Apple’s growing market power, intensifying competition challenge sector.
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
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.
The other reason we liked Canada was because it’s been dominated over the past decade by three companies—Rogers Communications RCI, Telus TU, and BCE BCE. They have run sort of a rational oligopoly. About 95% of the market share goes through these three guys, and they’ve prioritized market share of profits over market share of subscribers. That sort of strategic mindset has led to higher economic efficiency in profitability metrics. But over the last couple of years, that’s taken a little bit of a turn, as new spectrum was allotted and smaller, fragmented new entrants were able to join the fray and disrupt profitability on a small scale across the country.
Guziec: What about the tower companies?
Love: Instead of investing in one of the soldiers in that war, which are the carriers, you can invest in the companies that make the bullets, which are the tower companies. They provide the real estate that the carriers put their antennas on to transmit their signals, so that the carriers can accommodate the insatiable demands for data. Over the past few years, it’s been the tower companies that have been the best performing names in the sector.
Guziec: A high profile product is Apple’s 4G iPhone 5. How does that play out in a highly competitive and shifting competitive space?
Hodel: It’s interesting because it is the first LTE device. LTE is the “more legitimate” fourth generation. Purists say that LTE isn’t a true 4G technology; there’s another technology coming beyond LTE that’s true 4G. The big point, however, is that LTE is a complete changeover of technology.
Guziec: So, there’s more demand for the pipe to get fatter. How does that play out with the industry’s pricing and profitability?
Hodel: That’s an interesting question, because right now on the one end, AT&T and Verizon Wireless have moved to a usage-based pricing model, Sprint has held firmly with its unlimited pricing model, and now you have T-Mobile going back to an unlimited pricing model. So, the two carriers that are the most poorly positioned to deliver additional capacity to customers are the ones who are out there marketing unlimited usage, whereas the guys who are the best positioned….
Guziec: It’s because it doesn’t cost them anything if you can’t supply it.
Hodel: Well, I don’t know about that, but I think it tells you something about where the true state of capacity utilization and marginal cost of deploying capacity is today. The typical smartphone is not particularly taxing on the network. It’s the folks who are using the wireless networks for laptop cards, tethering their phone to a laptop, or using a tablet who are putting the strain on the network.
So, to me, the iPhone is not a huge driver of bandwidth demand. Yes, having more people using a device that’s capable of accessing a fast wireless network like LTE will increase demand, but it’s nothing like what you have with people who are using second generation devices like an iPad, where you’re seeing the real toll on the network.
The way I think about it is that on the capacity side the most noise is made about spectrum, and at this point in the U.S., we have a lot of spectrum that’s still not being used. At the same time, you have this major technology shift coming from 3G to LTE, and that shift alone will add a large amount of incremental capacity. I think that the carriers want to make a lot of noise about spectrum constraints and a spectrum crisis, but that’s the industry serving its best interests, which are having as much spectrum as possible made available because that reduces their need to invest in capital expenditures.
Guziec: Another way the iPhone is affecting the industry is these high subsidies carriers must pay Apple. How much of an impact is Apple having on the market?
Hodel: Five years ago, the industry had cyclicality to its margins; people upgraded phones more often in December than in, say, April or whenever. That caused some seasonality in margins, but what the iPhone has done is caused that to become extreme. The quarter when a new iPhone is launched, margins will plummet for all the carriers that offer that device. Then, margins will snap back. In fact, you see very strong margins in quarters where people are anticipating the next iteration of the iPhone. For example, in the second quarter of 2012, there were record margins pretty much across the board in the wireless industry, because nobody was buying phones; everyone’s waiting for the iPhone 5 to come out. So, margins have become much lumpier than they had been historically.
