Telefonica’s M&A Plan Leaves CEO With No Room for Error

Telefonica SA notched up its strongest January share rally in six years after it clinched a sale of its wireless towers for 7.7 billion euros ($9.4 billion).

The jump still leaves Telefonica far behind its rivals, and Chairman Jose Maria Alvarez-Pallete now faces a series of more daunting challenges to keep his new investors onside.

First up is a sale of most of Telefonica’s underperforming Latin American units. The promise remains mostly unfulfilled because the pandemic is ravaging economies and putting off potential buyers, according to people familiar with the negotiations. Efforts to bring new investors into Telefonica’s technology ventures are also proving to be a much bigger challenge than expected, they said.

Telefonica’s M&A Plan Leaves CEO With No Room for Error

For now, the sale of more than 30,000 tower sites to American Tower Corp. has helped to counter a perception often voiced by investors that Telefonica management is over-promising and under-delivering on asset sales needed to cut debt. Few had expected Pallete to give up full control of the wireless infrastructure to net a bigger cash windfall.

“For some time, Telefonica’s management credibility was questioned and it showed through clearly in the stock’s under-performance,” said Bestinver Gestion fund manager Ricardo Seixas, who bought into Telefonica toward the end of last year. The tower sale “signals the company is doing what the market expects of it.”

There’s a lot more to do. Telefonica’s cash-rich core business in Spain is under pressure as the pandemic exacerbates intense competition. That means Pallete must move faster to cut a 37 billion-euro mountain of debt by selling underperforming assets and boost returns in Brazil, the U.K. and Germany. Debt is set to fall by 4.6 billion euros once the American Tower deal is complete.

Telefonica’s M&A Plan Leaves CEO With No Room for Error

One of his biggest moves came last May, when Telefonica and Liberty Global Plc announced the merger of their British wireless and cable businesses in Telefonica’s biggest-ever deal. In December, a consortium formed by Telefonica and two other carriers moved to acquire Brazil’s Oi SA, paving the way for a long-awaited consolidation of the country’s mobile industry.

Bringing new partners into Telefonica’s cloud computing, cybersecurity and Internet of Things businesses would help to honor Pallete’s promise to modernize the staid former phone monopoly and develop its tech business to boost returns. Even after January’s 10% share gain, Telefonica’s forward share price-to-earnings ratio -- a measure of its profit growth prospects -- is among the lowest of its big European peers, according to Bloomberg data.

Pallete hived off the tech activities into a new division and gave it its own CEO in 2019. The effort is only partially complete. Splitting teams such as sales away from the legacy business is proving a challenge, according to people with knowledge of the situation. Until the tech units are fully autonomous, Pallete can’t invite in new investors, said the people, who asked not to be identified discussing internal matters.

Telefonica declined to comment.

The company’s shares were down 0.48% to 3.705 euros per share as of 2:04 p.m. Shares are up 14.2% this year.

Spanish Battle

Since he became chairman in April 2016, the 57-year-old Pallete has relied mostly on using cash flow to cut debt, rather than disposals, and resisted calls to cut the dividend. Leverage has fallen by about 27%.

The tower deal fits with Pallete’s plan to find other investors to help shoulder new infrastructure investments and rein in his own spending. Telefonica has even partnered with insurer Allianz SE to set up a wholesale fiber-broadband business in Germany.

A durable turnaround for Telefonica can’t happen without improvements in Spain, which contributes almost a third of its revenue.

The pandemic has hammered the country’s economy and led the quietly-spoken Pallete, who usually shuns politics, to forge a closer working relationship with Prime Minister Pedro Sanchez.

Pallete has worked closely with the government to help draw up a national digital industry policy paid for out of European Union recovery funds. Spain passed a law during the pandemic allowing the government to block acquisitions of stakes above 10% in any company considered strategic. The law was passed to protect companies, such as Telefonica, whose shares have performed poorly in recent years from hostile takeovers.

The Spanish business depends heavily on higher-spending clients. Telefonica has added digital services ranging from home security to health and is even working on plans to sell solar panels and energy. Now it’s getting harder to squeeze more revenue from premium customers, just as the company battles to retain clients on cheaper subscription plans.

The mid- to lower end of the Spanish market is fiercely competitive, with one of the highest rates of customer defections in Europe and a host of phone brands fighting for business.

“Telefonica is forced to pivot urgently from premium to value in Spain,” Jefferies analysts wrote this month as they cut their rating on the carrier to underperform from hold. “Recession and a six-player market are the driving forces.”

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