The Evolving Telecom Sector: Opportunity or Land Mine?
Today's telecom industry is more diverse--and more uncertain--than ever before.
Traditionally, the telecom industry hadn't been great fodder for water cooler conversations. It has long been thought of as a boring, dividend-paying sector.
That's changing. Over the last few years, the industry has been undergoing a transformation, with telecom companies foraying into content distribution, upstart wireless firms grabbing market share, increasing digital data usage, and more.
"There are more headlines about telecom today than there were three years ago," says Alex Zhao, an equity analyst with Morningstar.
It's certainly a more exciting--and a more uncertain--sector than it has been for a while. And uncertainty around the sector's prospects have driven down the S&P 500 Telecommunications Services subindex 6.7% since January. Many of the more traditional players in the sector have seen declines: AT&T has fallen 3.5% year-to-date, while Verizon is down nearly 10% since the beginning of the year as of this writing. Other parts of the telecom market have climbed, though. Cable company Charter Communications, for instance, is up 13% year to date.
That divergence in returns among companies is emblematic of the difference between today's telecom sector and the telecom sector of old.
What's Happened with Wireless?
When most investors think of telecom, they likely think of the big-name wireless companies, such as AT&T (T), Verizon Communications (VZ), Sprint (S), and T-Mobile US (TMUS). There's plenty of change afoot here.
Years ago, AT&T and Verizon dominated the sector, and while they're still the largest players, their once-large moats have diminished as T-Mobile and Sprint have started taking market share. (Morningstar currently assigns a narrow moat rating to the former two companies and a no moat rating to the latter two.) That has impacted their pricing power, says Zhao. T-Mobile, for example, has introduced an unlimited data package, something the bigger carriers haven't wanted, but are now forced to do.
It's also unclear how the content play that some wireless firms have been engaging in will work out. If AT&T's purchase of Time Warner (TWX) goes through, it will own a lot of high-quality programming, such as HBO's lineup, which could allow it to generate advertising revenues and reduce the price it pays to show content on its various platforms. It may also give subscribers content-specific benefits, similar to how AT&T provides customers free data streaming for DirectTV Now. (AT&T purchased the satellite business in 2014.) However, Zhao doesn't think the bundling model will give these companies a sustainable edge, because competitors can also start offering content for free. For instance, T-Mobile gives customers who switch from AT&T a year's free credit for a DirectTV Now subscription.
The cellphone market is also fairly saturated. According to research site Statista, the number of U.S. wireless subscribers grew by just 5.4% year-over-year in the fourth quarter of 2016. Increasing competition, weaker pricing and slow growth doesn't say screaming buy, at least not in the near term, says Paul Greene, manager of the Bronze-rated T. Rowe Price Media & Telecommunications (PRMTX).
"The competitive environment in the U.S. wireless industry has gotten worse for the large incumbents," he says, though he does note that he has a sizable portion in T-Mobile, which is growing faster than the others.
Saying all that, buy and hold dividend investors may still be drawn to these companies, says Greene. They offer good payouts--AT&T has a trailing 12-month yield of 4.8%, while Verizon is yielding 4.85%. Like other dividend payers, these stocks may underperform in a rising rate environment--but the dividend is still attractive nonetheless.
Better Prospects in Cable and Towers
For investors who want more growth--and perhaps more upside--managers agree that there are two areas to look at within telecom: broadband cable and cellphone towers. The former, which includes companies such as Charter Communications and Comcast (CMCSA), has been taking market share from traditional wireline operators that transmit cable over a copper line. Broadband cable is delivered over the internet and is a much faster delivery system than wireline, says Scott Walker, an analyst with MFS Investment Management, who contributes telecom ideas to the Silver-rated MFS Utilities (MMUFX).
"It's really winning that race consistently," he says.
Broadband is also Netflix-proof. Since the internet is also delivered over broadband, even if someone cuts the cable cord, they'll need a fast and reliable connection to stream movies.
"If you ditch your cable bundle, you still need some way to consume Netflix (NFLX)," says Walker. "So your faster speed alternative will be (broadband) and that reinforces the bet in the long-run."
Both Walker and Greene are also fans of tower companies, which are physical towers that transmit wireless signals to cellphones. They charge carriers a fee for use of their towers, and that fee can increase as consumers consume more data. Companies in this subsector, such as SBA Communications (SBAC) and American Tower (AMT), typically raise prices by inflation or 3%, whichever is higher, says Walker.
As people use more data--Americans are expected to increase their data consumption by 535% between now and 2021, according to a 2016 Ericsson Mobility report--tower companies could start seeing double-digit revenue growth, says Walker. Greene thinks the sector will see strong internal rates of return, too.
"We can see compound returns grow at double digit rates with a lot of visibility and without much variation," he says.
Pick Your Spots--and Mind the Uncertainty
Currently, the telecom sector is just slightly undervalued according to Morningstar, trading at 0.96 fair valuation ratio. A few names are trading in 4-star range, suggesting they're undervalued by Morningstar's metrics: CenturyLink (CTL), Frontier Communications (FTR), and Windstream Holdings (WIN).
However, investors in this sector should pay close attention to uncertainty ratings, which vary by company. Despite the pressure on the traditional telecoms, AT&T and Verizon both earn medium uncertainty ratings, because they're still large companies that generate plenty of cash, says Zhao. However, CenturyLink, Frontier Communications, and Windstream Holdings all carry high or very high uncertainty ratings due, in part, to increasing competition in the cable sector.
While several Morningstar Medalist funds hold telecom stocks, Greene's T. Rowe Price fund is the only telecommunications fund that earns a medalist rating. Some other telecom-focused mutual funds and ETFs include Fidelity Select Telecommunications (FSTCX), iShares US Telecommunications (IYZ), S&P Telecom ETF (XTL), and Vanguard Telecommunication Services ETF (VOX).
Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.
Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.