Telecom Stock Outlook - June 2012 - Zacks.com

The telecommunications Industry is identified as a major driver of global economic recovery. An unprecedented growth of high-speed mobile Internet traffic, particularly for wireless data and video, has transformed the industry into the most evolving, inventive and keenly contested industry.

In addition, the emergence of mobile broadband technology has created several new service areas, which potentially offers huge growth potential. This includes IPTV, collaboration and cloud computing, videoconferencing and mobile payment, to name a few. Research firm Ovum recently reported that global revenue of telecom service providers exceeded $1.91 trillion in 2011, an improvement of 6.7% year over year. The momentum is expected to remain high in 2012.

Recent Performance

The U.S. telecommunications industry is witnessing consistent growth despite experiencing a slow moving U.S. economy. This is evident from the stock price movement of the large nationwide carriers. Year to date, the stock price of Verizon Communications (VZ - Analyst Report) was up 9.64%, the stock price of AT&T (T - Analyst Report) up 17.04%, and that of Sprint Nextel (S - Analyst Report) was up 27.35%. However, during the same time period, the benchmark S&P 500 index was marginally up by 3.81%.?

Most of the large national telecom service providers together with the regional prepaid telecom operators generated net subscriber addition in the first quarter of 2012. Verizon Wireless, a joint venture between Verizon Communications Inc. and Vodafone Group plc. (VOD - Analyst Report), added 501,000 post-paid subscribers out of total net addition of 734,000. AT&T Inc. added a net 187,000 post-paid subscribers out of total net addition of 726,000. Sprint Nextel Corp. gained a net 263,000 postpaid subscribers out of total net addition of 1.1 million. MetroPCS Communications Inc. (PCS - Analyst Report) and Leap Wireless International Inc. (LEAP - Analyst Report) added net 131,654 and 258,000 wireless subscribers, respectively, in the previous quarter.??

Structure

The telecommunications industry encompasses a lot of technology-related businesses. The legacy local and long-distance wireline phone services, telecommunications industry also includes wireless communications, Internet services, fiber optics networks, cable TV networks and commercial satellite communications.

A major characteristic of the telecommunications industry is the huge barriers to entry due to scarcity of public airwaves (spectrum). The U.S. telecom market is controlled by just four national players, as regional low-cost operators are not eligible to compete with these large carriers. Furthermore, it is not easy to establish a new telecom carrier since it will require government permission to transmit voice, data and video on public airwaves. Spectrum licenses are limited and therefore quite expensive. Moreover, deployment of network infrastructure, whether high-speed wireless (3G/4G) or wireline (fiber optic), requires significant capital expenditure, which very few entities can afford.

Key Attribute

We believe that the overall economic dynamics may shift in favor of telecommunications industry, primarily due to its key attribute of being a major infrastructure product for both the emerging and developed nations. Telecommunications is one of the very few industries, which witnessed massive technological improvement even under recession. The major thrust of the telecommunications sector is backed by continuous network and product upgrade and invention by the industry players.

For the last 15 years, the U.S. wireless sector invested no less than $300 billion to install seamless communications networks throughout the world. The telecommunications industry as a whole generates over 2.4 million jobs in the U.S., which is expected to grow by another 200,000 in 2012 due to increasing adoption of next-generation super-fast 4G LTE networks. Growing demand for technically superior products has been the silver lining for the telecommunication industry in an otherwise tough environment. These developments are also helping telecom equipment manufacturers, infrastructure solutions providers and mobile phone makers to consolidate their finances.

Wireless is the Key

Despite the massive growth in fiber-to-the-home networks, we believe wireless networks will be the key player in the telecom industry growth story. The sector is witnessing a fundamental change. Earlier, it was voice calls that brought money to the operators. Currently, data and video have become the focus. Any new network standard aims at faster data connectivity, quick video streaming with high resolution and rich multimedia applications. Growing demand for wireless products has been the silver lining for the telecommunication industry in an otherwise tough environment.

Spectrum Crunch & Market Saturation

The U.S. wireless industry is facing acute spectrum shortages, sometime resulting in data packet dropping. Carriers are investing heavily for more effective utilization of their existing spectrum holding and are trying hard to add more spectrums to their portfolio. In addition to the four nationwide carriers, all the smaller pre-paid wireless operators are also opting for a sound LTE network to offer hassle free broadband video streaming and data transmission.

Meanwhile, smartphone penetration has crossed more or less half of the total U.S. post-paid wireless subscribers. Recently, pre-paid carriers have decided to offer high-end smartphones, such as iPhone 4S in the near future.

Spectrum crunch coupled with gradual smartphone market saturation are forcing the wireless operators to look for other options to raise revenue. These include new pricing plan, a shift from unlimited data usage to tier-based data usage, and higher upgrade fees for smartphones in order to offset handset subsidies. Nevertheless, the average revenue per user for most of the wireless carriers are rising over the last two years and are expected to grow in the long term, primarily due to a massive growth of mobile data usage.

