Telecom: Firms Strive to Be More Than 'Dumb Pipes'

• Overall, we view the communications services sector as fully valued at a market-cap-weighted price/fair value of 1.01.
• U.S. telecom continues to combat the fear of being a "dumb pipe."

U.S. Telecom Continues to Combat the Fear of Being a 'Dumb Pipe'

Perhaps the most important trend we're seeing in U.S. telecom is the ongoing shift in strategy to diversify away from being a pure wireless network provider.

Ultimately, we think the industry fears being just a supplier of "dumb pipe," where it becomes a commoditylike business with no ability to differentiate based on network quality or reliability. We still see

T-Mobile continues to execute well and offer aggressive pricing in order to capture customers, including many from Verizon, which reported notably disappointing quarterly results. Sprint continues to face challenges associated with capturing and retaining customers as well as building out a high-quality network.

Perhaps the most exciting news for both T-Mobile and Sprint investors is the potential for a merger between the two firms during Donald Trump's administration, as the Federal Communications Commission has been visibly focused on deregulation and might allow for such a merger to go through.

China Mobile Still Dominates in Broadband Even as the Mobile Subscriber Market Evens Out a Bit In the Chinese telecom market, we see wireless competition evening out a bit (albeit in a slower-growing market than in years past) but still see China Mobile as the dominant player in broadband.

As background, from the beginning of 2009 until the end of 2013, the "3G era,” China Mobile dominated the Chinese telecom industry, capturing half of new customers, while the remainder were split between China's other two large telcos,

However, the story in broadband is very different, with China Mobile cutting a swath through that market, adding 64% of new customers over 2016 compared with 28% for China Telecom and only 8% for China Unicom. While China Mobile's fixed broadband average revenue per user is only around half of the incumbent fixed-line operators, it is taking most of the new growth at over 65% of new fixed broadband customers in the market over 2016.

China Mobile's already-mentioned very strong balance sheet combined with its relatively low dividend payout ratio mean it can easily invest heavily in this market and make life difficult for its two competitors in the fixed-line market. Indeed, at the result briefing, management indicated it viewed an integrated fixed and mobile broadband offering as essential and set itself an ambitious target of adding a further 20 million fixed broadband customers in 2017, a slight increase on 2016 net adds.

Top Picks

China Mobile

CHL

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $66.00

Fair Value Uncertainty: Medium

5-Star Price: $46.20

We expect narrow-moat China Mobile to generate earnings per share growth of around 10% annually over the next five years, putting it toward the upper end of Asia-Pacific telecom companies in terms of growth. We expect China Mobile's strong market share gains from moving to 4G technology to drive this growth. Also driving growth are the upgrading of around 40% of its customer base to phones supporting mobile data, cost savings from the tower company, and a potential rerating in its stake in the tower company when it lists.

Telefonica

TEF

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $14.00

Fair Value Uncertainty: High

Consider Buying: $8.40

Telefonica is leading the European communications market into converged services. Additionally, it is laying extensive amounts of fiber to better compete with cable operators in providing fixed broadband services. It acquired E-Plus in Germany and GVT in Brazil, which strengthens its position in both countries and provides lots of opportunities for cost savings. We don't believe the market appreciates how well the firm is positioned and its margin expansion opportunities, which has caused its stock to trade around a 40% discount to our fair value estimate.

Millicom International Cellular

MIICF

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $83.00

Fair Value Uncertainty: High

Consider Buying: $49.80

Despite the decline in the stock due to the Colombian peso's continued weakness, Millicom is still one of our favorites in the sector. We expect the acquisition of UNE, the second-largest cable TV operator in Colombia, to enable Millicom to generate revenue growth even after currency declines in Colombia and other countries. We expect the firm to generate organic revenue growth in local currency terms in excess of 6% for the next five years, the fastest growth rate of any of the European communication companies we cover. On an enterprise value/EBITDA basis, Millicom trades below 4 times our estimate of 2016 EBITDA, the lowest in our European coverage. The stock also yields in excess of 4%, a dividend that we believe is safe.

More Quarter-End Insights

Market Outlook: Lofty Valuations Call for Careful Stock-Picking

Video Report: Few Values Left in the Global Stock Market

Economic Outlook: First-Quarter Underscores Slow Growth Expectations

Credit Market Insights: Bond Indexes Perform Well as Spreads Tighten Further

Basic Materials: The Most Expensive Sector We Cover

Consumer Cyclical: Still Opportunity in a High-Confidence Environment

Consumer Defensive: Still Thirsty for Growth

Energy: Coming Shale Growth a Major Threat to Oil Prices

Financial Services: Weighing the Strategic Tradeoffs of the Fiduciary Rule

Healthcare: Stock-Picking Increasingly Important as Valuations Rise

Industrials: Solid Fundamentals, but Few Screaming Buys

REITs: Playing Defense in an Uncertain Market

Tech: Overvalued Overall, but Opportunities Remain

Utilities: Is There Enough Growth to Offset Higher Interest Rates?