Our Outlook for Media and Telecom Stocks

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What goes up in the financial markets doesn't necessarily have to come down, but bumps along the way are inevitable. Last quarter, we noted several non-U.S. telecom stocks that we believe offer an attractive way to offset the impact of a falling U.S. dollar and a weak U.S. economy. Of course, the greenback has strengthened since then, punishing the ADRs of most non-U.S. telecom firms. We believe giants  BT  and  France Telecom (FTE) will provide fairly stable cash flows, even if weakening economies across the U.K. and Europe pressure growth, thanks to the defensive nature of the telecom business. Both stocks offer solid value and a nice way to diversify a portfolio with heavy U.S. exposure. We also see lots of opportunity to invest in businesses that will benefit as an increasing percentage of the world's population adopts wireless phone service.  America Movil (AMX), for example, enjoys a dominant position in its home market, providing some stability, and exposure to countries around Latin America.

With several relatively stable and attractively priced telecom firms out there, we don't see much reason to bet on firms in less stable locales. For example, we recently increased the cost of equity in the discounted cash flow models we use to value Russian companies, lowering our fair value estimates for these firms (all else equal). Among the Russian carriers, we like the growth potential  VimpelCom (VIP) offers, but we'd wait for a better price before considering the ADRs, even with the shares down 40% over the past three months.

Within the U.S., the shares of telecom giants  AT&T (T) and  Verizon (VZ) have fallen to levels not seen for a couple years. Both firms' wireless businesses have performed well recently, but the cable companies have started taking significant share in the consumer fixed-line business. We expect this trend to continue as the cable companies press their ability to offer service bundles over a single, often superior network. Verizon is significantly more exposed to the consumer fixed-line business than AT&T, and its results will likely be hit harder. We also believe growth across the entire U.S. telecom sector will slow over the next year or so as the wireless and Internet access businesses mature and enterprise spending weakens.

With growth slowing, few telecom carriers are in the mood to increase network spending these days, and equipment suppliers from  Cisco (CSCO) down through tiny  Acme Packet  have warned investors to expect tepid growth over the next several quarters. We believe Cisco is poised to extend its competitive advantages while its rivals struggle in the current environment. For most investors, we see little reason to look beyond the networking giant for exposure to the industry given the current share price. That said, the steady decline in valuations seen across the entire telecom and network equipment industries has made a handful of stocks too cheap to ignore.  Radware (RDWR) comes to mind.

The steadily slowing advertising market continues to pummel "old media" firms, including newspapers and radio broadcasters, as their sales have recently been declining at an accelerating pace. (See our recent Stock Strategist on the newspaper industry: Newspaper Stocks Are Value Traps.) We continue to think companies in these industries are overvalued, especially ones that carry a heavy debt load. On the other hand, media giants  Disney (DIS) and  Time Warner  continue to trade at attractive valuations, in our view. Both firms have been aggressive in monetizing their content through digital distribution, and they have benefited recently as cable network ad spending has remained solid. Ad spending also continues to migrate online, with  Google (GOOG) standing as a primary beneficiary. As we wrote last quarter, we expect Google's dominance of the search advertising market will increase significantly if its planned partnership with  Yahoo  goes through and becomes a long-term arrangement. The power of such a partnership has drawn the ire of major advertisers, such as the Association of National Advertisers, who are starting to line up against the deal in advance of the Justice Department's review.

Valuations by Industry
We believe most industries within the media and telecom sectors are undervalued in aggregate and have become more so over the past quarter. Radio is the only exception, reflecting our belief that these firms have more pain yet to endure. We also believe newspaper stocks are significantly overvalued as a group. Newspapers fall into the publishing industry along with a number of other firms that we believe are nearer to fair value, such as direct marketing.

