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Quarter-End Insights

Our Outlook for the Telecom Sector

Growth is limited, but we're still big fans of these mature international firms.

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Rapid expansion in telecom markets around the world, particularly in emerging markets, has caused stock prices to skyrocket in recent months. Echoing our last sector report, some of the increase in prices is warranted, and we have updated a number of fair value estimates to account for the opportunities these companies enjoy. However, high-double-digit growth in many international markets has left firms such as  NTT DoCoMo (DCM) and  SK Telecom (SKM), which were once the crown jewels of the telecom industry, in the dark, as these companies' growth stages are long gone. But although growth is important, cash flows determine the value of companies at the end of the day, and these stodgy telecom operators continue to generate significant amounts of cash and attractive margins.

In countries where wireless technologies are more developed, price is no longer the key differentiator. Instead, customers place more emphasis on the quality and variety of services provided and aren't afraid to pay up for them. As a result, the average revenue per user in mature markets is substantially higher than what we see in emerging markets. The constant need to innovate in order to satisfy the appetites of tech-savvy customers has allowed these providers to become pioneers of the wireless world, and carriers have used their industry expertise and strong free cash flow to take advantage of opportunities abroad.  Hutchison Telecom (HTX), for example, controls one of the largest wireless operators in Hong Kong and Israel. But with wireless penetration rates surpassing 100% in both countries, growth is scarce, and the company has turned to other regions for expansion. The firm created Hutchison Essar, a joint venture in India that quickly became one of the biggest wireless companies in the country, thanks to the company's extensive experience. Hutchison sold its Indian subsidiary to  Vodafone (VOD) earlier this year for $11 billion. While such opportunities are hard to come by, we believe the financial flexibility and competitive advantages of these telecom companies will allow them to remain at the forefront of the wireless industry.

Aside from the lack of growth prospects, increasing competition in historically stable markets like Japan and Korea has also pressured stock prices as the market feared that profitability will be permanently impaired. Most of the damage stemmed from the introduction of number portability, which allows customers to switch carriers while keeping their old numbers. Nevertheless, the after-effects of number portability are often short lived, and we think investors could take advantage of the buying opportunities that are being presented.

Valuations by Industry
Despite increases in our fair value estimate in the past months, the average price/fair-value ratio of telecom companies remains among the highest among the 12 sectors we cover.

 Telecom Industry Valuations
Segment

Current Median Price/Fair Value

Three Months Prior   Change (%)
Telecommunications Service 0.99 1.05 -5.7
Wireless Services 1.02 1.04 -1.9
Data as of 11-16-07.

Wireless telecom stocks in emerging markets continue to run as a result of the stellar growth rates these firms are delivering. Demand for mobile phone services in emerging markets is stronger than ever as customers are terminating their fixed-line services for cellular services, or going straight to wireless as their first phones. As a result, investors had bid up prices beyond what we believe are fair long-term values. Our average star rating is 2.8, and  Sprint (S) is the only 5-star stock out of the 78 telecom companies we cover.

Telecom Stocks for Your Radar
Outstanding growth in various emerging markets has caused these five more mature international telecom operators to be largely ignored. Still, we believe these firms are some of the finest telecom companies in the world, with four of the five sporting narrow economic moats. Most of them are trading near our Consider Buying price and are good stocks to be placed on your radar screen.

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

P/FV

NTT DoCoMo $18 Narrow Average 0.88
KT Corporation $29 Narrow Average 0.99
Hutchison Telecom $27 None Above Avg 0.82
NTT $32 Narrow Above Avg 0.74
SK Telecom $38 Narrow Above Avg 0.82

Data as of 12-11-07.

 NTT DoCoMo (DCM)
DoCoMo's revenues have been hurt in recent periods thanks to a harsh pricing environment led by competitor Softbank and the introduction of number portability. However, we believe the effects should subside soon, as customers who chose to switch providers would have done so already. The company is also successfully migrating users to its next generation network (3G) after resolving some network issues. More than three fourth of its customer base are now on its 3G network, which should drive the firm's average revenue per user higher.

 KT Corporation (KTC)
Despite increasing competition in the Korean telecom industry, KT remains the dominant leader in the country's fixed-line market. The company is also the controlling shareholder of KT Freetel, Korea's second-largest wireless provider. KT's profitability suffered over the past year, as a result of soaring handset subsidies in an effort to win subscribers. However, wireless providers are beginning to cut back on subsidies, which should help expand margins in the near future. KT is the largest integrated telecom firm in Korea, giving it a leg-up against competitors.

 Hutchison Telecom (HTX)
After selling its fast-growing operation in India, Hutchison Telecom's stock plummeted (after accounting for the special dividend) as the market worried about the firm's lack of growth opportunities. The firm is using the immense amount of cash it received from the sale of its Indian business to invest in high-growth areas such as Indonesia and Vietnam. Although the firm will face some pressure, especially in Indonesia, its seasoned management team should allow the company to become a sizable player in these markets. Furthermore, Hutchison also has solid operations in Hong Kong and Israel, where profitability is much higher.

 Nippon Telegraph and Telephone (NTT)
Nippon Telegraph and Telephone is Japan's incumbent fixed-line company, and continues to dominate the nation's fixed-line and Internet access markets. NTT holds a 57% stake in DoCoMo. Its wireless subsidiary has been the firm's growth engine in the past, but DoCoMo's recent weak performance, along with slower-than-expected uptake for fiber-optic service, has led to falling revenues for NTT. Nevertheless, the company continues to generate significant cash flow, which it is using to invest in new prospects.

 SK Telecom (SKM)
SK Telecom is the leading wireless carrier in Korea, with more than 50% market share. While increasing competition has hurt margins, SK remains the most profitable wireless carrier in Korea, thanks to its high-spending customer base. With growth slowing at home, the company has been making investments in foreign markets such as China and Vietnam to boost growth rates. SK recently announced its intention to bid for Hanaro Telecom, Korea's second-largest fixed-line provider, which will make it a fully integrated telecom firm in Korea. While we are big fans of the stock, foreign ownership restrictions continue to strain the firm's ability to return value to shareholders.

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