Telecommunication stocks have significantly underperformed the broader market to the tune of 15% over the past year and nearly 40% over five years. But does this mean the sector is a buying opportunity? Whether this now marks a contrarian opportunity depends on the fundamental drivers of profitability and valuations.
Why are Telecoms So Cheap?
Essentially, we find that European telecommunications have become increasingly attractive from a valuation perspective. Yet, it is important to acknowledge that assets typically become cheap for a reason. In the case of European telecommunication companies, the fundamentals are currently very weak, with stagnant real revenue, compressed profit margins and return-on-equity at a 14-year low. Therefore, in assessing whether telecommunication companies offer an attractive investment opportunity, we must further understand what the drivers of these poor fundamental returns have been and whether they are likely to improve in the future.
Clearly, profit margins will be very important as this has been the main drag on earnings; with sales relatively flat whilst earnings have slumped. If one is to expect sustainably higher return-on-equity, it is likely to come from a pickup in profit margins, either via increased revenue or cost efficiencies. This in turn is likely to be dependent upon reduced capital expenditure or weakening competitive and regulatory pressure.
In this regard, we find that capital expenditure has particularly disappointed, as investors expected capex as a percentage of sales, which currently stand at a historical high, to decline. This hasn’t transpired, with the ongoing risk that telecommunication companies continue to invest heavily but cannot raise prices, cannot improve free cash flow generation, and thereby fail to reduce debt or deliver returns to shareholders. However, that is the glass half empty viewpoint.
By applying a glass half full outlook, we can also see that the recent spike in capex has been focused on 4G and fixed-line fibre businesses, which are expected to result in increased data consumption in addition to network differentiation.
This change in the quality of the network may help to achieve revenue growth, but may also lead to divergence within the sector, separating high-quality players from the low-cost providers. In the long-term, the high-quality players should be able to maintain pricing power, even if they are pinched in the short term by the bundling of services and the removal of roaming charges.
On this basis, there is reason to believe that pricing power may become more correlated to the quality of network rather than scale, where hopes of further industry consolidation have also disappointed. This is important as concentration issues already exist, with the top five companies – Vodafone (VOD), Deutsche Telekom, Telefonica, BT Group (BT.A), and Orange – making up 72.1% of the industry, increasing the sensitivity to company-specific shocks.
Indebtedness
A fundamental profitability assessment must also address the highly indebted nature of the sector. The general fear is that highly indebted telecommunication companies are vulnerable to changes in borrowing costs. Clearly these costs are more likely to manifest themselves when debt needs to be rolled over, making it worth looking at the debt profile of the sector to gauge whether funding costs are a current problem.
Looking at this holistically, we find that the sector is exposed to interest rate changes, but there is an argument that the sector could absorb rising rates better than others, and to the contrary, may even reduce debt if rates fail to meaningfully rise and refinancing opportunities present themselves.
Don’t Forget the Dividends
The plight of the telecommunications sector will ultimately drive the dividend policy, which is also important as dividends are currently 4.8% and one of the most prominent features of the telecommunications sector.
Telecommunication companies have recently been reluctant to reduce dividends and instead opted to retain payouts at high levels. With earnings-per-share now well below dividends-per-share, the sustainability of dividends, and ability for dividend growth, must be questioned.
On face value, this would appear to be a cause for concern and illustrates the importance of understanding what is driving the earnings decline and the likelihood of a rebound. Specifically, if the recent slump in earnings proves more structural than cyclical, dividend cuts could be inevitable and would materially impair the fundamental outlook for the sector. This all necessitates a margin of safety.
Withstanding the above, buying low and selling high is about acknowledging the weak fundamentals and understanding how much of the weakness is already priced into markets. We think that the valuation-implied returns of European telecommunications appear reasonably attractive, especially on a relative basis.
