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.
• 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

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

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

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

CHL

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.

More Quarter-End Reports

Market Stock Market Outlook: Equity Valuations Look Lofty

Economy Midyear Economic Forecast: Lower Inflation, Slow Growth

Credit Markets Credit Market Insights: Bond Indexes Perform Well in a Quiet Market

Equity Sectors Basic Materials Outlook: Propped Up and Too Expensive

Consumer Cyclical: Amazon Reshapes Retail in Real Time

Consumer Defensive: Retailer Consolidation Sparks Concerns, but Opportunities Exist

Energy: Despite OPEC Cuts, a Crude Awakening Is Near at Hand

Financial Services: Our Take on U.S. Tax Reform and Bank Deregulation

Healthcare Outlook: ACA Repeal Efforts Unlikely to Yield Major Legislative Changes

Industrials: China Shows Signs of Softening, but the Sector Remains Healthy Overall

REITs: Some Scattered Opportunities in a Fairly Valued Sector

Tech: A Tectonic Shift Toward Enterprise Cloud Computing

Utilities: Tough to Stop This Sector's Powerful Performance

Mutual Funds First Half Winners and Losers for Funds

Second Quarter in U.S. Stock Funds: Growth on Fire

International-Stock Funds Continue to Prosper

Bonds in the Second Quarter: The Flattening

Portfolio Planning With Christine Benz Trends and Takeaways From 2017's First Half

PitchBook Reports Tapping the Brakes on M&A

Private Equity: Capital Deployment Remains a Challenge

Venture Capital: Less Is More?