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Telecoms Move to De-Risk Balance Sheets

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm here today with Mike Hodel. He is an associate director of research at Morningstar. We'll take a look at the telecom industry. See why companies are paying down their debt and if the bonds or stocks look attractive right now.

Mike, thanks for joining me today.

Michael Hodel: Thank for having me.

Glaser: Mike, can you talk a little bit about the trends over the past year that you've seen with the telecoms and their balance sheets?

Hodel: Well, we recently put out a piece looking at credit quality across the entire telecom universe that we rate here at Morningstar, which encompasses about 20 companies. What we've found is that those firms that we've rated have paid down about $27 billion over the past 12 months, so a pretty sizable amount for the industry.

Glaser: Why do you think that they're paying down debt at such an aggressive rate?

Hodel: Most of the companies that we've rated are large incumbent phone companies; they don't have tremendous growth prospects going forward, and they do face risks to their business as technology evolves and as consumer habits evolve. I think companies are trying to take some risk out of their balance sheet as they face this somewhat uncertain future.

Glaser: Have any firms stood as really taking out a lot of debt and ones that maybe have been a little bit less aggressive?

Hodel: The one firm here in the U.S. that's paid down a tremendous amount of debt in the last year is Verizon. Part of that's because they spun off a big piece of their fixed line business that generated cash, but also Verizon Wireless continues to generate a ton of cash flow, and they are directly almost all of that cash flow to debt repayment. The implications for Verizon Inc., the parent company that most people would invest in as an equity investor, aren't as favorable as the headline number might appear, because most of that debt repayment is happening at the Wireless business, which Verizon owns about 55% of.

Glaser: So, when we think of companies reducing their debt and taking risk out of the equation, we think that might be a boon for bondholders. Have you adjusted any of the credit ratings for these major telecom companies?

Hodel: We haven't adjusted any of the ratings at this point. One of the reasons for that is, if you look at debt relative to profitability or cash flow, like a debt-to-EBITDA type measure, those figures really haven't moved all that much over the last year. In addition to that, our credit rating methodology really is meant to be forward-looking. We use a five-year explicit forecast, and we look at expected cash flows over that entire time period relative to a firm's obligations to pin a rating on each firm, and really, those five-year estimates haven't changed dramatically over the past 12 months. Telecom does tend to be a stable, relatively easy-to-predict business in the grand scheme of things.

Glaser: Do any of those bonds look attractive today, then?

Hodel: So, that's the flip side of the equation. Back in the summer, we took a look at AT&T and Verizon, compared their bond yields to their dividend yields on their stocks. We found that the stocks were far more attractive than the bonds. At that time, we rated AT&T and Verizon, both 4 stars. We recommended investors looking for income own the equity and not the bonds.

Since then, AT&T and Verizon shares have performed fairly well. They are no longer a 4-star rated, they are now 3-star rated, but the yields on those stocks are still significantly higher than what you could get investing in the firm's bonds. We think that, for most investors, we would rather take a little bit more risk on the equities and capture that dividend yield rather than buy the debt where your yields are much more limited.

So, one piece of the equation for telecom is that the equity yields are more attractive generally than the bond yields, but we have also found that bond yields aren't particularly attractive in telecom relative to spreads of similarly rated credits in other industries. So, if we compare the yields you get on most telecom issuers to the Morningstar Corporate Bond Index and the types of yields you are getting on average, telecom compares fairly unfavorably. So, again, we don't see don't see a lot of opportunity in fixed income in the telecom universe right now.

Glaser: So bond investors should probably look elsewhere, but equity investors might have some opportunity. What would be some of your favorite names for the equity?

Hodel: Well, what we found looking through equity yields versus fixed-income yields across our entire sector, which encompasses both U.S. and non-U.S. names, is that the same sort of theme that equity is more attractive than debt is playing out in other countries as well.

One of our favorites right now is France Telecom; it's a stock that we've been recommending for some time now. We think it is very cheap; it's a 5-star rated stock. It offers an 8.3% dividend yield, that's excluding withholdings tax. So as a U.S. investor, you are probably going to realize a little bit lower yield than that, but that's still a far better yield that you would get investing in France Telecom bonds.

Glaser: Mike, thanks so much for the pick today.

Hodel: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.