Spanish telecom giant Telefonica S.A. (TEF) reported disappointing first half 2012 results with adjusted earnings of EUR0.62 per share (80 cents per ADS) declining 22.9% year over year.

Net income dropped 24.1% year over year to EUR2.82 billion ($3.6 billion) due to the lingering economic downturn in several countries, intense competition and adverse regulation that partially offset strong growth from Latin American and Germany.

Consolidated revenue inched up 0.3% year over year to EUR30.98 billion ($40.21 billion) in the first half. The improved performance was credited to solid development in Latin America, which offset weaker operations in Europe.

Adjusted operating income before depreciation and amortization (OIBDA) declined 6.2% to EUR10.4 billion ($13.5 billion), resulting in OIBDA margin of 33.7%, down from 36.0% in the year-ago period.

Segment Results

Telefonica Latin America: Latin America continued to grow at a faster pace and remained one of the best performing regions. Revenues increased 7% year over year to EUR15.0 billion ($19.4 billion), driven largely by Venezuela (representing a growth of 41.4%), followed by Ecuador (23.9%), Central America (23.3%), Peru (18.2%), Argentina (17.6%), Columbia (15.4%), Uruguay (9.6%) and Chile (9.3%). However, revenue from the key markets — Mexico and Brazil — registered a considerable declines of 3.9% and 3.2%, respectively, in the first half 2012.

Telefonica Europe: Revenues from Europe slid 6.1% year over year to EUR15.1 billion ($19.6 billion) mainly due to economic headwinds, mobile termination rates (MTRs) cuts in Spain and UK and stiff competition. The largest decline came from the operator’s Spanish revenues that slipped 11.7% year over year to EUR7.7 billion ($10.0 billion).

In Espana, wireless revenue fell 14.5% to EUR3.4 billion ($4.4 billion) resulting from a reduction in MTRs. Wireline revenues also dropped 8.9% year over year to EUR4.9 billion ($6.3 billion) due to weak traffic revenue and repositioning of the new tariff portfolio.

Revenues from the UK, Ireland, and Czech Republic and Slovakia declined 0.4%, 15.9% and 6.0% year over year to EUR3.4 billion ($4.5 billion), EUR313 million ($406 million) and EUR1 1 billion ($1.3 billion), respectively in the reported period. On the other hand, revenues from Germany showed a 4.7% increase to reach EUR2.5 billion ($3.3 billion).

Other companies (ATENTO): ATENTO revenue increased 6.3% to EUR948 million ($1.2 billion) from the year-ago period.

Subscriber Statistics

At the end of the first half of the year, total customer access reached approximately 311.7 million, up 5.7% year over year, driven by a 10% year-over-year growth in Latin America.

On an annualized basis, mobile access rose 7.1% to 243.5 million customers. Total Internet and data access grew 2.3% to 19.3 million driven by a substantial 4.5% increase in mobile broadband access to 18.4 million. Pay TV access reached 3.3 million, up 7.2% year over year. Fixed telephony access dropped 1.6% to 40.0 million subscribers at the end of the first half.

Liquidity and Capital Expenditure (CapEx)

Telefonica exited the first half 2012 with net debt of EUR58.31 billion, up from EUR56.42 billion at the end of first half 2011. The leverage ratio (net debt-to-EBITDA) improved to 2.65 times from 2.63 times as of December 2011.

CapEx fell 4.7% year over year to EUR3.6 billion in the reported period. Operating cash flow (OIBDA-CapEx) deteriorated to EUR6.8 billion from EUR7.5 billion in the year-ago period.

Dividend

Given the lingering economic conditions, Telefonica suspended dividend payments and share buybacks for the second half of 2012 and the first half of 2013. The company will nevertheless resume the payouts in the fourth quarter of 2013 with a lower dividend rate. The company would pay a dividend of EUR0.75 per share, down 50% from the EUR1.50 per share projected previously.

Telefonica distributed EUR2.8 billion in cash dividend so far in the 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.

Our Take

Telefonica continues to remain challenged by intensifying European woes, weak domestic operations, slowdown in Brazil, adverse regulations, 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). Further, the scrapping of shareholders return would demoralize investors.

We currently have our long-term Underperform recommendation on Telefonica. For the short term (1-3 months), the stock retains a Zacks # 3 (Hold) Rank based on the company’s cost-cutting initiatives, restructuring efforts and the expansion of Global Resources unit. Such efforts would lead to strong commercial activity, the main goal of the company, and translate into strong revenue and profitability.

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