Some High-Quality Telecom Stocks Are on Sale

In September, we told subscribers of Morningstar StockInvestor about two cheap foreign telecom stocks. Both stocks are up since then, but still trade for less than our fair value estimates and boast at least 4-star Morningstar Ratings. Below is the article as it appeared in the Sept. 15 issue.

The market often panics when change and uncertainty engulf an industry. Such situations can sometimes provide interesting investment opportunities. I think one of these opportunities exists in the fixed-line telecommunications industry.

My main job at Morningstar is covering international telecom stocks. Prior to working at Morningstar, I spent 10 years at an investment management firm, and during that time I followed telecom stocks quite closely. Right now, based on cash flows, many fixed-line telecom stocks are trading at the cheapest prices that I've ever seen.

These stocks are cheap because of significant industry turmoil. The telecom landscape is undergoing significant change. Deregulation in the 1980s and 1990s has created the competition regulators wanted. Fixed-line phone service is now available from cable television networks, voice over Internet protocol providers, or other capacity resellers.

In emerging markets, the bigger threat to fixed-line firms has been mobile substitution, a situation where a customer goes straight to a wireless phone and doesn't bother with a fixed-line connection at all. In many countries, wireless operators are much more evenly matched with the incumbent fixed-line operator, so the incumbent doesn't receive the huge advantages that typically come from having a large installed base of fixed-line customers.

Both fixed-line and wireless operators are also being hurt by telecom regulators cutting interconnection fees, which are fees received for connecting phone calls between people using different networks. These fees had been quite lucrative to telecom firms in the past. So, with all these negatives, why am I bullish?

First of all, cash flows are still enormous. Fixed-line networks were very expensive to build, and the incumbent operators have large noncash depreciation charges. In most cases current capital expenditures are less, sometimes significantly less, than depreciation, so earnings don't accurately reflect the cash-flow performance of these firms. I expect cash flows to continue to be higher than earnings, and because cash flow is what ultimately drives value, I think these firms may hold more value than the market gives them credit for.

Plus, to offset some of the losses in its core voice businesses, telecom firms are providing new value-added services such as high-speed Internet access. Additionally, even though the wireless markets in Europe are nearing saturation, many of the incumbent operators have significant exposure to emerging markets that are still growing rapidly.

Overall, we think that investors have overreacted to the changes in the industry and have forgotten the fundamental cash flows these firms can still generate. The following narrow-moat telecom firms are trading below our estimates of their fair value as of Nov. 3. Each of these firms also sports a high dividend yield.

 France Telecom (FTE) is the incumbent operator in France. It also has significant wireless operations in the U.K., Spain, and Poland as well as Eastern Europe and Africa. We think its African business in particular is more valuable than the market gives it credit for. It is one of the largest providers of high-speed Internet access and wireless services in the world, with 8.5 million and 88.7 million subscribers, respectively.

Telecom Corporation of  New Zealand (NZT) is the incumbent operator in New Zealand. It dominates the fixed-line market in that country and also has a presence in Australia. In New Zealand, it is in a duopoly wireless market with  Vodafone (VOD), which generally enables both firms to be very profitable.