heaviest debt burdens of any company in the world. According to analysts at Bernstein Research, Telefónica has €14.5 billion ($18.8 billion) in debt to refinance in the next two years but will generate just €9.6 billion of real cash in that period (outside Venezuela and Argentina, where hyperinflation makes revenues difficult to assess). The fall-out of a housing crisis in Spain and a lack of faith in the government’s ability to pay its debts have destroyed investor faith in Telefónica, even though 75% of its revenues come from outside Spain. Last week, the company announced it would sell off a chunk of its German unit in an IPO. It also may start selling company jets to cut costs. The stock price is now barely more than half its post-crisis high of around €20 per share.

The main reason for this turn south is two risky decisions that the telecoms giant made in 2010, says Bernstein Research senior analyst Robin Biesenstock. It bought out Portugal Telecom’s stake in Brazilian company Vivo for a staggering €7.5 billion, which made its debt swell, and it shifted the bulk of its debt from long term to short term. Short-term borrowing is generally cheaper for companies. But if rates suddenly rise, the the company faces refinancing at far higher rates than it initially expected. When times were good and the sovereign debt crisis was in its infancy, low borrowing costs for Spain made Telefónica’s borrowing relatively cheap too. Now, however, risks to Spain are higher, and so are Telefónica’s funding costs.

Guillermo Roditi Dominguez of New River Investments also points to the company’s 10.46% stake in Telecom Italia. The Italian firm is highly indebted and has little infrastructure to grow its business. So it is not providing much revenue against the debt that Telefónica racked up when it bought the stake in 2007.

Telefónica was not alone in making poor decisions as the first signs of crisis began to surface. In the energy sector, Fitch Ratings analyst Erwin van Lümich explains, “The M&A activity was right at its peak during 2007-8, so going into the crisis [companies] had quite high expectations, high leverage [debt].” The subsequent crisis caught them unprepared.

How to trim the debt, cut risk, and thus make borrowing cheaper? For many companies the answer has been selling off assets. Banco Santander sold off 25% of its Mexican unit in an initial public offering (IPO) of stock in late September. Spanish energy company Iberdrola is reportedly considering selling off its wind power business in Poland, even as regulations will force the country to shift even more business to renewable energies. Telefónica, in addition to its German shares and two corporate jets, is said to be thinking of selling some shares in its businesses in Latin America too.

However, these sales are a bit of a gamble. “In Europe, it is likely that in many industries the growth prospects will be fairly limited,” van Lümich says. “So it’s not clear that these divestments [particularly in Latin America] have a positive impact on [credit] ratings.” Telefónica, for example, saw business in Spain contract by 7.6% last year. By contrast, two-thirds of the company’s 312 million customers and half its sales are in Latin America, where revenues grew by 12.3% in 2011, and where the Pyramid Group estimates that the mobile penetration rate will increase from 109% now to 130% by the end of 2015.

Then again, these overseas businesses also require a lot of investment and carry quite a bit of risk. Roditi says investors should be concerned about a possible nationalization of Telefónica’s subsidiary Movistar in Argentina, or new laws that would prohibit the parent company from taking profits outside the country. The Argentine government has been outspoken about its desire to get involved in the telecom industry. The fact that it nationalized the Argentine unit of Spanish energy company YPF Repsol suggests that it might take similar actions in the telecom industry.

Yet the most immediate threat to Telefónica—and its Spanish counterparts—is likely to come from ratings agencies and the Spanish government. Investors are expecting Moody’s ratings agency to cut Spain’s sovereign rating to “junk” status any day now. Spain’s government has been periodically paying as much as 7% to borrow money on the open market for 10 years, and analysts think a formal bailout request is a matter of if, not when. If that happens, Telefónica would have to pay a steep new premium on the cost of funding its debt.

The fallout could be even worse, according to Bienenstock, who writes that a downgrade of Telefónica could put the company in violation of its debt contracts. Details about the terms of those financing contracts are not clear, however. A Telefónica spokesman tells us, “No downgrade would imply any violation of Telefónica’s debt agreements,” qualifying that the company may have to increase the collateral it puts up to borrow.

And while Telefónica’s is a particularly sorry plight, its story is echoed in numerous companies around the euro zone. Leaders have been allowing the crisis to drag on until they can garner popular support for measures that will keep the monetary union together. That delay is at the expense of companies like Telefónica. These corporate debt problems will magnify the impact of the crisis on the greater euro zone economy.

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