Four great value telecoms stocks to buy now
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David Stevenson Jul 16, 2010
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Until two months ago, telecoms shares were among the least popular on the planet. While global equity markets were soaring last year, no one really wanted to know about phone companies. They simply weren't exciting enough.
But there have been some signs of a change of heart by investors. As equity markets overall have faltered, demand has begun to rise for shares in these out-of-fashion telecoms service providers. This could be just the start. The sector is now cheap and, better yet, gives bigger dividend yields than almost anything else on offer in the market.
Why so cheap?
Why have telecoms fallen out of favour? Partly because 2009's 'dash for trash' rally focused on cyclical stocks, such as commodity producers and manufacturers, whose profits had been smashed by the recession. The hope was that these firms' earnings would bounce along with an expected recovery in the world economy. Phone service firms weren't invited to the party. These are the companies that supply you with your landline, provide internet packages down the wires, and operate mobile-phone networks. Between the March 2009 lows to the end of April this year, they undershot the wider stockmarket indices by around 25%.
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That was perhaps understandable. Telecoms firms used to be seen as high-flying tech stocks. But many have been poorly run, destroying shareholder value by overpaying for acquisitions at the peak of the dotcom boom. That has clouded sentiment towards the sector ever since. The industry also faces the double whammy of rising capital-expenditure (capex) needs and stricter regulation. "Analysts are uneasy about the lack of visibility on investments needed to improve and expand networks," say Joanne Frearson and Nicola Leske for Reuters. "Delaying investments, on the other hand, could cost companies customer confidence."
Some experts fear that fixed lines are vanishing, replaced by mobiles or the internet. And while the companies' cash flows are generally strong, there's concern over the size of possible capex bills for fixed-line firms that will need to invest in fibre networks to make their internet services more competitive. That could mean these firms raising fresh cash from shareholders through rights issues.
On the wireless side, there's a risk of networks struggling to cope with the explosion of data traffic due to 'smartphones', such as Apple's iPhone. This could mean more investment in upgrading networks than the phone firms would like. Then there's the threat to profit margins from government cuts in mobile termination rates. What happens here is that regulators set the rates operators can charge each other to connect calls. These cuts are expected to lower European mobile operators' service revenue growth by between 2% and 3% a year over the next three to four years, says Fitch.
So why buy telecoms stocks now? We won't dispute that the outlook is opaque in places. But we reckon this is now firmly 'in the price'. Also, telecoms are neglected by analysts – which is a good sign. These days, it makes sense to value telecoms stocks as utilities, similar to electricity, gas and water suppliers. Both have relatively high borrowings combined with strong cash flows, which enable these debts to be serviced. But this means phone stocks "slip through the cracks", says Simon Caufield in his True Value newsletter. "They're overlooked. Neither technology nor utility analysts consider them 'must-own' stocks." That creates buying opportunities while attention is elsewhere.
Analysts are wrong Most analysts' fears for the industry's future are wrong, says Caufield. Yes, there's a trend towards fewer fixed-line phones, but some of the decline is cyclical. Recession-related job losses mean that businesses need fewer phones. But the dole queues won't grow forever.
Secondly, phone firms will benefit from future internet growth. They used to give away almost unlimited amounts of data, but "that's now changing", says Caufield. "New tariffs mean that customers pay for the volume of data downloaded. That raises revenue and profits for both fixed-line and mobile operators."
Thirdly, although telecoms stocks are generally blue-chips listed on mainstream stockmarkets, many have significant exposure to fast-growing emerging economies. So longer-term growth prospects could prove much better than analysts' current estimates.
And because they've been out of fashion for so long, shares in phone service suppliers are now cheap. For example, the Bloomberg Europe Telecommunication Services Index (BETSI) is on a current p/e of 10.7. By contrast, the Bloomberg European 500 Index, which measures the performance of 500 of Europe's biggest companies, is now on a multiple of 15.5. Even better, many phone companies are paying out most of their net profits to shareholders as dividends. This allows investors to access some of the highest equity-market yields currently available. BETSI yields 6%, almost double the payout on the overall market.
