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Our Outlook for the Telecom Sector

Some telecom firms may provide a refuge from the storm.

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In the last quarterly update, the telecom sector was the least attractively valued as a whole, and it retains that position this quarter with an average star rating of 2.67. However, as fear has gripped the market amid various blowups in subprime lending and derivatives, there is something to be said for the steady cash flows generated from the telecom sector.

We also think the industry will be mostly immune to difficulties elsewhere. Direct access to some kind of phone service in the U.S. and most developed countries is now considered a necessity, not a luxury. Even wireless service, which is more of a discretionary item, is generally purchased with a contract, at least in the U.S. Therefore, canceling service prior to the contract's end is difficult, particularly as contract lengths are extending to two-year terms. As contracts end, a small percentage of customers may choose not to resubscribe or may switch to less costly prepay service, but we think most Americans who have used a cell phone will have a difficult time giving it up.

With less cash in their pockets, subscribers may cut back on handset spending and buy lower-end phones. In the U.S., however, handsets are subsidized to such an extent that even this will probably be minimal. Internationally, where subsidies tend to be smaller, this could be an issue.

Besides the steady cash flow produced by telecom firms, we have upgraded the fair value estimates of many of the telecom companies under our coverage during the quarter, bringing several closer to our Consider Buying price. We have raised our fair value estimate on 34 of 80 telecom firms during the third quarter and lowered our fair value estimate on only one. These upgrades show our confidence not only in the current economic environment, but into the foreseeable future.

Valuations by Industry
Many telecom stocks have continued to run, so despite the upgrades to our fair value estimates, the average price/fair-value ratio remains relatively high. The majority of our upgrades are in our international coverage. Wireless growth in emerging markets continues to be the primary growth driver for these firms. Most of these companies are either located in emerging markets or have operations in some emerging markets. We have seen higher penetration rates in Eastern Europe and Russia than we had expected and are using this data to project higher penetration rates in other emerging markets around the world. In countries where growth has slowed, we have seen a stabilization and, in some cases, an increase in average revenue per user (ARPU). Based on this observation, we are now expecting a more rapid increase in margins in some countries than we had previously.

 Telecom Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Telecommunications Service 2.68 1.05 58
Wireless Services 2.64 1.04 22
Data as of 09-19-07.

The median price/fair-value has declined to 1.05 for telecom service from 1.15 last quarter, and wireless services have declined to 1.04 from 1.08. However, they remain among the most overvalued subsectors. U.S. firms--with the exception of  Sprint Nextel (S)--and certain emerging-markets firms remain the most overvalued. Europe, Asia, and a few emerging markets generally have the most value. Overall, the significant undervaluation we touted during the summer of 2006 is gone. Returns since then have been outstanding.

Despite the runups in the industry, there remain some defensive positions as several firms, such as  Telecom Corporation of New Zealand (NZT) and  France Telecom (FTE), still have dividend yields above 4%. There are also still potential opportunities in some emerging markets, including Latin America and the Indian subcontinent.

Telecom Stocks for Your Radar
Below are five stocks we think are worth keeping on your radar. Sprint Nextel has struggled since the merger that created the firm, but we think operations will recover. There are also two high-yielding international stocks on the list, as well as two that are benefiting from rapid emerging-markets wireless growth.

 Stocks to Watch--Telecom
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Yield

Sprint Nextel   $26 Narrow Average 0.6%
Telecom Corp of NZ $21* Narrow Average 8.7%
America Movil $83 Narrow Above Avg 0.5%
Telenor $79 Narrow Above Avg 2.1%
France Telecom $38 Narrow Average 5.0%
Data as of 09-25-07. * Adjusted for 9-25-07 stock split.

 Sprint (S)
The wireless industry has seen major consolidation in recent years, and our thesis has been that the three largest operators--Verizon Wireless, Cingular (now AT&T Mobility), and Sprint Nextel--will prosper because their resources far outstrip those of other industry players. Yet Sprint has languished while Verizon and AT&T Mobility have surged ahead. We believe that the firm's problems are temporary, though, and that Sprint's advantages will shine through over the long run. The firm has tightened credit policies, stopped adding customers in markets where capacity is tight, continued investing in the network, sharpened advertising, and introduced dual-mode phones.

 Telecom Corporation of New Zealand (NZT)
Telecom Corporation of New Zealand is well positioned to respond to changes in the industry landscape that are unsettling the firm's cozy domestic position. We believe that NZT will continue to enjoy solid returns on capital despite some crimping of margins as competition and investment in new technologies increase. We do expect that the Australian operation will continue to struggle, however, given the weak position in a more-competitive market. Despite this, the business continues to generate very strong free cash flow, which can be invested in new technologies and support generous dividends.

 America Movil (AMX)
America Movil continues to astound us with its performance. Not only is it maintaining strong growth in new subscribers, but it is beginning to increase ARPU in many countries. With operating costs increasing at a lower rate than revenues, the firm is also generating solid margin growth. With its recent purchases of  Verizon's (VZ) businesses in the Dominican Republic and Puerto Rico, it has operations in 16 countries with 137 million wireless subscribers.

 Telenor (TELNY)
We like Telenor's combination of developed- and emerging-markets telecom assets. We think its emerging markets operations will provide growth for many years, but we are concerned with Altimo, its partner in several businesses. Telenor has solid phone assets in Scandinavia, in both fixed-line and wireless, that generate significant cash flow. The firm is taking this cash flow and investing in emerging markets, where it has some very interesting positions. It dominates Bangladesh with 60% wireless market share. This is a poor country, but it has 147 million people and is growing rapidly. Telenor also has strong positions in Pakistan, Thailand, and Russia.

 France Telecom (FTE)
France Telecom's fixed-line telephone business in France is beginning to stabilize, as the firm has successfully transitioned customers to Internet-based services. We also expect the firm to continue to enlarge its wireless business. We particularly like its position in emerging markets, and we don't think this is appreciated by the stock market. FT has 40.2 million subscribers--out of 102.5 million--in its "rest of world" category, a figure that grew 36% over the past year. We expect this segment to grow significantly faster than the rest of the business. The firm also continues to pay a substantial dividend.

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Allan C. Nichols does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.