Communication Services: The Race to 5G Wireless Is On, at Least for Some
We continue to see value in communication services, even if the industry isn't delivering meaningful growth.
Stocks across the global telecom industry have generally struggled recently even as market valuations in the U.S. have surged higher. In some cases, this pain has been self-inflicted, with investors taking a dim view of large-scale acquisitions, especially deals that push firms outside of their core telecom businesses. Rising U.S. interest rates have likely hurt valuations more broadly given the high yields many telecom stocks offer, as conventional wisdom holds that higher rates are a negative for dividend-paying stocks. Lastly, the industry isn’t delivering meaningful growth. Most telecom markets today are at or quickly nearing maturity, meaning that even a low-key price war in a given market can easily send revenue lower. The stark contrast between telecom growth and that of the technology firms whose operations rely on telecom networks almost certainly accounts for the relative stock performances of the two groups, especially in this market environment.
Despite these issues, we continue to see value in the communication services industry, with the average stock, on a market-cap-weighted basis, trading at a 13% discount to our fair value estimates. This value gap represents a sizable divergence from the market as a whole. Across Morningstar’s equity coverage, the average stock trades at a 2.3% premium. Consider Verizon (VZ), for example, which trades at less than 13 times trailing earnings, down from more than 15 times four years ago despite the strong bull market of the period. Or Comcast (CMCSA) trading at less than 17 times trailing earnings, down from more than 20 times. Comcast shares bottomed at 14 times earnings earlier this year before it dropped its bid for Fox . Outside of the U.S., three of our favorite stocks, Telefonica (TEF), China Mobile , and BT Group , have all hit five-year lows during 2018, in both their local-currency and U.S.-dollar-denominated shares.
In the U.S., the proposed merger of T-Mobile (TMUS) and Sprint remains the most important near-term development. The firms have begun making their case for regulatory approval directly to the FCC, promising rapid 5G network deployments and continued “maverick” pricing moves to keep Verizon and AT&T (T) honest. The firms have also touted their ability to bring broadband competition to millions of homes, especially in rural areas where few options exist today. On the other hand, several firms, including Dish Network (DISH) and Altice USA ATUS, have filed complaints with the FCC against the deal. Dish needs to build out a wireless network to avoid losing the spectrum licenses it has spent around $20 billion to acquire in recent years. In its opposition, the firm outlined how the merger would further inhibit its ability to enter the wireless business.
Dish’s fear is well founded, in our view. The wireless industry exhibits several elements of the efficient scale economic moat source, including high capital intensity, mature demand, and a relatively commoditized service offering. Potential new entrants like Dish face years of losses and poor prospects of earning attractive long-term returns on capital. The U.S. wireless business, however, hasn’t benefited from efficient scale recently because of the competitive imbalance in the industry. T-Mobile and Sprint have had little choice but to price services aggressively in an attempt to close the scale gap with AT&T and Verizon. A merged Sprint/T-Mobile would drastically improve the long-term structure of the U.S. wireless industry, at least for carriers, in our view.
At this point in the deliberations, we continue to place the odds of merger approval at 50/50. Predicting the behavior of regulators under the current administration is difficult, at best, considering recent actions. Most notably, regulators have staunchly opposed AT&T’s acquisition of Time Warner while quickly approving Disney’s (DIS) deal for Fox.
While U.S. carriers are pushing hard with plans to deploy the next generation of wireless technology (5G), carriers in Europe are taking a more measured approach. Instead, European firms remain focused on core network infrastructure, building fiber optics deeper into their networks and rolling out 4G technology to enable converged service offerings. Spain has long been the leader in convergence, with around 80% of broadband customers subscribing to a wireless service from the same company. France and Germany have been pushing convergence but aren't as far along. Now even the U.K. and Italy, which have been big laggards, are starting to offer converged services. The push to lay fiber is, in part, a response to cable competition and increasing consumer demand for faster speeds.
Europe has been much slower at moving to 4G than the U.S. or Asia, but 4G has really taken off in the past year. The move to 5G will likely similarly lag other regions, though the focus on fiber construction should make 5G easier to deploy down the road. Telia (TLSNY) of Sweden is one clear exception to this generalization. The firm was the first in Europe to offer 4G and, until recently, was the only operator discussing a 2019 5G launch of 5G. BT has also jumped on the 2019 launch bandwagon, but that firm has a lot still on its plate as it wrestles with regulators in the U.K. and shores up its global enterprise business.
On the other hand, carriers in Asia are racing ahead with 5G. In China, mobile data usage continues to surge at a torrid pace as wireless devices take a central role in more areas of daily life. Across the country, mobile data traffic has more than tripled year over year each of the past several quarters. To meet growing demand, China Mobile, the largest carrier in the world by customer count, aims to have 5G services up and running in early 2019. Also, Asian carriers have partnered extensively in search of the best technology solutions and to build new applications to take advantage of greater network capacity. China Mobile claims that it has over 500 patents on parts of the 5G standard and already had 5G trials in 17 cities (five for networks and 12 for applications).
In Japan, NTT DoCoMo has partnered with more than 1,500 firms to develop 5G applications. We expect partnerships and joint ventures will be key to the pace of 5G deployment in many countries. Carriers in many developed countries, including the U.S., have spent aggressively on 4G technology over the past decade with little incremental revenue or profit to show for it. We suspect the appetite to build another generation of technology without a clear path to acceptable financial rewards will be limited.
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $15
Fair Value Uncertainty: High
5-Star Price: $9
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 a wide discount to our fair value estimate.
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $23
Fair Value Uncertainty: High
5-Star Price: $13.80
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, it has begun a more aggressive marketing push into converged services.
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 they are more likely to increase from here. We believe the benefit on the pension will be greater than the hit on 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 its revenue in its global services division. The market appears to believe 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 6.7% 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.
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $42
Fair Value Uncertainty: Medium
5-Star Price: $29.40
Like its traditional pay-TV distributor peers, Comcast has suffered from the growth in cord-nevers and cord-shavers, particularly as over-the-top offerings like Sling TV, DirecTV Now, and YouTube TV gain traction. This ongoing deterioration in pay-TV economics has negatively affected the share price of Comcast and its peers. However, the combination of the hostile bid for Sky and the bid for Fox assets has had a larger impact. We believe that a shift in focus toward M&A from returning capital to shareholders has spooked some investors, but we believe the decision to walk away from Fox demonstrates that management will remain disciplined in its approach to capital allocation.
After the M&A headlines disappear, we believe Comcast is the best-positioned U.S. communications firm. Irrespective of the challenges faced by traditional pay TV, broadband demand continues to accelerate. We believe Comcast is better situated to benefit from this trend, owing to the faster Internet speeds it can offer versus many of its telco peers. The current regulatory environment is favorable because of the reversal of Title II and net neutrality rules. With the threat of pricing regulation diminished, Comcast can potentially offset deteriorating pay-TV economics with higher broadband prices.
Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.