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By Jeremy Glaser | 11-18-2010 12:22 PM

Telecom Stocks Preferable to Bonds

With telecom bonds in the U.S. and Europe looking richly valued, investors should focus on high-yielding telecom stocks says Morningstar's Mike Hodel.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm here today with Associate Director, Mike Hodel to take a closer look at international telecoms to see how their bonds are trading and why our view might be a little bit different than some of the major rating agencies.

Mike, thanks for talking with me today.

Michael Hodel: Thanks for having me Jeremy.

Glaser: So when you take a look at the big picture of the European telecoms, how do they differ from the ones that we might be familiar with in the United States like AT&T and Verizon?

Hodel: Sure, the big incumbent carriers in Europe are going to be fairly similar to the big incumbents here in the U.S., AT&T and Verizon. They are subject to the same technological trends, technological changes. They both operate in very mature markets where there is not a lot of growth potential left. Competition has kind of settled in most markets to a fairly steady-state. You are going to have some differences in regulation, and one area that we pay particular attention to in Europe is cost flexibility.

So, one of the risks that you have as a telecom company is that as technology migrates and changes and customer habits change. There is potential that revenues could start to drop fairly rapidly again, sort of what we saw maybe 10 years ago, starting with the shift away from fixed line to wireless. Some of these carriers had pretty big revenue declines for much of the last decade.

If you get into a situation where revenues start to slide again, you really want to have cost flexibility. Some of the carriers in Europe don't have as much as cost flexibility, the ability to pair down their workforce as we might have in the U.S. An example that we frequently give is Germany, Deutsche Telekom has a much less flexible labor pool than you typically find in most telecom carriers, and as a result, it is one of the only companies, major telecom companies that we don't give a moat rating too. We actually have it as no moat. The company has been unable to earn its cost of capital for much of the last decade and a lot of that is due to their inability to bring costs in line with revenues.

Glaser: So if they have trouble cutting these costs and profitability isn't as good, what's the impact of that on the balance sheet? The balance sheets of a company like Deutsche Telekom and France Telecom are fundamentally different from those in the United States?

Hodel: The balance sheets aren't fundamentally different. European carriers tend to carry a bit more leverage than the typical major U.S. carrier. The bigger impact on our credit rating is in our business risk or business risk is one of our four ratings pillars that we look at Morningstar. Because we rate Deutsche Telekom no moat, it has a lower business risk or than a typical carrier.

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