It took time for the markets to catch on to this situation. In the fourth quarter of 2011, when the iPhone 4S was launched, margins in the U.S. took a big hit, and the stocks of AT&T and Verizon VZ got hit pretty hard. But it’s important to keep in mind that overall profitability isn’t necessarily dramatically different; it’s just that it’s bigger than it used to be. The iPhone is, by far, the most heavily subsidized device in the world. Rumor has it that it’s around $400 per device of subsidy that the carriers are kicking in for each iPhone sold. That compares to maybe $150 or $250 on an Android or Windows device. It’s interesting because the carriers are getting the same revenue stream off of either of those two devices. So, they would much rather sell you an Android or a Windows phone because they’re getting the same revenue stream off of you as a customer, and they’re subsidizing you much less heavily than they would if they sold you an iPhone.
So, you have a lot of interest among the carriers to develop these ecosystems that diversify their customer basis away from the iPhone as much as possible. AT&T, for example, was aggressively pushing the Lumia 900 from Nokia NOK, which was a Windows 7 phone, over the spring and summer. The phone didn’t sell real well, but you will see all the carriers aggressively promoting Windows 8 in the holiday season. They’re trying to give Microsoft a strong place in the market, so they can dilute Apple’s power and bring the subsidies on the iPhone down.
But ultimately what gives Apple the ability to extract that subsidy is the fact that they’ve created this device that the carriers believe they have to have to be the most competitive they can be. There’s still a level of competition in the marketplace that’s strong enough among the carriers that they’re willing to give Apple essentially what they want. If competition was less intense, carriers would be more willing to push back on Apple than they do today.
Guziec: So, what are the opportunities out there for telecom?
Hodel: AT&T and Verizon are the two most widely held stocks across the board in the U.S. The U.S. telecom industry has gotten to a point where most stocks across the sector are slightly overvalued at this point, and that’s because the sector is viewed as a relative safe haven for investors looking for yield. Nine months or so ago, AT&T and Verizon common stock yielded around 6.5%, and that attracted a lot of investors who see telecom as being a stable, recurring-cash-flow-type business. As a result, we’ve seen the price of those stocks run up pretty dramatically, to the point where their yields are down to the 4% range.
Allan Nichols: Europe is very different. Many of the telecoms there are very cheap because the dividend is not stable in Europe. Telefónica TEF outright canceled its dividend, France Telecom FTE and KPN KKPNY reduced theirs. Vivendi and Telecom Italia TI cut theirs.
The euro crisis has certainly hurt them. Telefónica and Portugal Telecom PT have been hurt by interest rates going up and concerns about their debt positions. Deutsche Telekom DTEGY owns Hellenic Telecommunications in Greece; it’s small, but sentiment-wise, it’s not good. Also, another issue is Iliad, which is a new competitor in the French market and has put a lot of pressure on all the French operators. France is where we see the most upside; they are all either in 5-star territory or close to it. France Telecom is our favorite name because they actually do have some countercyclicality with Iliad, because Iliad pays for usage of their network. As Iliad is successful there, its payment to France Telecom goes up, so that helps offset some of the losses that France Telecom is having elsewhere.
Another firm that we find interesting is NTT DoCoMo DCM in Japan. It trades at even a lower multiple than France Telecom; it’s around three and a half times enterprise value EBITDA with yields much lower relative to the Europeans, but for Japan, which has been in a recession for 20 years, a yield of 4.5% is huge. DoCoMo has no net debt, which is very rare for a phone company, and it has almost 50% market share. They do not have the iPhone, which has been one of the reasons that they’ve been hurt. They have refused to make a deal with Apple, so they have been losing some market share to KDDI and especially SoftBank. But despite that, DoCoMo is generating tons of cash, and they are close to two years ahead of the others in offering LTE, which they’ve had since December 2010.
Love: I go back to the towers. American Tower AMT is best in class and on our best ideas list. It’s a play on that underlying theme of growing data demand. They pay a very small dividend, now only about 1.3%, but they are the only publicly traded tower company that offers a dividend. They are also the most diversified across the globe; they’re in Latin America, India, and Africa. They have the highest margins, and they’re also the least levered of bigger tower companies. That’s a pretty good combination.