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Our Outlook for the Telecom Sector

Takeover speculation is fueling a surge in telecom sector valuations.

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Since the proposed buyout of  Alltel (AT) by private equity investors in May, speculation has run rampant about future acquisition targets among U.S. and Canadian wireless carriers. In most cases, we think the hype is unwarranted. However, that hasn't prevented shares of  Sprint Nextel (S),  U.S. Cellular (USM),  Telus (TU), and other rumored takeout candidates from surging in anticipation of similar lucrative bids. Alltel, the nation's fifth-largest wireless carrier, is being sold for $28 billion, representing more than a 20% premium to its share price before word of an expected deal spread. The transaction marks the largest private buyout ever in the telecommunications industry, which historically has been ignored by private equity investors.  BCE (BCE), the biggest communications company in Canada, has also attracted multiple suitors and is poised for a buyout.

Investors would be wise to value wireless carriers based on their discounted cash flows as stand-alone entities, instead of betting on a takeout. Alltel's solid recurring cash flows, exceptionally strong balance sheet (which is capable of supporting significantly more debt), and seasoned management team made it attractive to private equity buyers and induced what we consider a steep purchase price. However, Alltel's profile is fairly uncommon in the telecommunications industry, making a flurry of future deals unlikely, in our view.

A closer look at some of the most frequently rumored deal participants uncovers company-specific hurdles likely to impede buyout activity. Sprint Nextel is considered a takeover target because it's the only independent nationwide wireless carrier remaining in the U.S. But Sprint's management team has struggled to make decisions following the 2005 merger that created the firm, and the company has since struggled to stem customer losses and improve depressed margins. Further, a deal for Sprint would be difficult to pull off given the large sum of required capital. Sprint would likely sell for 3-4 times the price paid for Alltel, or in the neighborhood of $100 billion--enough to qualify it as the largest leveraged buyout ever across any industry.

The biggest obstacle to a U.S. Cellular buyout, in our view, is its ownership structure. The Carlson family controls fixed-line carrier  TDS (TDS), which in turn owns 81% of U.S. Cellular. We are skeptical of the family's willingness to part with its crown jewel. Shares of  Deutsche Telekom (DT), Germany's incumbent telephone company, also rallied after Alltel's announcement, as investors clamored for the company to sell its T-Mobile USA subsidiary. We think Deutsche Telekom will balk at selling T-Mobile USA, the fourth-largest wireless carrier in the U.S., because that is one of the company's few growing businesses.

Valuations by Industry
The market's anticipation of takeover activity is adding fuel to the surge of telecom sector valuations. Of the 12 sectors covered by Morningstar, telecommunications is the most overvalued when measured on an average price/fair-value basis.

 Telecom Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Telecommunications Service 2.27 1.15 56
Wireless Services 2.45 1.08 20
Data as of 06-15-07.

The mean price/fair value ratio is 1.18, indicating that telecom stocks on average are 18% overvalued. Historical market performance isn't an inherent barometer for valuation, but it provides for some interesting perspective. During the past 12 months, the telecommunications sector has generated a whopping market-cap-weighted return of 44%. Industrial materials, the second-best performer, returned 38%.

As would be expected given this strong market performance, telecom bargains are hard to come by. The selection of attractively valued stocks is the slimmest we've seen since the height of the telecom bubble in 2000. The average star rating is 2.3, trailed only by the energy sector. There is currently not a single 5-star stock in our telecom coverage universe, which totals 76 companies. Still, we think a few scattered opportunities remain, particularly in the international realm. International telecom and pay television firms comprise nine of our 12 4-star stocks.

Telecom Stocks for Your Radar
Finding a good deal on a telecom stock today is as challenging as finding a good deal on a souvenir at Disneyland. To help, we've selected five telecom stocks for your radar screens that are near our "Consider Buying" price. The list includes four international telcos and a domestic wireless carrier.

 Stocks to Watch--Telecom
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Telefonica  $78 Narrow Average 0.83
France Telecom $34 Narrow Average 0.82
Telecom Italia $34 Narrow Average 0.82
Tele Norte Leste $24 None Above Avg 0.79
Sprint Nextel $26 Narrow Average 0.85
Data as of 06-22-07.

 Telefonica (TEF)
This company has by far the best growth rates of the big incumbent European telecom firms, primarily from its past acquisitions in Latin America. With the acquisitions of O2, Cesky Telecom, and Colombia Telecom in the past year, Telefonica has become the third-largest wireless operator in the world. The fixed-line, Internet access, and pay television businesses add to Telefonica's size, giving it the scale to provide cost advantages. And its name recognition, particularly in Spanish- and Portuguese-speaking markets, enables it to earn high returns on capital, which we think provide Telefonica with a narrow moat.

 France Telecom (FTE)
Despite a slowdown in France Telecom's revenue growth, we still like the company. The firm has been successfully moving into Internet-based services, and we think it has an under-appreciated emerging-markets wireless portfolio. Wireless and high-speed Internet access have been growing rapidly. Despite slowing growth in France and the U.K., growth in the rest of the world is still midteens.

 Telecom Italia (TI)
Telecom Italia is the incumbent telephone operator in Italy and remains the country's leader in fixed-line, wireless, and high-speed Internet access services. Although only the Internet operation is showing much growth, these businesses continue to generate significant cash flow, which the firm has been using to expand internationally. One caveat worth mentioning is that the company's management and ownership have been in a state of flux since previous chairman Marco Tronchetti Provera  resigned in 2006.

 Tele Norte Leste Participacoes (Telemar) (TNE)
Telemar is the largest fixed-line operator in Brazil covering the north and east parts of the country, including Rio de Janeiro. Growth has disappeared from this business, but it generates ample amounts of cash. Telemar's growth is primarily coming from the wireless business, which continues to perform well. The company has benefited from Brazil's improved economic fundamentals. One note of caution: This is a volatile stock.

 Sprint Nextel (S)
Although we don't think Sprint makes an attractive takeover candidate, we think its problems are short term in nature and that the strength of the firm's position in the industry will significantly improve financial performance over time. Sprint's large customer base provides operating benefits, such as marketing scale and broader network coverage, which reduce the cost of providing service. As a wireless pure play, Sprint is an attractive partner for cable companies looking to offer phone service. Also, Sprint is using its considerable spectrum holdings to deploy WiMax, a next-generation technology that will bolster its data capabilities.

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Patrick Elgrably does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.