Although we think most media and telecom industries are undervalued as whole, there is considerable dispersion among stocks within some categories. The cable TV industry, in particular, is split between firms we think are significantly under- and overvalued. Financial strength, especially important in the current environment, is the key differentiator between these groups. We believe  Comcast (CMCSA) and  Time Warner Cable  are in a position to continue aggressively attacking the market while making network investments that will help extend their advantages into the future. At the other end of the spectrum, we wonder if the current credit crunch will finally spell the end of  Charter (CHTR), one of the most heavily levered firms we cover.

Communication Stocks for Your Radar
We currently give each of the stocks highlighted below our 5-star rating, and we consider all but one to have wide economic moats. With equity valuations down pretty much across the board, we believe there is plenty of opportunity to invest in the strongest businesses. We don't currently have wide-moat ratings on any of the telecom service providers we cover, but America Movil is one the best-positioned carriers around, in our view.   

Stocks to Watch--Media and Telecom
Company	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
America Movil		$76	Narrow	High	0.59
Cisco Systems, Inc.		$31	Wide	Medium	0.74
Comcast Corp.		$27	Wide	Medium	0.72
Time Warner, Inc.		$25	Wide	Low	0.56
Walt Disney Co.		$40	Wide	Low	0.82
Data as of 09-23-08.

 America Movil (AMX)
America Movil serves more than 169 million customers in 17 different countries, including a dominant 70% share of the Mexican market. Relatively low wireless penetration rates along with strong economic growth in Latin America have allowed America Movil to produce double-digit revenue growth over the past couple of years. The company also delivers some of the highest margins in the telecom industry in many of the countries it serves, thanks to its immense scale. But with the markets beginning to mature, America Movil has seen a decline in revenue growth, and margins have been pressured, especially in Brazil, as rival operators fight for new subscribers. While we expect growth will continue to slow, we think the firm has an arsenal of attributes--scale, strong management team, healthy balance sheet--that should allow it to perform well and deliver attractive returns on capital.

 Cisco Systems  (CSCO)
Though current market conditions are tough, network convergence, data-center consolidation, and increased global communications needs should drive relatively solid demand for Cisco's equipment through a depressed spending environment. We also expect Cisco to gain share at the expense of certain of its smaller, resource-constrained competitors during this economic downturn. At its current price, we believe the market is offering investors the opportunity to pick up a great long-term holding at a reasonable price.

 Comcast (CMCSA)
Slowing growth and higher capital spending punished Comcast's shares toward the end of 2007, and the stock has traded around our "Consider Buying" price since. We believe slower growth is inevitable as high-speed Internet access adoption in the U.S. nears maturity over the next couple of years and the phone companies skim off some customers as they upgrade their networks. But the strength of Comcast's network relative to the phone companies' across most of its service territory is starting to show. During the second quarter, Comcast added three times as many high-speed Internet access customers as AT&T and Verizon combined.

 Time Warner 
We could have included Time Warner Cable  in this list, but with the planned spin-off of this business from Time Warner not yet complete, we'd be content to buy Time Warner today. In addition to a strong cable business, we believe Time Warner controls some of the most prominent assets in media, including Warner Bros., HBO, and other valuable cable networks. Most of these businesses are leaders in their respective industries and possess formidable competitive advantages. We are optimistic that the intrinsic value of these assets will eventually be realized under the leadership of CEO Jeff Bewkes, who took over in January. The company is now actively looking to unload AOL, a move we think would allow Time Warner to focus more on its core content businesses.

 Walt Disney  (DIS)
The strength of the Disney brand has allowed the company to exploit its characters and franchises through box office and home video sales, theme park and resort attendance, and merchandising. The company's largest profit generator is its media networks, including ESPN, ABC, and the Disney Channel. While we anticipate solid performance in filmed entertainment, theme parks, and merchandising, we expect the media networks to account for the majority of the compa­ny's profit growth for years to come. Disney's cable networks are more dependent on affiliate fees and less dependent on advertising, which should help buoy the firm's financial results during these challenging economic times.

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