The ongoing slow-motion train wreck that is Spain has dragged down plenty of otherwise companies, and Telefonica (NYSE:TEF) definitely belongs on the list. Although Telefonica's health isn't tied to the solvency of Spain as much as other major banks such as Santander (NYSE:SAN) or BBVA (NYSE:BBVA), the state of the economy there still does make a big difference. With hefty debt and a global decline in the returns of wireless as an industry, Telefonica has its challenges. Although the company's debt load is a roadblock to significant value for the shares today, I wouldn't completely count out this company (or its shares).

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No Dividend for 2012
Telefonica is a prime example of how if a dividend yield seems too good to be true, it probably is. Although the yield was once north of 10%, the company announced with its first-half earnings that it was canceling the dividend for 2012. While management intends to reinstate the dividend in 2013 (at a yield of about 6.7% of today's price), it realizes that it needs to focus on cleaning up the balance sheet and curtailing some of the risk (optical or otherwise) of being tied to Spain's macro situation.

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Cleaning Up the Balance Sheet Is Going to Take Some Work
With over $72 billion in debt on the balance sheet (more than $15 per share), liquidity is definitely a concern for Telefonica. Although the company does generate solid double-digit free cash flow margins which mitigate the servicing risk, investors are understandably concerned about any debt-heavy company that garners a substantial portion of its earnings from Spain.

Unfortunately, it's not clear whether the company has many viable options. The decision to cut the dividend entirely would seem to be at least partly in response to a lack of progress in asset disposals; a failure that seems all the worse given Vodafone's (Nasdaq:VOD) comparative success in monetizing non-core assets.

Selling the company's German business would probably be the most attractive option, but it seems like there's nobody willing to step up with a compelling offer ((a little strange, perhaps, given America Movil's (NYSE:AMX) expressed desire to pick up European assets)) and the company is looking to list O2 Germany on the public markets. On the flip side, selling the LatAm businesses might be easier, but this would also rob the company of its best growth prospects. Instead, it sounds like the company is looking at the possibilities of floating some of this business through a share listing.

SEE: Earning Forecasts: A Primer

Still Plenty of Room for Things to Go Wrong
Although providing fixed-line and mobile telephone service is generally seen as a solid business through good times and bad, it's not without its risks. In particular, it would seem that Telefonica is vulnerable to both usage/revenue declines tied to worsening economic conditions in areas like Spain, the United Kingdom and Latin America, and to additional macro risks. Devaluation and depreciation have cut the value of the cash flow streams out of Venezuela and Argentina and threaten to do the same with Spain, if that country's ongoing problems ultimately push it out of the euro.

At the same time, companies such as Vodafone, France Telecom (NYSE:FTE) and America Movil continue to offer fierce competition across multiple markets. If Telefonica lags behind in network upgrades in an effort to conserve cash, it risks higher churn and lower revenue/cash flow from those regions.

The Bottom Line
There are at least two different ways to consider these shares. In terms of the company's earnings power (whether you use earnings per share or EBITDA), the shares look cheap - EBITDA is probably going to remain under pressure through 2013, but the company's current 5.3 times multiple looks low, even for a business with exposure to more mature European markets.

On the other hand, the cash flow picture is more challenging. Although low-to-mid-single digit free cash flow growth is more than enough to support a healthy fair value for Telefonica shares, that huge debt load is problematic. What's more, while asset sales should lessen the debt, it likely comes at the cost of lower future cash flows.

All in all, Telefonica looks like a stock that has gotten punished a little too much for its balance sheet and the turmoil in Spain. It has definite potential as a recovery/turnaround play, but I'm not sure the stock can outperform without more optimism in the market regarding Spain and/or the pace of deleveraging the balance sheet.

Stephen D. Simpson has owned shares of America Movil since 2004.

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