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Telecom Titans and the Rise of the Machines: Big Dividends and Big Growth

By Roger S. Conrad on Aug. 16, 2017

The Dow Jones Utility Average has gained 253 percent since the index bottomed on March 9, 2009. And many US gas, water and electric utilities trade at historically elevated valuations after the massive rally that followed Donald Trump’s election.

In contrast, the S&P 500 Telecommunications Services Index has appreciated by only 74 percent since bottoming on Oct. 10, 2008. Excluding dividends, the index is roughly flat since the third quarter of 2012. Among yield-oriented equities, only master limited partnerships fared worse over this period, thanks to the collapse in oil and gas prices.

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S5TELS SPX UTIL

The telecom sector’s underperformance dates back even further. Sector heavyweight Verizon Communications’ (NYSE: VZ) stock price has yet to revisit its October 1999 high of $62.29, while Wall Street darling T-Mobile US (NSDQ: TMUS) still trades at a 22 percent discount to its July 2007 high of almost $82.

Despite this underperformance, the sector hasn’t been without its success stories since the Telecommunications Act of 1996 broke up local-phone monopolies and deregulated the industry.

A wave of consolidation has given the remaining big cable companies an effective oligopoly in the entertainment space and in some regional broadband markets.

Industry behemoth Comcast Corp (NSDQ: CMCSA), which has grown its cash flow consistently over the years, trades at 18 times its share price from 20 years ago.

Over the same period, the value of regional player Shenandoah Telecommunications’ (NSDQ: SHEN) common stock has increased seventeenfold, fueled by the company’s consolidation of cable, television, local-phone, and wireless services in Appalachia.

But failures easily outnumber these happy outcomes.

Customers who bought Vonage Holdings Corp’s (NYSE: VG) 2006 initial public offering on the promise that its voice over internet protocol (VoIP) would supplant local phone connections are still down by almost 50 percent. WorldCom has been extinct for more than 15 years, while the headstones of smaller players litter the telecom graveyard.

Income-seeking investors once flocked to rural telecoms for their high yields and the steady revenue in ostensibly less competitive markets. Among the names covered in our Utility Report Card, only Consolidated Communications (NSDQ: CNSL) hasn’t slashed its dividend, though the recent acquisition of FairPoint Communications arguably has put the payout in danger.

Given all this carnage, investors can be forgiven for taking a dim view of the telecom sector. But best-in-class telecom providers appear to be on the verge of an underappreciated growth phase, spurred by the rise of machine-to-machine communications and the internet of things (IoT).

The Evolution Revolution

In addition to the availability of inexpensive data storage and processing power, the internet of things owes its recent ascendance to the evolution of global telecommunication technology over the past two decades.

When President Bill Clinton signed the Republican-led Congress’ Telecommunications Act of 1996 into law, most communications took place over the plain-old telephone service (POTS)—the same copper wires that had connected the country for about a century.

Today, wireless phones have supplanted wirelines as the primary means of voice communications, while Skype, WeChat and other internet-based video applications have also taken market share. Accordingly, the telecom sector’s formerly lucrative long-distance business has all but vanished. Copper wires still crisscross the country, but households and businesses continue to cut the cord at an accelerating pace.

Cable and satellite television providers also continue to lose customers as access to high-speed wireless and fiber-optic broadband networks expand.

The replacement of 20th-century telecom systems with high-capacity broadband systems has driven much of the turmoil in the sector. But the companies that have spearheaded this transition and kept their heads above water are well-positioned to profit from rapid growth in IoT applications and machine-to-machine communication. Stragglers, on the other hand, will fall even further behind.

For investors in the telecom sector, avoiding the disasters has been just as important as picking the winners. Regional telecom Windstream Holdings (NSDQ: WIN), for example, recently eliminated its quarterly dividend and has given up almost 90 percent of its value since we sold the former Aggressive Income Portfolio member for a 52 percent gain in August 2014.

But growing adoption of the internet of things means that the sector’s best operators offer exposure to a massive secular growth trend for the first time in decades.

Unfortunately, the market’s obsession with subscriber additions appears set to persist for the next year or two. Investors should also expect plenty of chatter about what John Legere, CEO of T-Mobile US, recently referred to as “the non-stop rumor mill at Bloomberg” concerning prospective mergers and acquisitions.