Sure, there are risks. The 'cover' is low (dividend payments are high compared with earnings), so phone firm payouts can be vulnerable to a dip in profits. But even if many telecoms' dividends were trimmed, their yields would still be higher than that of the overall market.
So what are the best bets? We're spoilt for choice. Even after excluding those with higher than average political or regulatory risks, the list of the cheapest, highest-yielding shares in the world is full of phone firms. Below we look at two of the best buys in the British market, along with two European stocks.
The four best telecoms stocks
C&W Communications (LSE: CWC) was part of the old Cable and Wireless group that was split up four months ago. C&W operates in 38 countries – it's the top player in most of these – via four regional hubs in Panama, the Caribbean, Macau, and Monaco and Islands, offering fixed line, broadband, mobile and entertainment services. Before the demerger, the cash that C&W was generating was required to fund the overall C&W group. But now the firm is free to use this money to set its own dividends. C&W, which reports in US dollars, has already declared a dividend of eight cents a share for 2010/2011. At the current £1/$1.5150 exchange rate, that's 5.28p. That puts the stock on a prospective yield of 9%, while the p/e is just 10.3.
Staying in Britain, mobile-phone giant Vodafone (LSE: VOD) is a classic case of a company that historically has overdosed on merger and acquisition (M&A) activity. Yet despite all the wheeling and dealing, the shares are no higher than they were 12 years ago. That could be about to change to shareholders' benefit. Vodafone holds 45% of Verizon Wireless (VW), which owns the largest US mobile-phone network, with more than 90 million subscribers and $62bn of revenues.
Over the last five years, Vodafone has got no tangible return on its Verizon stake, while the latter has been paying off debt. But according to John Killian of Verizon Communications, which owns the other 55% of Verizon, Vodafone is likely to get dividends from the firm again in 2012. "This would have a transformative effect on Vodafone," says Robin Bienenstock at Sandford C Bernstein, "by increasing free cash flow by over 30%, which could be a boon for the group's shares." These are already cheap on a current p/e of 9.3 and prospective yield of 6%. Management has committed to lifting the dividend by 7% a year over the next three years. Add in the Verizon contribution "and dividends could hit 14p per share in three years", says Caufield. That would tot up to a near-10% yield at today's 145p. Vodafone also has low debt, a strong balance sheet, and is selling on a discount to net asset value of 20%. If ever a 'boring' telecom stock were really quite exciting, this has to be it.
Across the Channel, France Telecom (FP: FTE) provides fixed-line, mobile, cable TV and internet services. Once again, the shares have lagged the market and are very cheap. France Telecom stands on a current year p/e of just 8.6, while the prospective yield is a stunning 9.5%. The company has a clear growth-oriented strategy, aiming to double revenues in emerging markets by 2015. Africa and the Middle East are the main target areas. But there's a caveat. This expansion will mean heavy capital expenditure and mergers and acquisitions costs, which could put pressure on cash flows. That raises a question mark about whether the ultra-high dividend payout can be maintained.
So while France Telecom looks great value, we'd be more cautious about it than an alternative, such as Telecom Italia (IM: TIT). It provides fixed-line, mobile and internet services, plus satellite communications. The group's Brazilian unit adds emerging market exposure. The 2010 p/e is 8.4. The prospective yield of 5.8% is lower than some of its peers, but dividend cover is a better-than-average two times. And the group's profits growth is being driven by an "aggressive cost-cutting" programme, says Torsten Achtmann at JP Morgan Cazenove. That makes it more likely that the payout will be raised. Analysts' consensus estimates for next year are for a near-10% dividend hike, putting the stock on a 2011 forecast yield of 6.3%.
Clearly, buying these shares could give you some great returns. But if you prefer to let someone else buy the stocks, you could consider an exchange-traded fund (ETF). The S&P Global Telecommunications Sector Index Fund (NYSE: IXP) does what it says on the tin, investing in the world's major phone firms. Its top holding, equal to 15% of the fund, is US giant AT&T (NYSE: T). The management fee is 0.5% and the fund yield is 4.9%. That's less spectacular than those individual stocks, but having more holdings does spread the risk.
• This article was originally published in MoneyWeek magazine issue number 495 on 16 July 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
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