On a macro basis, the big overhang on the UK market has been Brexit. So far, the main effect on the UK from the Brexit vote has been a weaker currency, which impacts investment outside of the UK, but hasn't really hurt the economy, which has held up quite well.
The concern is that a hard Brexit or no deal at all could cause the economy to go into a recession. While a recession would likely slow revenue growth for all British companies, the effect on telecom operators is likely less than on the average firm, in our opinion.
Telephone and broadband services have become critical to most people's lives. For those on a prepaid wireless plan, usage may come down some, but outright cancellation is unlikely, in our view. Additionally, most wireless subscribers now take a post-paid plan. Vodafone doesn't break out its wireless base between pre-paid and post-paid.
Likewise, with broadband, most people aren't about to cancel their service. Internet connectivity has become an indispensable aspect of people's lives.
One area of concern with Brexit is the movement of employees. Most of the phone companies transfer some employees around their operations. Thus, the inability to easily move employees in and out of the UK could be a problem.
While we believe the operators will be able to deal with Brexit itself, we are increasingly becoming concerned with its effect on UK politics. Brexit has split the Conservative Party, and polls now show the Labour Party leading in the polls, which has been taken over by Jeremy Corbyn. Increasingly, those that support his far-left proposals have moved into key leadership roles.
Corbyn has said that he will reverse the tax cuts that have previously been passed. Higher tax rates would particularly hit BT (BT.A), which has the majority of its business in the UK.
Dividends are Important
The growth rate of the telecom industry has slowed significantly since the 1990s as most people in developed markets that want access now have fixed-line, broadband, and wireless services. Even in emerging markets, new wireless subscriber growth has slowed.
There is still demand for faster wireless service as the transition to smartphones, especially in emerging markets, continues. We expect increased data usage to be the main driver of wireless telephone revenue.
There is still growing demand for broadband and pay-TV services in developed markets and even more so in emerging markets. In developed markets, the demand gains are primarily for faster speeds as FTTP networks are built. These faster speeds again provide an opportunity for higher revenue, as operators charge a premium for the higher speeds.
One of the primary drivers for the faster speeds is video streaming. While this can compete against pay TV, in Europe it is generally seen as complementary. With these growth areas slowing, demand for expanded networks slows, which can lead to reduced capital expenditures. This allows for free cash flow to be spent on dividends.
Dividends have also been an important component of telecom’s total return, but with the slower growth we believe they are becoming even more important.
We believe these high yields pay investors a nice return while they wait for improved sentiment in the sector and a recovery in some operations. Three companies – Vodafone (VOD), BT Group, and Telefonica, carry yields higher than the average.
Thus, investors are paid well while they wait for the market to recognise the undervaluation of these stocks. We would also note that for US investors, dividends from UK-domiciled firms like Vodafone and BT aren't subject to local withholding taxes, per the tax treaty between the US and UK.
