Spanish telecom giant Telefonica (TEF) reported strong fiscal 2011 results. The company reported adjusted earnings of $2.31 per ADS (EUR1.66 per share) outpacing the Zacks Consensus Estimate of $1.79. However, earnings per share decreased 16.4% from the prior year due to lingering domestic economic downturn, intense competition and higher operating costs.

Adjusted net income dropped 16.6% year over year to EUR7.5 billion ($10.5 billion) in 2011. Adjusted net income for the year excluded the one-time negative impacts from EUR1,870 million charge related to the provision for workforce restructuring in Spain, EUR481 million of Telecom Italia stake write-downs, EUR56 million difference in market value of the BBVA stake, EUR30 million of tax reassessment, and EUR790 million of deferred tax liability on PPA. This was partially offset by the positive impact from EUR184 million related to the partial reduction of exposure to Portugal Telecom, EUR952 million deferred tax liability related to the Vivo acquisition.

Including these special items, net income plunged to EUR5.403 billion ($7.5 billion) from EUR10.2 billion in 2010.

Consolidated revenue rose 3.5% year over year to EUR60.84 billion ($87.63 billion) in 2011 beating the Zacks Consensus Estimate of $82 billion. Despite weaker operations in Spain and Europe, Latin America drove the double-digit revenue growth.

Consolidated operating expenses increased 10.2% year over year to EUR44.501 billion ($62.06 billion). Adjusted operating income before depreciation and amortization (OIBDA) slid 2.1% to EUR22.7 billion ($31.6 billion), resulting in OIBDA margin of 36.1%, down from 38.2% last year.

Segment Results

Telefonica Espana: The operator’s Spanish revenues fell 7.6% year over year to EUR17.3 billion ($24.1 billion), hurt by declines in both wireline and wireless businesses. Wireline revenues dropped 6.7% year over year to EUR10.6 billion ($14.8 billion) due to lower access, voice and Internet broadband revenues partially offset by higher data and IT revenues.

Revenues from wireless operations fell 9.4% to EUR7.7 billion ($10.8 billion) resulting from a reduction in mobile termination rates (MTRs). This was partially offset by strong mobile data revenues and improved handset sales.

Telefonica Europe: Revenues from Europe slid 1.3% year over year to EUR15.5 billion ($21.6 billion) manly due to lower MTRs. Excluding this, revenues inched up 1.7% benefiting from the successful mobile data pricing strategy.

Revenues from UK fell 2.7% year over year to EUR6.9 billion ($9.7 billion) in 2011. Revenues from Germany showed a 4.3% increase to reach EUR5 billion ($7 billion), while Ireland, and Czech Republic and Slovakia declined 14.7% and 5.5% to EUR723 million ($1 billion) and EUR2.1 billion ($3 billion), respectively.

Telefonica Latin America: Latin America continued to grow at a faster pace in fiscal 2011 and remained one of the best performing regions. Revenues climbed 13.5% year over year to EUR29.24 billion ($40.8 billion), driven largely by Brazil (accounting for 49% of the revenues in Latin America and representing a growth of 5.4%), followed by Argentina (14.5%), Venezuela (11.2%), Peru (6.1%), Chile (4.8%), and Columbia (4.5%). However, revenue from the key Mexico market registered a considerable decline of 12.3% due to reduced MTRs.

Revenues in Brazil (the largest market) increased 5.4% year over year to EUR14.3 billion ($20 billion) backed by strong commercial activity and the high adoption of new services in the second half. Telefonica’s Brazilian wireless business showed a 10.6% increase in revenue to EUR8.4 billion ($11.8 billion) from the last year. Wireline revenues fell 1.4% year over year to EUR5.9 billion ($8.2 billion).

Other companies (ATENTO): ATENTO revenue increased 8.4% year over year to EUR1.8 million ($2.5 million).

Subscriber Statistics

At the end of 2011, total customer access reached approximately 306.6 million, up 6.7% year over year, with 9.6% and 3.2% year-over-year growth in Latin America and Europe, respectively.

On an annualized basis, mobile access rose 8% to 238.7 million customers and mobile broadband access shot up 61% to 38 million. Total retail fixed broadband access grew 5% to 18 million, driven by the rapid adoption of bundled services (voice, broadband, and television). Pay TV access reached 3.3 million, up 19% year over year. Fixed telephony access dropped 3% to 40.1 million subscribers in 2011.

Liquidity and Capital Expenditure (CapEx)

Telefonica exited the year with net debt of EUR56.3 billion ($78.5 billion), up from EUR55.6 billion at the end of 2010. The leverage ratio (net debt-to-EBITDA) was 2.63 times as of December 2011.

CapEx grew 3.3% year over year to EUR10.2 billion ($14.2 billion) in 2011. Despite the strong investments in spectrum, free cash flow improved to a record EUR9.27 billion ($12.9 billion) from EUR8.5 billion in the prior year.

Looking Ahead

For 2012, Telefonica expects revenue to grow at least 1% year over year with lower EBITDA margin decline. Additionally, the company expects leverage ratio (net debt-to-EBITDA) to be equivalent to 2.35 times for fiscal 2012.

Telefonica reiterated its dividend payment policy announced in December 2011. The company expects to pay a total dividend per share of EUR1.50 for 2012 and 2013. The company will pay a cash dividend of EUR1.30 per share and buy back shares with the balance.

Our Take

Telefonicaremains challenged by a weak domestic economy,the slowdown in Brazil, the ongoing reduction in mobile termination rates, a highly leveraged balance sheet and growing competition from France Telecom S.A. (FTE), Vodafone Group Plc (VOD), China Mobile Ltd. (CHL) and America Movil S.A.B. de C.V. (AMX).

However, Telefonica’s presence in the strong performing Latin American region, in particular Brazil, would boost future earnings growth. Additionally, continued investments in the expansion of broadband services (both fixed and wireless) are expected to stem some of the rot in domestic operations. Further, we are impressed with the company’s efforts to expand its broadband and data services in several markets. The company’s increased efforts would lead to strong revenue and profitability, thereby increasing shareholder returns.

We are maintaining our long-term Neutral recommendation on Telefonica. For the short term (1-3 months), the stock also retains a Hold rating with a Zacks #3 Rank.

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