The Morningstar communications services sector was reconstituted at the end of 2019 to reflect the blurring lines between several industries related to traditional telecom: the changing ways people communicate with one another and use networks for a multitude of daily activities. Previously, telecom stalwarts AT&T T and Verizon VZ dominated the index. Both firms still have large weightings in the new index, but not to the same extent--combined, the two firms account for about 17% of the sector index. Instead, internet giant Alphabet GOOGL is now the largest firm in the sector, with a 28% weighting, followed by Facebook FB at 16%.
The broader character of the sector has caused it to lose some of the defensive nature it has historically been known for. Sector performance thus far in 2020, throughout the turbulence tied to the coronavirus pandemic, has largely mirrored the broader market. The Morningstar U.S. Communications Services Index is down about 14% year to date versus nearly 16% for the broader market.
Looking deeper, Alphabet and Facebook have posted declines similar to the overall market, which we think makes both stocks attractively priced. Alphabet is our favorite of the two. Advertising spending will certainly take a hit as firms tighten budgets in response to COVID-19. Alphabet’s Google and YouTube platforms won’t be immune, but we don’t expect the firm’s online dominance to wane over the longer term. The stock now looks more attractive than it has since the short-lived market downturn in late 2018.
Disney DIS has been among the hardest-hit stocks in the sector, down about 30% year to date. Disney has taken the biggest hit directly from the pandemic among traditional media firms because its theme parks business contributes about 30% of total revenue (Comcast CMCSA, by contrast, the next-largest theme park operator, only generates about 5% of its revenue from this segment.) But the current pandemic also provides Disney with opportunities to extend its reach in new ways. With children at home from school, Disney+ has likely garnered increased attention relative to other streaming services with moves like the early release of Frozen 2. We expect firms with strong content franchises and solid balance sheets, like Disney, will manage reasonably well through a downturn and will perform well, more importantly, over the long term. With the drop in Disney shares, we think the firm is attractive at current prices.
Comcast’s exposure to theme parks and media generally seem to have soured investors on the shares in this environment—the stock has underperformed standalone cable firms Charter CHTR and Altice USA ATUS thus far in 2020, which we believe is unwarranted. The core cable business still accounts for about 70% of Comcast’s consolidated EBITDA. We believe this business is in great shape and should see minimal impact from the pandemic. An increase in telecommuting and television streaming, if anything, could further highlight Comcast’s network advantage versus its phone rivals. In addition, Comcast’s debt load--while a little bit higher than it has been in years past with the Sky acquisition--is still solid. Net debt is at about 3.0 times EBITDA versus 4.6 times for a peer like Charter or 5.3 times for Altice USA. So we think Comcast is in a great position financially as well.
The shares of AT&T and Verizon have diverged pretty sharply thus far in 2020. Verizon has provided the traditional stability investors have come to expect from telecom, while AT&T shares have declined about 20% year to date. Of course, AT&T’s business looks a lot different than it did five years ago and we’ve not been a big fan of the acquisitions that the company has made in recent years. But we think the market has unfairly punished the stock. The wireless business, which is still AT&T’s largest segment, should have a solid year as fewer customers look to change carriers and as T-Mobile TMUS focuses its effort on integrating Sprint. While some investors seem to be disappointed that AT&T has halted share repurchases here during the pandemic, we're actually happy to see this shift. We’d like to see the firm continue to repay debt instead of buy back stock, lowering the risk of a dividend cut at some point in the future. We think the dividend is safe for now, but we'd like to see the firm return a solid balance sheet like it's had in years past.
Lastly, the strongest performers in the sector thus far in 2020 are, unsurprisingly, those that stand to benefit in the pandemic. Netflix NFLX sits at the top in terms of contributors to the sector thus far in 2020. We continue to believe that Netflix's limited distribution outlets--while a positive when everyone is staying home--will prove to be a disadvantage over the long term.