However, leading telecom companies will start to change the conversation by focusing more on IoT-related opportunities in their investor presentations. As this growth trend starts to show up more prominently in quarterly earnings, this theme will become even more difficult to ignore—and will command the same level of attention as trends in wireless customer additions.

As always, network quality, free cash flow, and balance sheet strength will distinguish the winners from the losers in the telecom sectors.

Grounds for Separation

Telecom analysts and industry observers pay lip service to a range of operating and financial metrics, though much of the recent conversation has coalesced around revenue growth and customer additions. The companies that have performed the best in these areas tend to command higher valuations.

In terms of enterprise value to operating cash flow, American Tower Corp (NYSE: AMT) and Crown Castle International Corp (NYSE: CCI)—both of which own wireless towers—command the highest multiples in our telecom coverage universe. These decidedly low-tech businesses offer exposure to steady revenue growth from asset acquisitions and growing utilization of existing infrastructure.

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Telecom Valuations

Takeover targets such as Charter Communications (NSDQ: CHTR) and Level 3 Communications (NYSE: LVLT), which agreed to a tie-up with CenturyLink (NYSE: CTL), also fetch elevated valuations. Charter Communications and fellow cable provider Comcast’s solid revenue growth likewise sets them apart from the crowd.

In contrast, Windstream and other regional telecoms that continue to struggle with declining revenue and a shrinking customer base trade at much lower valuation multiples. Revenue stability has proved challenging for this group, with subscriber attrition rates accelerating in recent quarters—a point underscored by Frontier Communications Corp’s (NSDQ: FTR) recent woes.

Much of the weakness in regional telecoms stems primarily from broadband sales failing to offset losses in local-telephone services. Increasing broadband competition from cable television providers, many of which boast superior economies of scale, has made the transition from local-phone service to broadband a more challenging proposition. The proliferation of 4G wireless networks across America likewise hasn’t helped matters.

The recent flurry of mergers and acquisitions involving regional telecoms could keep these companies afloat for a while, but revenue declines and customer attrition show no signs of abating. And the cash flow retained from dividend cuts will go only so far in servicing hefty debt loads.

Among the regional telecom companies, Shenandoah Telecommunications and Telephone & Data Systems (NYSE: TDS) stand out as the cream of the crop and the most likely survivors. However, both companies lack the elements needed to participate in the IoT boom:

  • Spectrum:Wireless and wireline spectra are the highways for IoT data—the more a company owns, the better its opportunity set.
  • Scale:Only the largest networks will be able to handle the flood of data traffic created by increasing IoT adoption. Capital spending, not customer additions, serves as the best proxy for network quality. The more money an operator can invest in improving the capacity and speed of its network, the more likely that company will win IoT business. We continue to prefer the handful of telecom titans that can outspend their rivals without taking on significant debt, especially if they have ample excess cash flow to supplement organic growth with acquisitions. Lower rates of capital intensity—spending as a percentage of revenue—tends to correspond with superior scale.
  • Capability: Combining wireline fiber infrastructure with high-speed wireless can improve network capacity and speed. Names that play in both worlds will be best-positioned to thrive.
  • Balance Sheet: Only a small handful of US telecoms still boast investment-grade credit ratings. Given the relatively tight yield spreads between investment-grade and junk bonds, this distinction hasn’t mattered as of late. But rising interest rates and credit market disruptions can widen these spreads, straining junk-rated telecoms’ ability to refinance existing debt.
  • Vision and Strategy: Management teams need to have a clear vision for the company to have a chance of achieving these goals. We prefer names focused on building a sustainable business, as opposed to those struggling to ensure their near-term survival at any cost.

Conservative Income Portfolio holding Verizon Communications ticks all these boxes. In the mid-1990s, the former Bell Atlantic’s management team realized that the future resided in wireless and broadband, and built a national franchise by merging with the former NYNEX, GTE and MCI. The company also partnered with Vodafone (LSE, NYSE: VOD) to roll out its wireless network.

AT&T underwent a similar evolution. The former SBC Communications absorbed three “Baby Bells,” a regional player in New England and AT&T, which, at the time, focused on long-distance telephone services. Comcast built an industry behemoth by building a national cable television and broadband franchise, and complementing this business with media holdings.

