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Quarter-End Insights

Our Outlook for the Telecom Sector

A pullback provides opportunities in the defensive telecom sector.

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In previous quarterly updates, we've talked a lot about the virtues of international telephone companies. As we discussed, one of the nice features of telecom firms is the significant cash flows they generate.

For many incumbent fixed-line operators, the amount paid by customers is a flat fee, regardless of usage. Although the number of subscribers is declining because of increased competition, particularly from cable operators now offering phone service and from customers choosing to go wireless and use only a cell phone, the decline in revenue is mostly being offset by new services offered, such as high-speed Internet access. On the other hand, many customers of wireless telephone firms, especially in emerging markets, are on prepaid plans that do depend on usage. However, many of these countries are still adding subscribers at rapid rates that will offset declines in some customers' usage.

The reality is, very few people who have had a phone will choose to go without one. The phone has become a necessity, not a luxury.

In volatile economic times like these, the cash flow from a needed service is particularly nice to have. Ultimately, the value of a firm is the present value of its future cash flows. The value of a company that has more predictable cash flows should increase relative to other firms with less predictable cash flows when markets are concerned about economic issues and the sustainability of revenues, margins, and cash flows. In addition, international companies are less likely to be as directly affected by the weak U.S. economy.

Valuations by Industry
Despite the defensive nature of the telephone sector, many of the stocks in the sector have had a significant pullback.

 Telecom Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Telecom Services 0.88 0.99 -11.1
Wireless Services 0.95 1.02 -6.9
Data as of 03-14-08.

For the past several quarters, the telecom sector has been one of the most overvalued sectors Morningstar covers, and we have had a hard time finding companies to highlight. The wireless services sector is still one of the higher-valued sectors, but its median price to fair value ratio is now below 1, implying it's slightly undervalued. The telecom services industry is now middle of the pack versus other sectors, and the median stock in this industry is 12% undervalued.

In the last quarterly update, we noted that  Sprint Nextel (S) was the only telecom stock trading below our consider buying price. We continue to like Sprint and think it is now trading below the value of the spectrum it owns, based on the value of the currently ongoing spectrum auction. The 50 million subscribers and plant and equipment are thrown in for free.

Telecom Stocks for Your Radar
In keeping with our international theme, we're pleased to see that five international stocks are now trading below their consider buying price. Along with generating lots of cash, four of these five return some of that cash to shareholders with above-average dividends, though we expect  Telecom Italia (TI) to cut its dividend, so the trailing yield of 9.1% will most likely not be the yield going forward.

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

Dividend
Yield

BT Group  $69 Narrow Average 7.4%
NII Holdings  $64 Narrow Above Avg 0%
SK Telecom  $38 Narrow Above Avg 5.1%
Telecom Italia  $34 Narrow Average 9.1%
Telkom Indonesia  $65 Narrow Above Avg 3.2%
Data as of 03-19-08.

 BT Group (BT)
Our thesis for BT Group continues to play out with growth in "new wave" services offsetting the decline in traditional phone calls. We don't see any reason this will change. The firm's management has done a great job of developing a strategy and then executing the plan. BT is transitioning from a highly regulated provider of basic telephone services in the U.K. into a full-fledged supplier of technology services. After several acquisitions, the firm is now a global force in information, communications, and technology services.

 NII Holdings (NIHD)
NII Holdings has a strong position as a niche wireless provider serving the Latin American business market. Improving economic conditions in Latin America have helped the firm generate strong profitability and returns on investment. However, NII competes alongside telecom giants that dwarf its size and resources. NII's performance has been outstanding over the past few years. Although most wireless operators in Latin America are focusing on the fast-growing prepaid retail segment, NII has directed its operations toward corporate customers demanding instant connectivity.

 SK Telecom (SKM)
Intensifying competition in South Korea's telecom industry will likely hurt SK Telecom's profitability during the next couple of years, but the firm's dominant size and expertise in the market should help preserve its leading position and generate decent growth going forward. SK is the head of the pack in South Korea's wireless industry, commanding more than half the nation's mobile-phone users, while its two rivals,  KT Corp. (KTC) and LG Telecom, control the rest of the market. Korea has consistently been an early adopter of technology, making constant innovation a key to staying competitive. Through providing a broad array of value-added data features, such as mobile banking, the firm has been able to attract and secure some of the nation's most valuable customers, which in turn has allowed it to generate the highest average revenue per customer in Korea.

 Telecom Italia (TI)
Telecom Italia is the incumbent telephone operator in Italy and remains the leader in fixed-line, wireless, and high-speed Internet access services. Although only the Internet business is showing much growth, these businesses continue to generate significant cash flow, which the firm has been using to expand internationally. With minimal growth in its home market, TI is increasingly looking elsewhere for growth. It has 3.3 million Internet access subscribers in other European countries and has been expanding fairly aggressively, including the 2007 acquisition of  Time Warner's (TWX) Internet access business in Germany. TI also has a nice position in Brazil. It owns 81% of TIM Participacoes (TSU), which has been the fastest-growing wireless operator in Brazil.

 Telkom Indonesia (TLK)
Although competition is growing in Indonesia's telecom industry, we believe that Telekomunikasi Indonesia's (Telkom's) advantages will allow the firm to maintain its dominance. Indonesia's telecom market, which serves the world's fourth-most-populous nation, has experienced rapid growth over the past few years. The country's wireless customer base doubled to about 60 million in less than three years' time. Despite this expansion, wireless penetration rates remain low, at about 35%, presenting tremendous growth opportunities.

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