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Quarter-End Insights

Communication Services: A Deal Eludes Sprint and T-Mobile

But both firms still need scale to compete long term against Verizon and AT&T.

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  • Overall, we view the communications services sector as modestly undervalued at a market-cap-weighted price/fair value of 0.93.
  • Sprint and T-Mobile end merger discussions, but both firms should seek greater scale.
  • AT&T's efforts to diversify into media may be hampered.

 

Sprint and T-Mobile End Merger Discussions, but Both Firms Should Seek Greater Scale
We believe that telecom and cable economic moats, in particular, often stem from cost advantages associated with spreading their high fixed costs over a larger number of customers. As such, mergers and acquisitions are always at the forefront of the industry.

With that in mind, we were a bit surprised when  T-Mobile (TMUS) and  Sprint (S) announced that they have called off their merger negotiations. The firms could not reach an agreement on terms, which we assume relates to price and control of the combined firm. We believe a deal would have helped both firms, since it would have provided the scale needed to compete long term against  Verizon (VZ) and  AT&T (T).

Separately, we believe T-Mobile is in a much better position than Sprint. At the rumored deal price of around the $7-$7.50 Sprint had been trading at, we thought most of the value of the deal would have been going to Sprint's shareholders.

Independent of the deal, T-Mobile has done a great job over the past four years of gaining the majority of new wireless subscribers in the U.S. Although we expect it will continue to gain the majority of new customers in 2018, we think it will struggle to generate the returns needed to keep up with ongoing network investments funded by the much larger free cash flows generated by Verizon and AT&T. We believe Verizon in particular will use its extensive free cash flow to quickly roll out a 5G network, which will again re-establish the firm as having the best wireless network in the U.S.

AT&T's Efforts to Diversify Into Media May Be Hampered
AT&T previously made a bold bid to acquire  Time Warner (TWX) and diversify into the media space. Recently, the U.S. Department of Justice filed a lawsuit to block the merger of AT&T and Time Warner. The department believes that the combination of the two firms would allow AT&T to raise the fees on competitors to carry Time Warner content, which includes HBO and the Turner Networks (TNT, TBS, and CNN, among others), as well as slow down innovation within video distribution.

Although we previously believed the two sides would reach a deal, it now appears that AT&T is not interested in making any divestitures and that the Justice Department is eschewing behavioral remedies in favor of structural ones.

Management at AT&T began mounting a public-relations campaign against the agency well before the lawsuit to block the merger was filed. We expect that AT&T will continue to fight the lawsuit in the public square and will attempt to discover evidence that President Donald Trump or other officials influenced the department's decision.

Another argument that we expect the firm to continue to use is that this is a vertical merger, not a horizontal merger that would remove a competitor from the marketplace. This argument leans on recent antitrust precedents under which the Justice Department has settled for smaller divestitures and behavioral remedies to offset any potential future anti-competitive behavior as in the 2011  Comcast (CMCSA) and NBCUniversal merger.

Top Picks

 China Mobile (CHL)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $67.00
Fair Value Uncertainty: Medium
5-Star Price: $46.90

We expect narrow-moat China Mobile to generate underlying EPS 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 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 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 firm to generate average organic revenue growth in local currency terms of about 3.3% from 2018 to 2021, which 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 in our European coverage. The stock also yields in excess of 4% with a dividend that we believe is safe.

Quarter-End Insights

Stock Market Outlook: A Dearth of Opportunity Amid the Rally
Credit Market Insights: Flattening Yield Curve Impacts Performance
Basic Materials: The Most Overvalued Sector We Cover
Energy: A False Sense of Security for Oil Markets
Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All
Consumer Defensive: Hungering for Top-Line Gains
Financial Services: Asset Managers Are Forced to Adapt
Healthcare: Pick Carefully as Valuations Head Higher
Industrials: Pockets of Uncertainty Present a Few Opportunities
Real Estate: Slow but Steady Climb Continues
Technology: Most Bellwethers Are Overvalued
Utilities: A Weak December Could Foreshadow a Tough 2018
Venture Capital Outlook: Dry Powder for Late-Stage Deals
Private Equity Outlook: Eyewatering Acquisition Multiples
Crypto Asset Outlook: Installation Phase

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