These management teams may not make headlines for bold statements or moves, but they persevered and built lasting value for their shareholders. Whether a company manages expectations effectively and consistently meets quarterly guidance provide insight into the executive team’s performance. Nobody blames a CEO for the business cycle. However, it is unforgivable not to have a plan to manage through the cycle or to persist in a failing strategy.

Best in Class

Which telecom companies in our Utility Report Card have what it takes to benefit from growing adoption of IoT while avoiding the pitfalls associated with the transition away from 20th-century communications technologies?

Wireless tower owners American Tower and Crown Castle International appear to be the surest bets on rising data traffic, but both stocks trade at valuations that have priced in something close to perfection. Crown Castle International Corp rates a buy on a pullback below $90 per share, at which point we would add the stock to our Conservative Income Portfolio.

Note that we maintain our Sell rating on Uniti Group (NSDQ: UNIT), a real estate investment trust (REIT) that owns telecom infrastructure. The company generates the bulk of its revenue from Windstream Holdings—a threat to cash flow and its ability to grow.

Among the telecom service providers in our coverage universe, the best-positioned names continue to outspend their rivals by a wide margin. AT&T, Verizon Communications, Comcast and Charter Communications generate significant free cash flow. And all but Charter Communications have an investment-grade credit rating and exhibit relatively low rates of capital intensity, providing capacity to ramp up investment if necessary. That said, Charter Communications continues to pay down debt in pursuit of an upgrade.

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Telecom Capex

Of this foursome, Verizon Communications is best-positioned to ride the IoT wave, thanks to strategic acquisitions of spectrum owners and service providers. The company recently pipped AT&T to purchase Straight Path Communications (NYSE: STRP) and its valuable wireless spectrum for $3.1 billion.

Management expects the number of connected devices around the world to increase from 8.4 billion to more than 20 billion by 2020. The rollout of Verizon Communications’ 5G network in coming years will also create opportunities, while the $2.13 billion acquisition of Fleetmatics Corp adds software-as-a-service solutions that help to improve the efficiency of commercial fleets by collecting data related to vehicle and drive behavior.

Charter Communications is the only company among this group that trades at a premium valuation.

AT&T rates a buy when the stock dips below $38, and Verizon Communications is a Buy up to $52. Comcast Corp continues to trade 15 to 20 percent above our Buy target of $35. Charter Communications is a Hold.

Sprint Corp (NYSE: S) appears to be on the outside looking in on the IoT boom. The fourth-largest wireless provider in the US continues to spend as much as it can to compete in the consumer segment, leaving it with a growing pile of debt and limited ability to focus on emerging IoT opportunities. Despite ongoing speculation of a potential takeover, Sprint Corp rates a Sell.

T-Mobile US continues to take market share from Sprint, thanks to an aggressive pricing and marketing campaign.

Deutsche Telekom (Frankfurt: DTE, OTC: DTEGY), which owns a 64 percent equity interest in T-Mobile US, eventually may receive an offer for America’s No. 3 wireless provider that’s too good to refuse—and has a chance to secure regulatory approval. Ideally, a potential suitor would own broadband assets that would complement T-Mobile US’ wireless network and enable it to compete for IoT business.

A combination with Sprint would deprive T-Mobile US of a lucrative source of new customers and would overburden the combined company with debt.

If a viable takeover offer for T-Mobile US emerges, Deutsche Telekom would reap the rewards. We also like the Germany-based company’s high-quality network and improving operations in Europe.

Deutsche Telekom’s American depositary receipt rates a Buy up to $17 in the Utility Report Card. In contrast, a stretched valuation, lack of a broadband wireline network and expectations for a takeover offer make T-Mobile US a Sell.

Asia

With 867 million wireless subscribers, China Mobile (Hong Kong: 941, NYSE: CHL) is the top dog in China’s telecom market and boasts the Mainland’s best network. Over the past 12 months, the migration to 4G spurred a 107.5 percent increase in the company’s data traffic. China Mobile also expanded its customer base by 41.3 percent, poaching many of these new subscribers from rivals.

The company slashed its data tariff for wireless phones by 36 percent and still managed to grow its average revenue per user by a robust 4.5 percent. This performance in a highly competitive market is impressive enough, but prospective investors should consider the upside from the rollout of its 5G network in coming years and a potential explosion in machine-to-machine communications.

