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State of the sector: telecom

Earnings growth for the telecommunications sector has been slower than expected.

  • Matthew Drukker, sector portfolio manager
  • – 07/10/2013
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The telecommunications sector continues to be a defensive one for investors. Even during periods of volatility in overall economic growth, factors such as a long sales cycle, ongoing subscription revenues, and the perceived necessity of voice and data services tend to make revenues for the telecommunications sector relatively consistent. Stable but modest top-line growth of 2% to 3% a year is the historical norm, and the past two quarters were no exception.

However, revenue growth for the sector has been on the low end of the range lately. Revenue from wired residential voice lines has declined steadily, as wireless subscriptions and Internet voice services have replaced traditional phone lines.

Revenue growth from wireline services to enterprise and small-to-medium businesses has continued to be slow. Sales growth in that category tends to lag the cyclical shifts of the economy because new businesses form and existing businesses expand cautiously, later into a recovery. Strong competition from cable television companies that now offer wired data and voice for businesses may present a rising challenge to wireline revenue growth going forward, and bears watching. Additionally, a reduction in federal Universal Service Fund fees negatively impacted revenues mildly, but these savings were passed through to users and did not affect profits.

Telecom earnings report

Earnings growth has been slower than expected. The large integrated telecommunications companies have been meeting general expectations for earnings growth, but compressed margins for wireless service providers have depressed earnings growth for the sector overall.

Intensified competition for wireless customers—particularly among the major carriers—likely had the largest impact on earnings in that industry, and this trend should continue for the near future. Higher-than-expected acquisition costs have depressed earnings for some of the larger wireless companies in the sector as well.

The wireless services industry continues to evolve. With the U.S. regulatory stance against consolidation of the four major carriers in the U.S., we have begun to see some acquisition interest focused on the marginal players. More importantly, a recent acquisition plan for one of the major wireless carriers, if it comes to pass, may invigorate that company and intensify the competition among all wireless carriers, potentially applying further pressure on future earnings.

Telecom valuations

Because businesses in the telecommunications sector usually have high but irregular capital investment needs, earnings growth is not always the best gauge of the sector’s performance, and the price-to-earnings ratio (P/E) is not always the best measure of valuation. Instead, stocks in this sector tend to trade based on a combination of dividend yield and recurring free cash flow yield.

In an economic environment of low interest rates for fixed income securities, relative dividend yields seem to have become an important factor in equity valuations. With stable revenues and predictable cash flows, telecommunications companies have tended to offer healthy dividend yields.

The sector’s yield spread over 10-year Treasury bonds has narrowed recently (see chart below, right), mainly due to a slight increase in the Treasury yield. However, the current spread of approximately 2.0% is on the high end for long-term averages, consistent with the recent range. Payout ratios (the percentage of earnings paid out to investors as dividends) for the bellwether companies of the sector have remained near 70%, perhaps suggesting little potential for valuation increases based solely on dividend growth.1

Recurring free cash flow yield, which divides the share price into the expected recurring cash flow generated by the company less ongoing capital expenses, is another useful valuation metric for the telecommunications sector.2 While dividend yield reflects the amount of cash returned to investors, recurring free cash flow yield measures ongoing cash generation that may be used for a variety of business purposes, including dividends but also including expansion, acquisitions, and share buybacks.

Recurring free cash flow yield had been at around 7% at the beginning of the year, which is near the low end of the sector’s range for the last few years and suggests high valuations.3 Current estimates for recurring cash flow in 2014 suggest that a slight increase to a 7.5% yield has occurred, but valuations are still relatively high.

Any further increase in Treasury yields would likely challenge valuations for the telecommunications sector. In 2009, when 10-year Treasury yields were above 3%, the bellwether companies in the sector were trading at an estimated 9% recurring free cash flow yield. With 10-year Treasury yields now closer to 2.5%, the current 7.5% recurring free cash flow yield likely reveals investors’ willingness to pay more for equities with higher dividend yields in the current environment of low rates.4 If the perceived risk-free yield represented by Treasury bonds were to increase further, valuations for the telecommunications sector could decrease.

Outlook for telecommunication services stocks

Revenue growth in the telecommunications sector tends to lag during periods of positive GDP growth, and we are likely to see 2013 revenue growth come in at around 2%, at the low end of the usual range. Wireless revenue growth was roughly 5% in 2012, and is likely to be lower for 2013, at around 4%. Wireline revenue continues its secular decline, eroding roughly 1% in 2012 and is likely to fall a similar amount this year.

Wireless and wireline data consumption together will likely continue to drive the sector’s revenue growth, though at a rate significantly trailing the actual increases in consumption. As broadband data service becomes more and more of a necessity for businesses and individual consumers alike, successful data service providers can expect to earn relatively stable revenues. What remains uncertain is whether service providers can resist deflationary pressures and find ways to grow profits to match consumption growth, especially after factoring in the capital expenditures required to provide greatly increased capacity.

Longer term, the relative stability of the overall sector may mask intense volatility for the underlying companies, which have varying levels of exposure to growing or declining segments of the market. Recent acquisition activity around one of the four largest wireless providers in the U.S. may signal the beginning of more consolidation.

Over time, reinvigoration of the less dominant players in the wireless industry may reward companies that have better opportunities to expand revenues and cut costs. The ongoing decline of wired voice, and competitive pressures in wired data from cable providers, may continue to challenge earnings growth for companies with high overall exposures to the wireline business.

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1. Source: Company filings, Fidelity Investments, as of June 17, 2013.
2. Source: Company filings, Fidelity Investments, estimate as of May 31, 2013. The calculation of recurring free cash flow yield requires analytical judgment to eliminate the effects of unusual events and uneven cash flow distributions. Therefore, recurring free cash flow yield is an estimated ratio. 3 Source: Company filings, Fidelity Investments, estimate as of May 31, 2013.
3. Source: Company filings, Fidelity Investments, estimate as of May 31, 2013.
4. Source: FactSet, Company Filings, Fidelity Investments, estimate as of May 31, 2013.
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