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Telecom Evolving Into a Defensive Industry

Investments in telecom stocks are more defensive than most might think.

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In the midst of one of the worst market meltdowns in history, investors will inevitably shift their focus from companies pursuing aggressive growth strategies in higher-risk industries to those that operate in more defensive industries. Ironically, the telecommunications sector has moved from the former to the latter in the eight years since the market implosion following the tech bubble. Since the beginning of the decade, this sector has matured in more ways than one, shifting from an industry known for high leverage, weak profitability, and uncertain growth potential toward solid cash flows and steady dividends. Despite these changes, stocks across the industry, both in the United States and abroad, have been beaten down to levels not seen since the last bubble burst.

Telecom Maturing, But With Growth Prospects Intact
A big part of the maturation process within the telecom industry has been the proliferation of wireless devices and Internet usage within our society. Wireless phones and Internet access are now viewed as necessities rather than luxuries for a major portion of the population. More than 80% of the U.S. population has a wireless phone today--double the penetration in 2000--and nearly 75% of Americans use the Internet, up from 44% eight years back. The phenomenon is by no means unique to the United States, as wireless penetration rates (defined as SIM cards per person) in most of Europe are in the triple-digit range, and emerging-markets countries are closing in fast.

The best part of the story is that high penetration rates don't necessarily suggest a low ceiling for growth. Demand for smartphones and mobile broadband is still on the way up. Globally, we estimate that smartphone sales will increase at a 30% clip for the next few years. Recurring telecom services revenue tied to these devices are likely to grow sharply over the next several years, since smartphone users are far more likely to surf the Internet and use multimedia messaging services. We believe average revenue per customer, or ARPU, can continue to rise even if competition intensifies.

As wireless and Internet access services have grown, carriers have begun to reap the rewards of the heavy network spending undertaken in years past. While telecom firms have continued to spend to add capacity, much of the basic infrastructure needed to provide services is already in place, and capital spending as a percentage of sales has declined for many firms around the world. As a result, telecom firms have continued to generate hefty cash flows. Chastened by the telecom bust, firms with questionable finances have used cash to pay down debt rather than make huge cash acquisitions or undertake major new projects. As balance sheets have improved, telecom dividends have become more sustainable and have actually increased in some cases. With juicy dividend yields and improved balance sheets throughout the sector, many telecom firms fit the profile of a traditional "bear market" play.

Unlike most industries, telecom fundamentals are often very different from country to country. Therefore, in the world of international telecom, there is no such thing as being "bullish" or "bearish" on the industry as a whole. For example, in India, where the penetration rate is below 30% and more than a dozen wireless carriers are fighting for new customers, ARPU is falling. In Russia, though, the reported penetration rate is 120%, but there are only three major carriers and ARPU is on the rise. Each country's industry has to be analyzed separately, and we find that some telecom markets are more intriguing than others. We take a look at two countries below that hold strong long-term potential, but one holds far more risk--and potential reward--than the other.

Canada's Strong, Lower-Risk Market
The Canadian telecom industry presents a calm environment, with carriers that are among the most profitable in the world. Over the past few years, a three-player oligopoly-- BCE (BCE),  Rogers Communications (RCI), and  Telus (TU)--has defined the industry, leading to benign price competition. The wireless penetration rate in Canada is still below 70%, leaving plenty of growth potential. Unlike the United States, the major wireless giants in Canada also offer cable television service, which creates opportunities for bundling, cross-selling, and economies of scale. The competitive landscape is set to change soon, as last summer's wireless spectrum auction once again opens the door for new competition. After more than 300 rounds of bidding, $4.3 billion was spent on new licenses, with 40% of that from new entrants. But it's going to be awhile before new entrants get up and running, and even longer before they might have a meaningful impact on the economics of the industry.

 Rogers Communications (RCI)
Morningstar Rating: 5 Stars | Moat Rating: Narrow | Fair Value Uncertainty: Medium
Rogers is the lone player in Canada using the GSM wireless standard. Because GSM is the dominant standard worldwide, its customers can more easily roam internationally than those using rival carriers. It also means Rogers is the only carrier in Canada selling  Apple's (AAPL) iPhone. While the incremental iPhone promotion and subsidy expenses will hurt margins over the near term, improved ARPU and customer loyalty should lay the groundwork for sustained long-term profit growth.

Russia as a High-Growth, High-Risk Alternative
The Russian wireless industry actually has a lot in common with Canada. Three major wireless carriers dominate, and each is very profitable. While the reported wireless penetration rate is more than 120%, carriers double-count certain customers, and the real human penetration rate is closer to 75%. More importantly, broadband Internet access penetration is still less than 10%, and the wireless carriers are working to roll out next-generation wireless networks to exploit the slow development of fixed-line alternatives. However, the macroeconomic backdrop in Russia is far less stable than in Canada. Until the ruble and oil prices (the biggest driver of the Russian economy) begin to recover and the political situation in Russia stabilizes, we think it is going to be difficult for Russian telecom stocks to appreciate substantially. Assuming stability comes, however, the Russian telecom industry offers immense upside.

 VimpelCom (VIP)
Morningstar Rating: 3 Stars | Moat Rating: Narrow | Fair Value Uncertainty: Extreme
VimpelCom is our favorite play in Russia because of its robust growth potential. Third-quarter revenue increased more than 45% year over year, on strong ARPU and usage growth in Russia. Last year's acquisition of Golden Telecom gives Vimpelcom an established base of broadband fixed-line Internet access subscribers, making the firm the country's first fully integrated telecom operator. Vimpelcom has already passed more than 5.5 million households with its fiber-to-the-building fixed-line network. We also expect the firm will have its next-generation wireless networks rolled out in more than 40 cities by the end of 2008.


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