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Quarter-End Insights

Telecom: Firms Strive to Be More Than 'Dumb Pipes'

U.S. telecoms are working to diversify away from being pure wireless network providers.

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  • Overall, we view the communications services sector as fully valued at a market-cap-weighted price/fair value of 1.01.
  • U.S. telecom continues to combat the fear of being a "dumb pipe."
  •  China Mobile (CHL) still dominates in broadband even as the mobile subscriber market evens out a bit.

U.S. Telecom Continues to Combat the Fear of Being a 'Dumb Pipe'
Perhaps the most important trend we're seeing in U.S. telecom is the ongoing shift in strategy to diversify away from being a pure wireless network provider.  AT&T (T), in particular, continues to move away from wireless and into satellite television and over-the-top, or OTT, TV via its acquisition of DirecTV and, more recently, the firm's pending entry into the media content space via its acquisition of  Time Warner (TWX).

Ultimately, we think the industry fears being just a supplier of "dumb pipe," where it becomes a commoditylike business with no ability to differentiate based on network quality or reliability. We still see  Verizon (VZ) as a bit of a holdout on this front, as the firm touts its network quality as a differentiator over AT&T,  Sprint (S), and  T-Mobile (TMUS). Verizon's acquisitions of AOL and Yahoo represent a far smaller bet (both strategically and financially) on advertising platforms.

T-Mobile continues to execute well and offer aggressive pricing in order to capture customers, including many from Verizon, which reported notably disappointing quarterly results. Sprint continues to face challenges associated with capturing and retaining customers as well as building out a high-quality network.

Perhaps the most exciting news for both T-Mobile and Sprint investors is the potential for a merger between the two firms during Donald Trump's administration, as the Federal Communications Commission has been visibly focused on deregulation and might allow for such a merger to go through.

China Mobile Still Dominates in Broadband Even as the Mobile Subscriber Market Evens Out a Bit
In the Chinese telecom market, we see wireless competition evening out a bit (albeit in a slower-growing market than in years past) but still see China Mobile as the dominant player in broadband.

As background, from the beginning of 2009 until the end of 2013, the "3G era,” China Mobile dominated the Chinese telecom industry, capturing half of new customers, while the remainder were split between China's other two large telcos,  China Telecom (CHA) and  China Unicom (CHU). China Mobile's wireless dominance extended into 4G, gaining 77% of net new customers in the mobile market in 2014 and 2015, with China Telecom adding 16% and China Unicom adding 7%. On the surface, in 2016 we have seen a fightback from the smaller operators, with China Mobile's share of net new adds at 44%, China Telecom at 34%, and China Unicom at 22%. Yet even these numbers are skewed, as a majority of net new 4G customers are still in China Mobile's favor, courtesy of its much bigger base of 2G customers, which it has been migrating up to 4G without impacting its overall net market share.

However, the story in broadband is very different, with China Mobile cutting a swath through that market, adding 64% of new customers over 2016 compared with 28% for China Telecom and only 8% for China Unicom. While China Mobile's fixed broadband average revenue per user is only around half of the incumbent fixed-line operators, it is taking most of the new growth at over 65% of new fixed broadband customers in the market over 2016.

China Mobile's already-mentioned very strong balance sheet combined with its relatively low dividend payout ratio mean it can easily invest heavily in this market and make life difficult for its two competitors in the fixed-line market. Indeed, at the result briefing, management indicated it viewed an integrated fixed and mobile broadband offering as essential and set itself an ambitious target of adding a further 20 million fixed broadband customers in 2017, a slight increase on 2016 net adds.

Top Picks

 China Mobile (CHL)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $66.00
Fair Value Uncertainty: Medium
5-Star Price: $46.20

We expect narrow-moat China Mobile to generate earnings per share growth of around 10% annually over the next five years, putting it toward the upper end of Asia-Pacific telecom companies in terms of growth. We expect China Mobile's strong market share gains from moving to 4G technology to drive this growth. Also driving growth are the upgrading of around 40% of its customer base to phones supporting mobile data, cost savings from the tower company, and a potential rerating in its stake in the tower company when it lists.

 Telefonica (TEF) 
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $14.00
Fair Value Uncertainty: High
Consider Buying: $8.40

Telefonica is leading the European communications market into converged services. Additionally, it is laying extensive amounts of fiber to better compete with cable operators in providing fixed broadband services. It acquired E-Plus in Germany and GVT in Brazil, which strengthens its position in both countries and provides lots of opportunities for cost savings. We don't believe the market appreciates how well the firm is positioned and its margin expansion opportunities, which has caused its stock to trade around a 40% discount to our fair value estimate.

 Millicom International Cellular (MIICF) 
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $83.00
Fair Value Uncertainty: High
Consider Buying: $49.80

Despite the decline in the stock due to the Colombian peso's continued weakness, Millicom is still one of our favorites in the sector. We expect the acquisition of UNE, the second-largest cable TV operator in Colombia, to enable Millicom to generate revenue growth even after currency declines in Colombia and other countries. We expect the firm to generate organic revenue growth in local currency terms in excess of 6% for the next five years, the fastest growth rate of any of the European communication companies we cover. On an enterprise value/EBITDA basis, Millicom trades below 4 times our estimate of 2016 EBITDA, the lowest in our European coverage. The stock also yields in excess of 4%, a dividend that we believe is safe.

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