Communication Services: AT&T and Verizon--A Duopoly No More

• Overall, we view the communications services sector as fairly valued at a market-cap-weighted price/fair value of 1.01.
•  AT&T (T) and  Verizon (VZ) still own industry economics, but  T-Mobile (TMUS) is now dictating the rules.
• Fixed-line telecom convergence continues to increase in Europe.

Although Verizon remains the leader in the U.S. wireless market, we believe that its duopoly with AT&T is being undermined at the margins by T-Mobile and  Sprint . Disruptive actions by these two smaller rivals, such as offering unlimited data plans, threaten to make overall U.S. telecom industry economics less attractive and conflict with Verizon's core strategy of leading with network quality and monetizing increasing amounts of data traffic. Although Verizon still benefits from a cost advantage over these smaller rivals and will still earn returns above its cost of capital, we expect Verizon's ability to command premium pricing to decrease, which we believe will constrain the firm's returns.

As the U.S. wireless market matures, AT&T has pursued large acquisitions in order to grow and diversify revenue. First, with the DirecTV acquisition, AT&T aims to cross-sell video offerings with its wireless service in the hopes of reducing churn and extracting increased value out of its subscriber base through strategies such as bundled packages. Second, with the pending  Time Warner acquisition, AT&T hopes that vertical integration will provide both revenue synergies and cost efficiencies in content-rights negotiations. We think AT&T paid a rich price for DirecTV, an asset that we believe delivers minimal benefits to the core telecom business, and we fear that the firm's horizontal and vertical expansion efforts will prevent returns from meaningfully exceeding its cost of capital.

T-Mobile is the top organic growth story among U.S. telecoms, coming off of three-plus years of industry disruption and outsized share gains. T-Mobile is the only large U.S. carrier growing wireless service revenue, and though we doubt the firm can keep growing wireless service revenue in the double digits, mid-single-digit growth appears achievable, versus declining revenue for the industry as a whole. As T-Mobile benefits from recent volume growth, we believe that the firm is approaching a multiyear ramp in profitability and free cash flow. In addition, T-Mobile presents added upside given its strategic appeal to potential partners.

Fixed-Line Telecom Convergence Continues to Increase in Europe
The convergence of fixed-line telecom services, which can include traditional telephone service, broadband, and pay-TV service, with wireless telephone service continues to increase in Europe. Carriers benefit from convergence via reduced churn and lower customer marketing and retention costs.

Spain remains furthest along this path, with around 80% of its broadband subscribers also taking wireless services in a packaged deal from the same operator. Other countries are following suit, with large amounts of bundled services in Belgium and the Netherlands. One of the drivers for  Vodafone (VOD) and  Liberty Global (LBTYA) joining their Dutch assets at the end of 2016 into a joint venture was to create a company that could go head to head in all areas and bundles with incumbent operator  KPN (KKPNY).

In France, operators are laying fiber to enhance their broadband speeds in an attempt to distinguish their networks and drive both fixed-line and wireless subscriber growth. In Germany, Vodafone has completed the integration of Kabel Deutschland and is increasingly offering bundled services that combine broadband and pay TV from Kabel Deutschland with its traditional wireless service.

Although the U.K. has been slow to move toward convergence, we expect this to increase as BT finishes up the integration of EE, which provides it with wireless capabilities on top of its traditional fixed-line offerings. As customers begin to move to bundled offerings by those companies that first offer them, other operators tend to follow. We anticipate this trend lasting for several years.

Top Picks

 China Mobile
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $67.00
Fair Value Uncertainty: Medium
5-Star Price: $46.90

We expect narrow-moat China Mobile to generate underlying earnings per share growth of high single digits 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 in broadband and from moving to 4G mobile technology to drive this growth. Also driving growth are the upgrading of around 25% 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: $14.50
Fair Value Uncertainty: High
5-Star Price: $8.70

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 25% 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
5-Star Price: $49.80

Despite the decline in the stock due to the Colombian peso's weakness in 2015 and 2016, Millicom is still one of our best ideas. We expect the acquisition of UNE, the second-largest cable-TV operator in Colombia, and other smaller cable systems in other countries to enable Millicom to generate revenue growth again starting in 2018. We expect the firm to generate average organic revenue growth in local currency terms of about 3.4% from 2018 to 2021, which remains one of the fastest growth rates of the European communication companies we cover. On an enterprise value/EBITDA basis, Millicom trades at about 4.4 times our estimate of 2017 EBITDA, one of the lowest in our European coverage. The stock also yields in excess of 4%, a dividend that we believe is safe.

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