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Making Money on Overseas Calls

Our analysts describe the layout of the global telecom landscape.

Haywood Kelly, 03/09/2010

On one hand, global telecom firms offer huge cash flows, high dividends, and, in some cases, good growth potential. On the other, they're exposed to massive risks of technological change and government regulations. To help make sense of the opportunities in global telecom, we chatted with members of Morningstar's telecom team--Allan Nichols and Imari Love.

Haywood Kelly: Big picture, what's your team's thesis on global telecom? Where do you see this industry 10 years from now?

Imari Love: A lot can happen in 10 years. If we look at how the telecom industry has evolved since 2000, the metamorphosis has been startling. Ten years ago, much of the wireless industry was defined by companies with high leverage and low visibility. Firms were still trying to figure out exactly how much they could get away with charging and the best ways to manage their cost structure. These days, the economics of the business are better understood. Throughout all of the global telecom sectors, cash flow and dividend yields have increased, while debt ratios have dropped off considerably. Cell phones have gone from being a luxury to being a necessity, and the carriers are now viewed as defensive plays that pay out healthy dividends and buy back stock. And in 10 years, the landscape will look a lot different.

Allan Nichols: We see continued integration between communication methods: fixed-line, wireless, broadband, and television. In 10 years, wireless communication will be ubiquitous. People will be able to receive a wireless signal almost anywhere in the world and virtually every adult and youth will have a mobile phone. Smartphones will rule the planet, with data being the biggest driver of revenues. We expect some tumultuous times as carriers revamp pricing strategies to charge users for the bandwidth they use. Currently, voice charges are paying the bills, but voice doesn't use a lot of bandwidth. AT&T T recently stated that 3% of its smartphone subscribers account for 40% of its data traffic. Current unlimited data plans don't cover the cost of such usage. Carriers need to lower the cost of voice and increase the cost of data. In the developing world, wireless phones will act as a computer for many people. Fixed-line networks often only cover about 20% of the population, and they are unlikely to be expanded. In developed markets, however, we expect the fixed-line network to remain the primary distributor of broadband. It is, and will remain, faster, more secure, and easier to view. Today, many cable firms are offering broadband speeds at 100 Mb/second or faster, which is much faster than the 20 to 30 Mb/second being offered by most European carriers. We expect greater competition between the cable firms and telephone carriers as they each offer the others services. We expect that phone companies will need to push fiber further out. We also think broadband speeds could reach 1 Gb/second in 10 years as fiber is built all the way to people's homes and new technology is invented.

HK: What would keep you awake at night if you ran a major telecom firm?

AN: My biggest concern would be regulation. The regulators continue to cut the fees carriers are allowed to charge other operators using their network, which could make it uneconomical to upgrade the network. Without upgrading, cable firms will eat their lunch. Cable companies are pretty much unregulated, providing an unfair playing field, in my opinion. Either cable firms need to be required to share their network or telecom firms need to be given greater pricing freedom. Otherwise, there is a real risk of carriers refusing to upgrade and consumers being left with slow data speeds.PAGEBREAK

HK: What countries are best positioned competitively?

IL: There are three things we focus on when trying to gauge the investment upside of a country's telecom sector:

1) Penetration Rate. What percentage of the country's population has a cell phone? What is the realistic ceiling?

2) Competitive/Regulatory Landscape. How many players are there? How rational are they? Are new players on the way?

3) Economic Efficiency. While average revenue per user is the most commonly used metric in telecom analysis, we also like to look at average margin per user--which focuses on the EBITDA generated by each mobile customer--because firms tend to have more control over costs than revenues.

With this in mind, we think the countries that are best positioned going into 2010 are Canada and France. Canada's cellular penetration rate is only 68% (versus more than 90% in the United States and more than 100% in many European markets), and it is dominated by a very profitable three-player oligopoly. While smaller new entrants are now starting to launch service, they lack the network, distribution, handsets, and finances to compete with the three incumbents. Plus, all three incumbents--Bell Canada BCE, Rogers Communications RCI, and Telus TU--have higher average margins per user than what we see in the United States.

AN: Likewise, France has three rational operators: France Telecom FTE; SFR, which is controlled by Vivendi VIV FRA; and Bouygues Telecom, owned by Bouygues EN FRA. All three have high average revenues and margins per user. However, the high returns prompted regulators in December to award a fourth wireless license. It will take two years for Iliad to build and launch its network, and even when it does, we don't think it will be nearly as disruptive as most people think. This might provide some attractive investment opportunities in the existing operators' stocks.

HK: Have there been any deals over the past year that you think are truly game-changing?

AN: There haven't been any game-changing deals, but we're seeing more in-market mergers. We expect this trend to continue. When two firms in different countries merge, there isn't much room for cost-cutting. There is some reduction in senior management and possibly some size advantage with dealing with suppliers, but it's fairly minimal for the larger firms. However, if both operators are in the same country, then there is room for lots of cost savings. Networks can be combined, more calls will stay on the expanded network, reducing roaming and interconnection charges, and staff can be reduced. France Telecom has proposals out with regulators to merge its U.K. operation with Deutsche Telekom DT and its Swiss operation with Danish telecom TDC. We've seen consolidation in Russia and Canada. The country in desperate need of consolidation is India, where more than a dozen wireless operators vie for subscribers.

HK: This industry requires massive investment. Which management teams have impressed you in how they allocate capital?

AN: Telephone companies have historically not been very good capital allocators. Huge prices were paid for acquisitions during the telecom bubble in the early 2000s. When the bubble burst, many firms were left with huge debts, and many smaller firms went bankrupt. Most carriers have new managements and have been more conservative with acquisitions and demanding of potential returns. However, we've seen some froth coming back into the market. Telenor TELNY just spent several billion to enter India, one of the most competitive markets in the world. Vivendi also just paid 12 times EV/EBITDA--a ridiculous premium--for GVT, an alternative carrier in Brazil.

HK: What about valuations? Are any of your stocks buys right now?

AN: France Telecom has been one of my favorite stocks for some time. It has been in and out of 5-star territory recently. Not only is it the leader in the French wireless market, it is leading in-country consolidation in Europe and has significant assets in Africa, providing some growth. It also pays a gross dividend of almost 7% (before 15% foreign tax withholding).

IL: Canada's Rogers Communications offers plenty of value in 2010 for three reasons:

1) Its country and sector strength. We've already seen what happens to new entrants who try to disrupt the oligopoly.

2) Rogers' network is still best-in-class. The gap (over Bell and Telus) has narrowed but not closed.

3) Margin superiority. Margins at Rogers are finally starting to rebound, just when margins at Bell and Telus are set to slide.

Canada remains one of the best structured wireless markets in the world. The first new entrant, Globalive, just recently launched service, but it does not have national spectrum to compete cross-country. We expect the firm to go the way of predecessors Clearnet and Microcell. It will run unprofitably for a few years before being bought up by one of the big three incumbents. While Bell and Telus have recently upgraded their networks, Rogers still has more spectrum and cell sites, which ultimately drive network reliability. The buzz around the new networks and entrants should allow investors to grab Rogers at a good price.

HK: Your team has been picking up several new European firms. Do any of them have economic moats in your view?

AN: We think Swisscom, Belgacom BELG, and TeliaSonera all have narrow moats. Swisscom has one of the strongest moats in the telecom universe we cover. Switzerland has three operators, and if France Telecom and TDC succeed in merging, it will be a duopoly, possibly the only one in a developed market. In addition, it is a very wealthy country where people are willing to pay up for quality and prefer to buy local. Swisscom has a superior network with greater coverage and faster speeds. At a cheaper price we would love to own this company.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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