Communication Services Investors Warm Up to Smaller Media Stocks

The Morningstar US Communication Services Index has traded in line with the broader market, trailing the Morningstar US Market Index by about 40 basis points in 2021 after outperforming by 70 basis points last year.

Despite pockets of uncertainty, communications stocks power ahead - source: Morningstar

While Internet giants Alphabet GOOG and Facebook FB dominated the sector’s performance in 2020, this year has been all about the smaller guys. Midtier media companies Discovery DISCA, ViacomCBS VIAC, and AMC Networks AMCX have jumped over the past couple of months, even after a decline following an equity issuance at ViacomCBS, as investors have apparently warmed to their direct-to-consumer content potential. While we like the DTC plans each of these firms has put in place, the market is evolving rapidly, and none has reached anything close to the scale of market leaders Netflix NFLX or Disney DIS.

After a big run, media stocks look much less attractive - source: Morningstar

Netflix and Disney still dominate media DTC efforts - source: Morningstar

Additionally, we expect these firms—Discovery and AMC in particular—will need to carefully balance their DTC offerings against the traditional cable networks business, which still produces the most revenue. Sports and, to a lesser degree, news serve as the anchors of the old-school cable content bundle. The business received a shot in the arm when the NFL chose to stick with its media partners, extending its rights agreements through 2033 in mid-March. While the new agreements are costly, topping $100 billion over 10 years, Disney, ViacomCBS, Fox FOX, and Comcast’s CMCSA NBC have secured must-have content that should allow each firm to manage declining demand for traditional television service.

Speaking of huge capital outlays, the three U.S. wireless carriers agreed to pay around $90 billion to secure additional wireless spectrum in the Federal Communications Commission's C-band auction. Verizon Communications VZ was the big “winner,” spending more than $50 billion, followed by AT&T T at a bit less than $30 billion and T-Mobile TMUS at around $10 billion. The carriers’ purchases reflect their spectrum positions going into the auction.

Big spectrum spending should add significant wireless capacity - source: Morningstar

We believe Verizon and AT&T have largely closed the midband spectrum gap between themselves and T-Mobile. Both carriers will likely spend heavily to put the spectrum to use, with Verizon committing an incremental $10 billion of investment over the next three years. While we believe the wireless business will continue to produce steady cash flow for the carriers, these investments reflect the challenge of maintaining competitive parity while earning attractive returns on capital over the long run.

Top Picks

Alphabet GOOG Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $2,605 Fair Value Uncertainty: High

As the economy recovers, we remain confident that accelerating growth in brand ad spending along with the return of ad spending in the travel industry and ongoing spending on direct-response ads will further strengthen revenue growth for Alphabet. Data, such as that from the Transportation Security Administration, indicate a slow but gradual recovery in travel. Plus, more agreements with publishers should help growth. In addition, while businesses accelerated digital transition in 2020, which helped Google's cloud business, we think strong demand remains for that business-to-business segment, driving further rapid growth and diversifying Alphabet's revenue base.

Lumen Technologies LUMN Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $18 Fair Value Uncertainty: High

Despite recent stock strength, we still believe Lumen is too cheap. Although we expect revenue to continue shrinking for the foreseeable future, financial fundamentals remain sound. The free cash flow yield on the equity is still higher than 20%, and we forecast free cash flow to remain relatively stable. Lumen’s 7.5% dividend yield is well covered—the payout ratio the last two years has been about 33% of free cash flow. Remaining free cash (about $2 billion annually) is being used to pay down debt. Less than $10 billion in debt matures over the next five years, and net debt/EBITDA is about 3.5.

America Movil AMX Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $18 Fair Value Uncertainty: High

America Movil is well positioned to benefit as demand for data services expands across Latin America. The firm is the dominant wireless provider in Mexico with more than 60% market share. While the broadband market is more competitive, Movil still holds about 50% share. In Brazil, the firm’s second-largest market, wireless consolidation promises to rectify a challenging competitive position. The planned sale of its U.S. business Tracfone to Verizon for $6 billion will leave Movil in a strong financial position. The firm raised its dividend 5% for 2021, giving the stock a 2.9% yield, and instituted a $1.2 billion share buyback.