* Investment Case: We remain around eu500m below consensus EBITDA forecasts for Telefonica. We expect Telefonica Brasil growth to continue to deteriorate as the Brasil telecoms market weakens, due to continued GDP erosion and pricing pressure (including cheaper x-net calls). We also continue to assume some drag on FX rates from inflation in Argentina and Venezuela. These negatives offset the recovery in GEM FX rates and Telefonica Spain growth.
* However, we continue to believe the 3-O2UK deal is likely to complete. This has gone from being a consensus view to a bull-case as the deal deadline approaches. With CKH motivated to complete the deal – the only way to achieve significant scale after trying to grow 3UK organically for 13 years – and several keen remedy-takers (e.g. Virgin, Sky, TalkTalk) we expect 3UK to be able to create the remedies required for the EC to agree the deal. The deal would transform Telefonica's balance sheet and see it returning some of the deal proceeds to shareholders through a return to a 75c cash dividend, a c 8% dividend yield at current price. Equally, a failure of the deal would have little or no downside to the current Telefonica share price (in our view), with the agreed sale price relatively low at 6.6x, other means to secure an investment grade rating without issuing shares and a continued 35c cash dividend giving a 4% yield in line with the sector. Given this skew, and our view that the deal will probably complete, we upgrade Telefonica to Neutral.
* Valuation: Telefonica trades at a premium on EV/EBITDA but a discount on equity FCF yield, due to a relatively cheap FTTH build in Spain.