Communication Services: Undervalued With a Case of Merger Fever

• Overall, we view the communications services sector as undervalued at a market-cap-weighted price/fair value of 0.82.
• U.S. telecom consolidation is in the works with a T-Mobile-Sprint merger.
• In Europe, telecom is focused on convergence and increased build-outs of fiber and 4G.
• In telecom and cable, we continue to see migration from traditional pay-TV providers to over-the-top, or OTT, offerings.

In the U.S., after two prior failed attempts,  T-Mobile (TMUS) and  Sprint  have reached a long-anticipated agreement to merge the two firms, with T-Mobile retaining its brand and management team as part of the planned merger. The deal will likely face hefty regulatory scrutiny, as it shrinks the number of nationwide wireless telecom providers from four to three. Yet both T-Mobile and Sprint are behind the industry leaders,  AT&T (T) and  Verizon (VZ), and a deal would be a panacea for Sprint in particular as the business strives to keep pace. We currently believe the deal has a 50/50 chance of passing through the current regulatory environment, as the loss of a fourth player may lead to higher wireless data prices for consumers in the United States. T-Mobile and Sprint touted the number of U.S. jobs that would be added by a merger, perhaps in an attempt to pre-emptively alleviate any regulatory concerns, yet job additions would likely reduce the combined firm's ability to extract cost savings, and we're not yet convinced that the comments made by both T-Mobile and Sprint will be enough to sway regulators. We don't expect a regulatory decision on this deal until 2019, but it would obviously shift the U.S. telecom landscape if consummated.

Elsewhere in telecom-related mergers and acquisitions, we have seen competing bids from  Twenty-First Century Fox  and  Comcast (CMCSA) in attempts to acquire U.K. satellite TV provider  Sky . Although we were previously skeptical of a bidding war between the two firms for Sky, recent regulatory announcements suggest that Fox's prior advantages when it comes to buying Sky (such as being the first bidder and already owning 39% of Sky shares) have been essentially nullified. Complicating the matters further is  Walt Disney's (DIS) bid to acquire assets from Fox, although the U.K. recently announced that if Fox were to gather enough support from shareholders to buy Sky, and Fox were then able to sell Sky News to Disney, the Fox-Sky merger might be more likely to receive regulatory approval. Nonetheless, we note that the latest price to acquire Sky is at our stand-alone fair value estimate for Sky, so any higher bids from here may result in a "winner's curse" for either Fox or Comcast.

In Europe, the main telecom themes still remain the move to convergence, along with increased build-outs of fiber and 4G. Spain has long been the leader in convergence, with around 80% of broadband customers subscribing to a wireless service from the same company. France has also been pushing convergence but isn't as far along. Germany was slower at pushing convergence but is pushing it increasingly. Now even the U.K. and Italy, which have been big laggards, are starting to offer converged services. The movement toward convergence is enhanced by the faster broadband speeds being offered by fiber. Historically, cable-TV operators have enjoyed an advantage with broadband speeds, owing to networks that were designed for video and include more fiber and coax rather than copper. However, in order to better compete, telecom operators are increasingly laying fiber that provides equivalent speeds to the cable operators. Europe has been much slower at moving to 4G than the U.S. or Asia, but 4G has really taken off in the past year. However, penetration rates are still behind the U.S. and parts of Asia. Thus, we expect the transition to 4G to continue as operators extend their 4G networks further. While the transition to 4G continues in Europe, the U.S., Japan, and South Korea are preparing for the jump to 5G. Several companies in these countries have discussed initial offerings by the end of this year.

For pay-TV distributors, we continue to see migration from traditional providers, such as Comcast and  Dish (DISH), to the newer OTT providers, such as Sling TV, DirecTV Now, and YouTube TV. We believe that the more concentrated bundle and the lower price point will continue to attract cord-shavers and possibly even some cord-cutters. The major OTT providers now have over 4.5 million subscribers in the U.S., and we project that this number will continue to increase. For traditional video providers with a broadband offering, we expect these providers like Comcast to shift margin from the video piece of the bundle to the broadband side. While Dish is benefiting from this transition because of its Sling TV product, the margins on OTT pay TV are considerably lower and the firm lacks a competitive broadband offering. Among media companies, wide-moat firms such as Disney and Fox have placed their most important channels across all major OTT TV platforms, while smaller firms like  Discovery (DISCA) and  Viacom  have struggled to gain carriage. We believe that these smaller firms will remain locked out, particularly if the new OTT platforms continue to add new subscribers.

Top Picks

 Telefonica (TEF)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $15
Fair Value Uncertainty: High
5-Star Price: $9

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 at a wide discount to our fair value estimate.

 BT Group
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $24
Fair Value Uncertainty: High
5-Star Price: $14.40

While narrow-moat BT Group has had some issues in the past two years that caused its stock to decline, we believe the sell-off is overdone. BT is the incumbent telecom operator in the United Kingdom. In 2016, it acquired EE, the largest wireless telecom operator in the country. The company now has the largest fixed-line telephone, broadband, and wireless telephone subscriber bases in the country. Additionally, it is the only operator in the U.K. that owns both a retail fixed-line and wireless network. We believe this provides BT with an advantage in selling a converged package of these services plus pay TV. The company has been slow to market its converged services, but now that it has reached an agreement with telecom regulator Ofcom regarding Openreach, its U.K. business that owns its fixed-line network and wholesales access to it to other operators, we expect a more aggressive marketing push into converged services during calendar 2018.

BT has been hurt by the widening underfunding of its pension plan as interest rates have declined in the U.K. We think interest rates have bottomed and they are more likely to increase from here. We believe the benefit on the pension will be greater than the hit on higher interest on its bonds, the reverse of what happened as interest rates declined. We also think the company has dealt with its problems in Italy and will be able to improve its revenue in its global services division. The market appears to believe the problems BT has seen will continue and potentially get worse, whereas we believe business can improve over the next few years. In the meantime, the stock yields 6.3% and the company has increased its dividend for each of the past seven years. Additionally, as it is a U.K.-domiciled company, there is no foreign tax withholding on the dividend.

 Comcast (CMCSA)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $42
Fair Value Uncertainty: Medium
5-Star Price: $29.40

Like its traditional pay-TV distributor peers, Comcast has suffered from the growth in cord-nevers and cord-shavers, particularly as OTT offerings like Sling TV, DirecTV Now, and YouTube TV gain traction. This ongoing deterioration in pay-TV economics has negatively affected the share price of Comcast and its peers. However, the combination of the hostile bid for Sky and the potential bid for the Fox assets has had a larger impact, as shares are down over 18% since the Feb. 27 announcement of the Sky offer. We believe that a shift in focus toward M&A from returning capital to shareholders has spooked some investors. While management appears ready to ramp up leverage at the firm to acquire both of its targets, we currently project that the original bidders (Fox/Disney in the case of Sky, and Disney for the Fox assets) will prevail over Comcast.

After the M&A headlines disappear, we believe Comcast is the best-positioned U.S. communications firm. Irrespective of the challenges faced by traditional pay TV, broadband demand continues to accelerate. We believe Comcast is better situated to benefit from this trend, owing to its faster Internet speeds, than many of its telco peers. The current regulatory environment is favorable because of the reversal of Title II and net-neutrality rules. With the threat of pricing regulation diminished, Comcast can potentially offset deteriorating pay-TV economics with higher broadband prices.

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