Are telcos a value trap?

A CHALLENGING MACRO ENVIRONMENT

We understand that rising interest rates can be detrimental to the telecom sector and that the competitive landscape could hurt the companies. This being said, we do see some positives on the macroeconomic front:

Competition has likely peaked for US telcos. At the start of 2017, all carriers went unlimited; there is not much further to go than that. The most aggressive player, which had been pushing prices lower, began to emphasize free cash flow and buybacks. Another factor reducing competition is longer handset cycles, which reduces churn and incentive for competition. As such, analysis performed by Morgan Stanley as of the end of Q1 2018 show that industry fundamentals are inflecting. In Q217, the industry began to see average revenue per user arrest its four-year decline. In Q417, for the first time since 2013, year-over-year revenue growth was positive.

In Europe, the regulatory environment has become friendlier to telecommunications operators. Thus, the scope for further consolidation is improving, which should limit competitive pressure in the future. In Asia-Pacific, however, we see continuing competitive pressures, as Japan, Australia and Singapore will all welcome a new entrant to their mobile markets by the end of 2019. On the other hand, it appears that pressure from mobile virtual operator networks (MVNOs), which have been gaining market share in recent years, is abating.

5G could provide a potential next leg of growth. While investors appear very excited about the internet of things and self-driving cars, they seem less interested about how these items will connect to the internet. The answer is likely via wireless networks and this could represent the next leg of growth for telcos.

Service providers in Asia-Pacific will likely benefit from exponential data usage and a growing contribution from nontelecom services. There is a strong trend in Asia to integrate telecommunications with other services such as content, financial services, food and daily necessities, and electricity; these can all be sold via the telcos’ existing customer relationship.

ATTRACTIVE FOR QUITE A WHILE NOW

The graph below illustrates the relative valuation of the global telecom sector versus the global market (the red line). Outside of a brief period in 2009, telcos are at their cheapest level in the last 10 years. While they were one standard deviation below their historical average in 2017, they are now two standard deviations below. In fact, relative valuation has continued to deteriorate year-to-date.

Looking at relative growth prospects, we believe investors appear to be overly punitive towards the sector on valuation. Presently, the MSCI World EPS growth is forecast at 11.5% vs. the MSCI World Telco at 2.5%, a difference of 9% (the blue line). To justify the current valuation, the earnings growth differential would need to expand by 15%. We believe just the opposite will occur. Our view is that the global EPS growth has peaked for the cycle, therefore bringing into question the 11.5% forecast. We expect that the less cyclical growth of telcos will hold better.

Those familiar with our market outlook know that our view is that most sectors are expensive. However, we believe that telcos are a notable exception to this view.

OVERLOOKED BY INVESTORS

Various surveys we use for our research show that all types of investors currently underweight the telecom sector. The blue lines in the Funds Manager Survey chart below from BofA Merrill Lynch illustrate that global portfolio managers have been underweighting the sector for quite a long time now, increasing their underweight positions in 2017. The black line shows the relative performance of the sector; similar to valuation, it is at very low levels.

Given our contrarian approach with investor sentiment, we see this indicator as a very positive signal. It adds up to other surveys that show investors have a strong preference toward cyclical sectors, at the expense of defensive sectors, which include telecoms.

THE “NO VALUE TRAP” THESIS

Investors’ current lack of interest and the poor returns of the telecom sector recently conflict with the historical attractiveness of the sector. But when market experts talk about value traps, they usually refer to industries that are showing a contraction in EPS combined with low valuation. We don’t expect this to be the case for telcos. Historically, the companies have been able to deliver modest EPS growth, regardless of the economic cycle.

Based on our three-vector framework of analysis, we believe telcos are currently one of the most attractive sectors globally. We are negative on the macro, recognizing the potential headwinds facing the sector and its lower relative growth compared to other sectors. But we see some room for optimism, as an inflection in fundamentals seems underway, especially in Europe and the US. Where the sector gets very appealing to us, is on the valuation and sentiment vectors. Given the above, we don’t believe that telcos currently represent a value trap.