Communication Services: Attractive, Sustainable Yields on Offer

Telecom stocks across the globe have held up well amid the market’s recent turbulence, with the Morningstar Global Communication Services Index down only 5% in the fourth quarter through Dec. 20 versus a 14% drop for the broader market. We continue to believe that Europe offers a particularly attractive hunting ground for value, with our telecom coverage there trading at a 24% discount to our fair value estimates. Telecom stocks in the U.S. look more reasonably priced, trading at a 15% discount, but opportunities still exist.

Exhibit 1: Telecom stocks have outperformed a volatile market recently

We suspect investors remain negative on European telecom stocks for a variety of reasons, including limited revenue growth potential, often complex operating structures, and, in many cases, exposure to emerging markets, where weak currencies have created messy financial results in recent quarters. Also, many European telecom companies carry relatively heavy debt loads, while investments in fiber-optic networks and new wireless technologies have pressured free cash flow, producing fears of dividend cuts. To top it off, Brexit and European Union telecom regulation produce additional uncertainty.

Exhibit 2: We still see several undervalued firms, especially in Europe

We believe that investors who wade through these complexities will be nicely rewarded. We expect capital spending needs to moderate in developed markets as fiber buildouts near completion and an increasing portion of wireless technology becomes software-based. Increased demand for data capacity should favor those firms that invested appropriately in the networks, driving revenue growth and margin expansion in future years. In short, we believe dividend payouts at most firms we cover are sustainable, providing generous returns as investors wait for telecom fortunes to turn around.

Exhibit 3: Yields are attractive and generally sustainable in our view

In the U.S., the proposed merger of T-Mobile and Sprint remains the most important near-term development. The wireless industry exhibits several elements of the efficient scale economic moat source, but the U.S. wireless business hasn’t benefited from efficient scale recently because of the competitive imbalance in the industry. T-Mobile and Sprint have had little choice but to price services aggressively to close the scale gap with AT&T and Verizon. A merged Sprint/T-Mobile would drastically improve the long-term structure of the U.S. wireless industry, at least for carriers, in our view.

Exhibit 4: Despite competitive onslaught, Sprint and T-Mobile still lag

Top Picks
 Telefonica (TEF)
Star Rating: 5 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 or its margin expansion opportunities, which has caused its stock to trade at a wide discount to our fair value estimate.

 Vodafone Group (VOD)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $32
Fair Value Uncertainty: High
5-Star Price: $19.20

Vodafone is one of the largest wireless carriers in the world. While the firm has had issues in some countries, such as India and Italy, it is increasing revenue in local-currency terms in most markets. The company has been focused on moving from a wireless-only provider to a converged operator. In Europe, fixed-line telecom services now account for about 30% of revenue. On the wireless side, Vodafone continues to transition customers to smartphones and 4G technology, both of which generally lead to higher data usage and higher revenue. The stock yields more than 7%, and we believe the dividend is safe.

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

With the bidding wars surrounding Fox and Sky resolved, a major source of uncertainty has lifted. While we were disappointed that Comcast was willing to pay a high price to win Sky, we believe management still showed discipline in walking away from Fox. We believe that the firm is very well-positioned competitively thanks to the strength of its core cable networks and the solid media franchises it possesses. We expect these strengths will serve Comcast well even as the television business continues to evolve.

Exhibit Sources: Morningstar, government agencies, the Federal Reserve. Data as of Dec. 20, 2018.