Cheap Telecom Stocks Offer Big Opportunities

GigaOM and TheStreet take a closer look at the mobile telecommunications industry.
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Editors note: This is an excerpt of a research report titled "Mobile Operators' Strategies for Connected Devices" written as part of a new partnership with technology information company GigaOM. The report was co-written by TheStreet's Jake Lynch and GigaOM's Peter Crocker, and will be distributed at GigaOM's Mobilize 2010 conference on Sept. 30.

The market sees telecoms' single biggest weakness as rapid technological displacement and obsolescence. While this may be true, a focus on that fact could be swaying forecasters to underestimate non-phone data's ability to compensate for and overcome declining landline revenue.

Telecom has introduced groundbreaking technologies, but the immediate adoption of these technologies has displaced preexisting businesses. Telecoms are currently in a phase of revenue and profit transfer: Established divisions like landlines are dwindling down and new divisions, such as mobile data, are growing. In this sense, the sector is constantly self-cannibalizing, which hurts its market perception. In other sectors, a tech boom differentiates winners and losers; innovative companies gain market share and slow-adapters die off. But in telecom, barriers to entry and a shortage of players render the major companies both winners and losers, with one division growing while the other dwindles. Consequently, analysts hold the global sector in disfavor.

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The U.S. Sector

The U.S. telecom sector receives an aggregate rating of 3.7 out of 5, according to Bloomberg; it ranks as the third-worst sector based on perceived upside in equities. Researchers' consensus view of U.S. telecom stocks narrowly exceeds that for financial and utility shares, the only two sectors with worse aggregate ratings. U.S. telecom also has the least number of securities followed on Bloomberg, at 41, as equipment and component makers (

Apple

(AAPL) - Get Report

,

Research In Motion

(RIMM)

, Skyworks, etc.) fall into technology subcategories.

Despite such a pessimistic view on the part of equity analysts, the U.S. telecom sector ranks third for median three-year earnings per share (EPS) growth, only lagging behind the growth of health care and technology. Telecom ranks second for three-year sales growth, another notable positive. Still, such growth is consistent with the market's perception because communications services can be considered a non-discretionary expense, explaining the sector's relative outperformance during the economic downturn from 2007 to 2009.

AT&T and Verizon Leading U.S. Carriers

AT&T

(T) - Get Report

and

Verizon

(VZ) - Get Report

rank as the two highest-yielding Dow components, with dividend yields of 6.2% and 6.4% and payout ratios of 760% and 78%, respectively. Based on three-year sales growth, AT&T and Verizon are the second and eighth fastest-growing Dow companies since 2007. Excessive payout ratios are compensatory for the weak growth expected of such investments.

Since 2007, AT&T and Verizon have generated annualized sales growth of 11% and 6% and suffered annualized share price declines of 13% and 12%, respectively. The telecoms' stocks haven't responded to sales gains. Even when factoring in the annual yields generated by the two stocks, AT&T and Verizon rank 24th and 18th among the 30 Dow components in terms of three-year total return. The stocks rank in the middle of the Dow for per-share dividend expansion, with three-year growth rates of 20%. The stocks fell out of favor during the downturn, despite strong financial performance, but they are back in vogue in 2010. AT&T and Verizon have returned 12% and 14%, respectively, including dividends, in the past six months; as the Dow declined 1.7%, the S&P 500 dropped 3.6% and the Nasdaq fell 3.8%. A yield premium, stemming from economic fears in U.S. markets, has catalyzed a rally in dividend-paying telecom stocks.

The Global Sector

Analysts are even more bearish on telecom regions outside the U.S. For BRIC countries, the telecom sector ranks third-to-last for median three-year EPS growth. The sector ranks last for that metric in Asia-Pacific emerging markets. Telecom hovers in the middle of the pack for three-year EPS expansion in the Middle East and Africa region. But telecom ranks second in the Western Europe region, which is to be expected, considering the sector's recessionary outperformance in the U.S., another advanced economic region.

Amid the global economic downturn, telecom companies outgrew other sectors in developed regions. Yet telecom is the cheapest sector in Western Europe, with a median forward earnings multiple of 10. Telecom stocks are also cheap in emerging markets, commanding a median multiple of 15 in Asia-Pacific emerging markets, 8.9 in BRIC countries and 9.2 in the Middle East and Africa region.

Taking a holistic global perspective of the sector, telecom stocks are undervalued. Aggregating telecom equities of every region yields a median forward earnings multiple of 11, making telecom by far the cheapest sector from a global perspective. This low multiple confirms the market's expectation for slow growth and weak returns. Investors will only purchase telecom stocks at a discount to other sectors.

To access the full report, visit GigaOM Pro

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