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Risks Loom Over Telecom Industry

Apple’s growing market power, intensifying competition challenge sector.

Philip Guziec, CFA, 12/09/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

Investors are fond of telecom stocks for their stability and dividends, but it’s a very competitive industry with one player looming large over the market: Apple APPL. The iPhone is still a must-have for telecom carriers, who pay heavy subsidies to Apple to offer the phone to customers. On the heels of the iPhone 5 release and the rollout of a new generation of wireless technology, we invited Morningstar equity analysts Michael Hodel, Imari Love, and Allan Nichols to discuss the current state of the telecom sector. (This discussion took place Oct. 8, two weeks before SoftBank announced that it will take a 70% stake in number-three wireless carrier Sprint Nextel S, a transaction that Hodel likes. “The deal with SoftBank will provide much-needed capital to bolster Sprint’s financial flexibility while dramatically reducing the risks facing Sprint shareholders,” Hodel says.)

Philip Guziec: Get us up to speed on the dynamics of the telecom value chain.

Michael Hodel: In the United States, AT&T T and Verizon Wireless dominate the telecom industry on the wireless side. Combined, they have 75% of the post-paid market of the wireless market. The rest of the industry has been battling to keep pace. Scale is an important attribute in this business, because you have to continually invest in your networks, invest in additional wireless spectrum, invest in marketing, and keep your customer service and your handset-device lineup fresh. If you’re not AT&T and Verizon Wireless, it’s difficult to make the necessary investments to keep pace.

So, we’ve seen T-Mobile, which is the fourth largest carrier in the U.S., agree to a merger with MetroPCS Communications PCS, which is the fifth largest carrier. MetroPCS is a prepaid wireless specialist; they pioneered the no-contract, unlimited wireless plan that many people might be familiar with. Essentially, you pay about $50 a month for unlimited voice and data, text messaging, and whatnot. In exchange for that, you’ll pay more for your phone, because you’re not getting much of a subsidy from MetroPCS on your phone, and customer service is typically not strong and coverage is typically not great. But it’s a specialized niche that’s grown nicely over the past three or four years. MetroPCS really bolsters T-Mobile’s position in that prepaid segment. It also brings together the firms’ networks and spectrum positions, so they can more efficiently add capacity and coverage.

Where this is really interesting is that it leaves number-three Sprint in a tough spot. Sprint is in the midst of a major network modernization program, and as a result, they’ve been on the sidelines in the M&A game, but we think that’ll likely change. We expect that Sprint will have to start thinking about how to build scale to stay ahead of T-Mobile and MetroPCS. So, consolidation is the major theme right now. Smaller players are trying to figure out how they’re going to gain the scale that they need to compete with the two firms that have become so much larger than everyone else.

Guziec: What about Canada? Historically, it’s been one of our favorite regions for telecom.

Imari Love: Yes. Canada’s wireless penetration rate is remarkably lower than it is in the U.S., because they started cellular service two and a half years later. Penetration in the U.S. is in the triple digits; in Canada, it’s still in the mid- to high-70% range.

Philip Guziec, CFA, is Morningstar's derivatives investing strategist. He leads Morningstar's OptionInvestor service, which applies Morningstar's fundamental research methodology and fair value estimates on 2,000 stocks to uncover option investing opportunities. Guziec joined Morningstar in 2003 after a career as an engineer and management consultant. Learn more about OptionInvestor.

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