Integrating wireline broadband with the wireless network will be critical to meeting the coming surge in human and machine-based data traffic. China Mobile controls about one-third of China’s wireline broadband network, with a customer base of almost 100 million.

During China Mobile’s second-quarter earnings call, management highlighted the telecom company’s ambitious plans for the internet of things (IoT). This strategy includes application development with more than 70 different industries and plans to start commercial use of these products in “certain key cities” by the end of 2017.

As in the US, the market tends to obsess over trends in customer additions instead of which telecom companies have the best opportunity to profit from the IoT boom. Intensifying price competition from China Unicom (Hong Kong: 762, NYSE: CHU) and other rivals, for example, has weighed on the performance of China Mobile’s stock. The rollout of rival 4G networks has also worried investors.

Although China Mobile’s impressive second-quarter results testify to the company’s dominance of the wireless market, the stock remains 25 percent below its April 2015 high and trades at a discounted valuation of 13 times earnings.

The company announced a 9 percent increase to its semi-annual dividend, which investors of record before Aug. 31 will receive. Meanwhile, the Hong Kong dollar’s loose peg to the greenback means that fluctuations in exchange rates are less of a concern for US investors.

China Mobile’s New York-listed American depositary receipt (ADR) represents five ordinary shares on the Hong Kong Stock Exchange. Prospective investors should note that there’s no dividend withholding. China Mobile’s ADR joins the Aggressive Income Portfolio as a buy up to US$60.

Nippon Telegraph & Telephone Corp’s (Tokyo: 9432, OTC: NTTYY) old-school name and the Japanese government’s one-third interest in the company have made it difficult for the telecom to shake its reputation as a stodgy relic of the 1980s.

This bias helps to explain the stock’s undemanding valuation of 13.6 times trailing earnings and 1.18 times book value. AT&T (NYSE: T), in contrast, trades at 16.9 times earnings and 1.83 times book value, while momentum darling T-Mobile US (NSDQ: TMUS) fetches an obscene 40.4 times earnings and 2.63 times book value.

But Nippon Telegraph & Telephone has reshaped itself into a dynamic, next-generation telecom company over the past decade. The wireless business—the company’s 68 percent equity interest in NTT Docomo (Tokyo: 9437, NYSE: DCM)—last year accounted for 40 percent of its revenue.

NTT Docomo grew its average revenue per user by 6.2 percent in its fiscal year ended March 31, 2017, and maintained its market leadership despite moderate competition. The next great leap forward will occur with the full launch of its 5G data network in 2020, after an extended trial that includes access to virtual reality apps and other innovations.

The wireless provider’s superior balance sheet—especially relative to junk-rated SoftBank Group Corp (Tokyo: 9984, OTC: SFTBY)—gives it a huge leg up in its push to be the first to offer 5G capabilities. This advantage could grow if the Japanese government follows through with tariff cuts on 4G networks. Meanwhile, Nippon Telegraph & Telephone’s fiber-to-home network provides multiple synergies and marketing opportunities.

Fixed-line services contributed roughly 24 percent of Nippon Telegraph & Telephones sales over the 12 months ended March 31, 2017. Cost reductions have helped the company to maintain its profit margins in this business, which continues to suffer consistent declines in its customer base and revenue per user.

The remaining 32 percent of Nippon Telegraph & Telephone’s revenue comes from its rapidly growing cloud networking and data communications business. International sales represent the biggest opportunity for this segment. Management’s guidance calls for revenue in this business line to increase to US$22 billion this fiscal year, up from US$15.6 billion.

Winning business overseas means competing with US heavyweights like Amazon.com (NSDQ: AMZN) and Microsoft Corp (NSDQ: MSFT)—a daunting task. But the company continues to win awards in Asia, and this evolving market leaves room for multiple competitors.

Nippon Telegraph & Telephone’s American depositary receipt (ADR) has lagged the large-cap US telecoms, but a 25 percent dividend increase announced in mid-May put the market on notice that the company could shake off its lethargy.

The latest addition to the Aggressive Income Portfolio, Nippon Telegraph & Telephone’s ADR rates a buy up to $50. Prospective investors should note that Japan withholds 15 percent of dividends paid to US investors; you can reclaim this amount by filing a Form 1116 with your taxes.

 

 

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ABOUT ROGER CONRAD

Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b