As smartphone users are now increasingly downloading multimedia contents, video has become the primary network traffic. What is more interesting, in addition to download, the smartphone and tablet users are uplinking more and more video content, and in turn, becoming broadcasters on their own. Several industry researchers predicted that video may account for 60% of total network traffic by the end of 2012.

Near-term Catalysts

The U.S. telecommunications industry is likely to be benefited in the near future from two ways: (1) recent approval of the U.S. Congress to initiate a fresh round of spectrum auction for the wireless industry (2) significant technological inventions and innovations that make even a mature market like the U.S. highly lucrative for the telecom operators.

In February 2012, the U.S. Congress has decided to free up spectrum currently used by TV broadcasters for commercial wireless networks and to deploy a nationwide interoperable public-safety broadband network. Huge proliferation of smartphones, tablets, and several other pocket-sized mobile devices significantly raised the demand for bandwidth for seamless wireless connectivity. The spectrum auction is expected to generate $25 -$30 billion from the U.S. government.?

Furthermore, as the global economy recovers slowly, demand for real-time voice, data and video increases by leaps and bounds. The FCC has estimated that within the next 5 years, mobile-data demand will grow 25-50 folds from its current level. These latest developments are enabling the telecom service providers to undertake large network extension while upgrading plans. The decision of Congress is mainly aimed to solve growing consumer demand for efficient wireless networks.?

Merger and Acquisition to Continue

Despite the failed merger agreement between AT&T and T-Mobile USA, we believe the U.S. telecom industry will witness more M&A in 2012. AT&T needs spectrum to compete with its bigger rival Verizon Wireless. Verizon has entered into a spectrum buying deal with major cable MSOs including Comcast Corp. (CMCSA - Analyst Report), Time Warner Cable Inc. (TWC - Analyst Report) and Bright House Networks. The deal is currently under FCC scrutiny.

Similarly, small prepaid operators like MetroPCS and Leap Wireless may also join hands or merge with a nationwide carrier in order to attain economies of scale and pricing power. DISH Network Corp. (DISH - Analyst Report), which holds a large wireless spectrum, has already declared that it is not averse to a deal as an acquirer or an acquired entity.

Competition Looms Large

Massive technology invention and innovation have resulted in significant competitive atmosphere within the telecommunications industry. Product life-cycle and upgrade-cycle have been reduced drastically since several firms are coming out with new types of products and services within a short span of time. Increasing competition is actually forcing each and every player to offer heterogeneous and bundled services.

We may see more product sharing deals between telecom, cable TV, and satellite TV operators as each of these players are trying to get a foothold into other?s territory. Even, pay-TV services, offerings to business enterprises, and mobile backhaul and metro-Ethernet segments may witness more convergence. Mobile phone makers are now gradually offering tablets (small laptops); chipset manufacturers are offering personal computers and mobile phones are frequently interchanging their areas of operations.

OPPORTUNITIES

The telecommunications industry as a whole offers a number of attributes that are difficult to ignore from the standpoint of investors.

• Telecommunications is a necessary utility: The need for telecom in both rural and urban areas, and its role in the infrastructure of both developed and developing markets, will continue to grow. In addition, economic stimulus plans in the U.S. and throughout the world should boost select service providers and equipment manufacturers.
• Structural Subsidies: The Broadband Stimulus Program of the U.S. government has received significant acceptance among rural carriers. President Obama has endorsed a wireless spectrum hike plan proposed by the FCC, which will nearly double the currently available spectrum for wireless broadband services while increasing Internet connectivity. FCC together with the U.S. Department of Commerce will identify unused airwaves to raise the available spectrum size to 500 MHz in the next 10 years.
• International diversification: Though diversification within a country offers only limited protection in the current highly-correlated world equity markets, it offers hedging opportunities from local economic weakness and associated currency exchange differentials.

The companies that match well with the aforementioned considerations include AT&T Inc., Verizon Communications Inc. and Sprint Nextel Corp.

WEAKNESSES

Generally telecommunications companies that were under pressure have high debt levels and large financial leverage ratios or are unable to cope with the recent market trends. Other risks that remain are as follows:

• Potential business slowdown: Lower overall top-line sales among carriers are expected to continue to weigh on capital spending decisions -- a major problem for equipment vendors. The companies are expected to remain focused on improving balance sheet, financial discipline and free cash-flow generation. Unfortunately, for the equipment vendors, the method of choice for improving free cash flows remains disciplined capital outlays.
• Weak credit profiles: Over the near term, telecom companies may be exposed to high debt levels and limited liquidity, which puts a premium on sustainable cash flow to service debt obligations. As a result, telecom companies may have free cash flow on the back of a slowdown in demand.
• ?Increased competition: The markets for broadband wireless solutions are emerging rapidly in terms of technological innovation. The pure wireless/wireline service providers started entering the video services market for cable operators, while the cable MSOs are entering the telephone business for the small & medium sized business enterprises.

The companies that match well with the aforementioned considerations include SK Telecom Co. Ltd. (skm - Analyst Report), Telefonica Brasil S.A. (VIV - Analyst Report) and NII Holdings Inc. (NIHD - Analyst Report).

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