Telefónica Cuts Payouts to Combat Debt

Spain's Telefónica will cut dividend payments this year and next in an effort to preserve its credit rating, after failing to sell assets including its UK mobile business because of regulatory opposition and weak investor sentiment.

The former state-owned monopoly said it would slash 2016 dividend payments to €0.55 ($0.60) per share, from a previous level of €0.75 ($0.82), and pay just €0.40 ($0.44) per share in 2017.

The plan is to boost free cash flow to pay off debts, which have ballooned following years of takeover activity in Europe and Latin America.

Telefónica is today one of the most heavily indebted operators in Europe, with a net-debt-to-EBITDA ratio of about 3.05 at the end of September.

The operator had hoped to reduce the figure through a sale of its O2-branded UK business to Hong Kong's Hutchison Whampoa Ltd. (Hong Kong: 0013; Pink Sheets: HUWHY), but that deal was blocked by European regulatory authorities concerned it would harm competition.

Subsequent plans to list shares in Telefónica UK Ltd. and infrastructure business Telxius have also been jettisoned amid weak investor sentiment. (See Telefónica Scraps Telxius Sale Plans and Brexit Batters Telefónica's O2 Sale Plans.)

During an earnings update with analysts, executives said debt reduction was necessary to prevent Telefónica from suffering a downgrade by credit-ratings agencies, and pointed to good progress on cash generation in the July-to-September quarter.

Net debts were reduced by about €2.6 billion ($2.84 billion) in that quarter, to €49.98 billion ($54.55 billion), and the aim now is to lower borrowings through "organic" measures.

"We are moving to an objective of organic deleveraging -- that is, increasing retained FCF [free cash flow] and generating cash in excess of dividend payments that will be directed toward improving the balance sheet," said Ángel Vilá, Telefónica's chief strategy and financial officer. "Inorganic measures that could be thought of remain available but we would not want to entertain discussions on those now."

Perhaps not surprisingly, investors reacted unfavorably to the news about dividend payments, sending Telefónica's share price down by nearly 4% during midday trading in Spain.

Analysts on the call with Telefónica's senior executives also appeared skeptical the operator could achieve its debt-reduction targets without negotiating asset sales.

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The operator has already sold businesses in Latin America and Ireland in recent years, and recently slashed its stake in Chinese mobile operator China Unicom Ltd. (NYSE: CHU), but it sees its chief operations in Spain, Germany and Brazil as integral to its strategic plans and seems to have run out of options for the UK subsidiary.

Delving into the details of cash generation, Telefónica said FCF had grown by 91% over the first nine months of the year, to about €2.3 billion ($2.5 billion), compared with the year-earlier period.

The improvement has come thanks to lower spectrum payments, capital expenditure, financial payments, taxes and dividends to minorities.

But there will be concern about the implications of the organic debt-reduction plan for investment activities.

In a presentation, the operator said the "capex/sales peak was behind us," having invested about 15.3% of sales in capital expenditure over the first nine months of the year.

The risk is that Telefónica slips behind rivals keen to maintain spending levels, although recent results from equipment vendors indicate that service providers generally have entered a phase of belt-tightening following several years of investment in 4G and fiber rollout. (See Nokia Forecasts Sales Decline in 2017, Shares Fall and Ericsson Swings to First Net Loss in 4 Years.)

While executives heralded profitability growth in key markets, Telefónica evidently remains under pressure when it comes to headline results.

Third-quarter revenues fell by 5.9%, to about €13.1 billion ($14.3 billion), while operating income before depreciation and amortization (OIBDA) was down 1%, to around €4.2 billion ($4.6 billion). On a purely organic basis, sales fell just 0.2%, while OIBDA rose 3.1%, insisted the company.

The good news is that Telefónica has taken huge strides since the second quarter, when reported OIBDA declined by as much as 7.1% on a year-on-year basis.

— Iain Morris, , News Editor, Light Reading