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Quarter-End Insights

Communication Services: Smaller Rivals Call the Shots in U.S. Wireless

The AT&T-Verizon duopoly is being undermined at the margin by T-Mobile and Sprint. Plus, the French telecom market has stabilized.

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  • Overall, we view the communications services sector as modestly undervalued at a market-cap-weighted price/fair value of 0.94.
  • AT&T and Verizon still own industry economics, but T-Mobile is now dictating the rules.
  • The French telecom market has stabilized since Iliad's disruptive entrance in January 2012.

Duopoly No More
While Verizon (VZ) remains the leader in the U.S. wireless market, we continue to believe that its duopoly with AT&T (T) is being undermined at the margin by T-Mobile (TMUS) and Sprint (S), and we don't see this trend slowing anytime soon. Disruptive actions by these two smaller rivals, such as offering unlimited data plans, threaten to make overall U.S. telecom industry economics less attractive and conflict with Verizon's core strategy of leading with network quality and monetizing increasing amounts of data traffic.

Although Verizon still benefits from a cost advantage over these smaller rivals and will still earn returns above its cost of capital, we expect its ability to command premium pricing to decrease, which we believe will constrain expansion of its future returns. Currently, AT&T, T-Mobile, and Verizon trade near our fair value estimates while Sprint remains significantly overvalued.

As the U.S. wireless market matures, AT&T has pursued large acquisitions in order to grow and diversify revenue. First, with the DirecTV acquisition, AT&T aims to cross-sell video offerings with its wireless service in the hopes of reducing churn and extracting increased value from its subscriber base through unique value propositions such as bundled offerings. Second, with the pending Time Warner acquisition, AT&T hopes that vertical integration will provide revenue synergies and cost efficiencies in content rights negotiations. We think AT&T paid a rich price for DirecTV, an asset that we believe delivers minimal benefits to the core telecom business, and we fear that the company's horizontal and vertical expansion efforts will prevent returns from meaningfully exceeding its cost of capital.

T-Mobile is the top organic growth story among U.S. telecoms coming off three-plus years of industry disruption and outsize share gains. T-Mobile is the only large U.S. carrier that is increasing wireless service revenue, and while we doubt it can keep increasing wireless service revenue in the double digits, mid-single-digit growth appears achievable, versus declining revenue for the industry as a whole. As T-Mobile benefits from recent volume growth, we believe it is approaching a multiyear ramp in profitability and free cash flow. In addition, T-Mobile presents added upside given its strategic appeal to potential partners. Rumors continue to persist that T-Mobile and Sprint may pair up, and we can't rule out such a scenario.

French Wireless Market Stabilizing
 Iliad's (ILD) aggressive entrance into the French wireless market in January 2012 turned a complacent market into one of the most competitive in Europe. However, the market is now stabilizing. Wireless prices remain below where they were in 2011, but the decline has slowed, and in some cases they have increased. Broadband continues to penetrate deeper into the market, and with fiber network buildouts increasing, we anticipate revenue growth returning, thanks to demand for faster broadband speeds.

In the French telecom market, we believe  Orange (ORAN) and  SFR (SFR) have narrow economic moats due to cost advantages and efficient scale. This is driven by unique assets creating the largest wireless telephone networks and fiber networks. Given the cost of building a network and the difficulty in gaining enough subscribers to generate a return on that investment this late in the game, we do not expect any new networks to be built.

We believe the market is overly pessimistic regarding Orange's ability to monetize its superior network in France and its growth opportunities in other parts of the world. Thus, we think Orange's shares are undervalued.

On the other hand, we believe the market is overly optimistic regarding Iliad's prospects in France, where the market appears to think substantial additional market share can be taken. We also think the market expects Iliad to achieve similar results in Italy. However, Italy is a very different market, and Iliad will find the going there much more difficult. We view Iliad's shares as overvalued.

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 underlying earnings per share growth in the high single digits 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 in broadband and from moving to 4G mobile technology to drive this growth. Also driving growth are the upgrading of around 25% 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: $15.50
Fair Value Uncertainty: High
5-Star Price: $9.30

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 strengthen its position in both countries and provide lots of opportunities for cost savings. We don't believe the market appreciates how well the company is positioned and its margin expansion opportunities, which has caused the stock to trade at around a 30% 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
5-Star Price: $49.80

Despite the decline in the stock due to the Colombian peso's weakness in 2015 and 2016, Millicom is still one of our best ideas. We expect the acquisition of UNE, the second-largest cable TV operator in Colombia, and other smaller cable systems in other countries to enable Millicom to generate revenue growth again starting in 2018. We expect the company to generate average organic revenue growth in local currency terms of about 3.3% from 2018 to 2021; this remains one of the fastest growth rates of the European communication companies we cover. On an enterprise value/EBITDA basis, Millicom trades at about 4.6 times our estimate of 2017 EBITDA, one of the lowest ratios in our European coverage. The stock also yields in excess of 4% with a dividend that we believe is safe.

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Private Equity Outlook: Larger Funds, Larger Deals

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U.S. Stock Funds: Steady as She Goes

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Bond Funds: A Period of Relative Calm

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