Our Outlook for the Telecom Sector
Looking into foreign-based companies has the potential to pay off.
Quarter-End Insights
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As a telecommunication analyst, it makes sense to look at a company's macroeconomic backdrop from time to time. After all, the telecom business is driven by consumer spending, which is a function of disposable income, which of course is driven by the health of the underlying economy. Factors such as inflation, changes in real wages, unemployment, consumer confidence, and GDP growth can have a real impact on not only the operating performance of a telecom company, but the overall interest from the investment community.
As we know, these are not the healthiest of times for the U.S. economy. In mid-June, the U.S. consumer confidence index fell to its lowest level in 28 years, as the rising prices of food and fuel continue to wreak havoc. The U.S. dollar continues to sink to new lows relative to other foreign currencies, and GDP growth is projected to be near its lowest levels since 2001. So it stands to reason that looking into companies based in other countries has the potential to pay off.
You might want to consider running north to Canada as a safe haven. The TSX Index in Toronto is up over 6% so far this year (in comparison, the S&P 500 is down 6%) thanks to an economy where inflation is actually falling along with central bank interest rates. The first-quarter current account surplus in Canada easily beat expectations, and unlike the U.S., unemployment is holding steady (instead of rising).
Other investors have decided to run south to Mexico, evidenced by the Bolsa Index also being up over 6% this year (it's up over 12% after accounting for currency effects). The unemployment rate there has been sliding lately and beat expectations last month. First-quarter GDP growth of 9% year over year also beat the 8.4% projection, and we are expecting consumer confidence to have risen sequentially in May.
But the best-performing major country exchange in the world year to date has been Brazil's Bovespa Index, which is up over 8% (and over 17% with currency effects). Brazil is one of the few countries that has had both higher real GDP growth and lower inflation rates in each of the last two years. So far in 2008, the economy has held up strong. In April (May data not yet available), industrial production was up over 10% and ran ahead of expectations, while the unemployment rate actually continues to slide at a faster rate than projected. Foreign investment into Brazil continues to rise, and just like in Mexico, the relative strength of the currency is a bullish sign that this will continue.
Valuations by Industry
Despite the defensive nature of the telecommunications sector, many of the stocks in this industry continue to pull back.
| Telecom Industry Valuations | |||
 | | | |
| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
 | |||
| Telecommunications Service | 0.84 | 0.88 | -4% |
| |||
| Wireless Services | 0.94 | 0.95 | -1% |
 | |||
| Data as of 06-13-07. |
For yet another quarter, both the telecom service sector and the wireless service subsector have become cheaper relative to their fair value. It looks as if most of the share price erosion has come from the wireline side, as mobile stocks continue to fall by less than the industry as a whole. This makes intuitive sense since wireless companies offer similar risk profiles but compensate investors with more growth upside. It also makes sense because we all are moving away from fixed-line services in favor of mobile technologies. The average sector median price/fair value is currently 0.90, so as a whole, the telecom services sector is undervalued in absolute and relative terms.
Telecom Stocks for Your Radar
In keeping with the top-down theme, here are five telecom stocks operating in economic backdrops that are more favorable than the U.S.
| Stocks to Watch--Telecom | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Country |
| |||||
| Shaw Communications |  | $27 | Narrow | Medium | Canada |
| |||||
| America Movil | | $83 | Narrow | High | Mexico |
| |||||
| NII Holdings |  | $64 | Narrow | High | Mexico |
| |||||
| Tele Norte Leste | | $33 | None | High | Brazil |
| |||||
| TIM Holding Company | | $40 | None | High | Brazil |
| |||||
| Data as of 06-20-08. |
Shaw Communications
A diversified communications company, Shaw provides broadband cable television services, Internet, digital phone, direct-to-home (DTH) satellite services, and satellite distribution services in Canada and the United States. The firm has more than 3 million subscribers based mostly in western Canada. Shaw recently reported fiscal second-quarter results that were largely in line with our estimates. The firm did raise its operating income growth forecast from 10%-12% to 13%-15%. It seems the outperformance is being driven by a cut in some Canadian Radio-television and Telecommunications Commission fees. The operating income uptick was offset by Shaw lifting its 2008 capital expenditure target from $650 million to more than $700 million (we were already projecting $727 million), so the free cash flow guidance--as well as our fair value estimate--remains $27 per share.
America Movil (AMX)
The largest wireless provider in Latin America, America Movil serves more than 147 million customers in 16 different countries. It also provides fixed-line services in four of its markets. The company was spun out of Telmex, Mexico's incumbent fixed-line provider, and it still continues to dominate the Mexican wireless market with more than 70% market share. The firm has done a wonderful job of expanding its operations across Latin America over the past few years. It is benefiting greatly from improving economic conditions there, and we believe its competitive advantages should allow it to continue to deliver attractive returns on capital.
NII Holdings
NII's performance has been outstanding over the past few years. Although most wireless operators in Latin America are focusing on the fast-growing prepaid retail segment, NII has directed its operations toward corporate customers demanding instant connectivity.
Tele Norte Leste
Tele Norte Leste is the majority shareholder of Oi, the incumbent fixed-line provider in Brazil's Region I. Oi has about 14.2 million lines in service, making it the largest fixed-line provider in the country. Its wireless operation, Oi Movel, controls 16 million wireless customers in its region, making it the leading cellular provider there, with a 27% market share. The company also has about 1.4 million Internet access subscribers. The firm recently announced its plans to buy 60.5% of Brasil Telecom Participacoes' voting shares, which is about 22% of the latter firm's total share capital, for roughly $3.5 billion. Tele Norte Leste's majority ownership of Brasil Telecom's voting shares will allow it to merge the two companies, creating a domestic player big enough to compete against foreign rivals in Brazil. The new company will be marketed under Tele Norte Leste's brand, Oi.
TIM Holding (TSU)
TIM is Brazil's second-largest mobile telecommunications operator with more than 31 million subscribers and a 26% market share. That market share rose in 2007 along with the firm's margins and minutes of use (MOU). This shouldn't come as much of a surprise given the strong macroeconomic trends coming out of Brazil lately. The last few years have seen bullish trends in the country's wage growth, interest rates, unemployment, and inflation. The result has been heightened disposable income, which has translated into escalating cellular penetration rates. Given its nationwide footprint, brand image, and scale, TIM has been one of the primary beneficiaries of the demand uptick in a consolidating industry.
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