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Quarter-End Insights

Communication Services: The Most Undervalued Sector We Cover

We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

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  • Overall, we view the communications services sector as undervalued at a market-cap-weighted price/fair value of 0.86.
  • In Europe, the main telecom themes are still the move to convergence along with increased fiber and 4G buildouts.
  • In telecom and cable, we continue to see migration from traditional pay-TV providers to over-the-top offerings.

In Europe, the main telecom themes remain the move to convergence along with increased fiber and 4G buildouts. Spain has long been the leader in convergence, with around 80% of broadband customers subscribing to a wireless service from the same company. France has also been pushing convergence but isn't as far along. Germany was slower but is increasingly pushing convergence. Now even the United Kingdom and Italy, which have been big laggards, are starting to offer converged services. The movement to convergence is enhanced by the faster broadband speeds offered by fiber. Historically, cable-TV operators have enjoyed an advantage with broadband speeds due to networks that were designed for video and include more fiber and coax rather than copper. However, to better compete, telecom operators are increasingly laying fiber that provides equivalent speeds to the cable operators. Europe has been much slower at moving to 4G than the United States or Asia, but 4G has really taken off in the past year. Penetration rates are still behind the U.S. and parts of Asia, though. Thus, we expect the transition to 4G to continue as operators extend their 4G networks. While the transition to 4G continues in Europe, the U.S., Japan, and South Korea are preparing for the jump to 5G. Several companies in these countries have discussed initial offerings by the end of this year.

For pay-TV distributors, we continue to see migration from traditional providers such as  Comcast (CMCSA) and  Dish Network (DISH) to the newer OTT providers such as Sling TV, DirecTV Now, and YouTube TV. We believe that more-concentrated bundles and lower price points will continue to attract cord-shavers and possibly even some cord-cutters. The major OTT providers now have over 4.5 million subscribers in the U.S., and we project that this number will increase. For traditional video providers with a broadband offering, we expect companies like Comcast to shift margins from the video piece of the bundle to the broadband side. While Dish is benefiting from this transition thanks to its Sling TV product, we note that the margins on OTT pay TV are considerably lower and the company lacks a competitive broadband offering. Wide-moat media companies such as Disney and Fox have placed their most important channels across all major OTT TV platforms while smaller companies like Discovery and Viacom have struggled to gain carriage. We believe these smaller companies will continue to be locked out, particularly if the new OTT platforms continue to add subscribers.

Top Picks

 China Mobile (CHL)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $65
Fair Value Uncertainty: Medium
5-Star Price: $45.50

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: $16
Fair Value Uncertainty: High
5-Star Price: $9.60

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 company is positioned or its margin expansion opportunities, which has caused its stock to trade at a wide discount to our fair value estimate.

 BT Group (BT)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $26
Fair Value Uncertainty: High
5-Star Price: $15.60

While narrow-moat BT Group has had some issues in the past two years that caused its stock to decline, we believe the sell-off is overdone. BT is the incumbent telecom operator in the United Kingdom. In 2016, it acquired EE, the largest wireless telecom operator in the country. The company now has the largest fixed-line telephone, broadband, and wireless telephone subscriber bases in the country. Additionally, it is the only operator in the U.K. that owns both a retail fixed-line and wireless network. 

We believe this provides BT with an advantage in selling a converged package of these services plus pay TV. The company has been slow to market its converged services, but now that it has reached an agreement with telecom regulator Ofcom regarding Openreach, its U.K. business that owns its fixed-line network and wholesales access to it to other operators, we expect a more aggressive marketing push into converged services in calendar 2018. BT has been hurt by the widening underfunding of its pension plan as interest rates have declined in the U.K. 

We think interest rates have bottomed and are more likely to increase from here. We believe the benefit to the pension will be greater than the hit from higher interest on its bonds, the reverse of what happened as interest rates declined. We also think the company has dealt with its problems in Italy and will be able to improve revenue in its global services division. The market appears to believe that the problems BT has seen will continue and potentially get worse, whereas we believe business can improve over the next few years. In the meantime, the stock yields 5.4% and the company has increased its dividend for each of the past seven years. Additionally, as it is a U.K.-domiciled company, there is no foreign tax withholding on the dividend.

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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.