An improving U.S. economy together with fabulous demand for mobile data and value-added services (VAS) has been the silver lining for the telecommunication industry in an otherwise tough environment. While our overall view is neutral for the industry, the recent sell-off has created attractive opportunities in a number of stocks.

The industry encompasses a lot of technology-related businesses. Besides the traditional local and long-distance wire-line telephone services, telecommunications also include wireless communications, Internet services, fiber optics networks, cable TV networks and satellite communications.

We believe that the overall economic dynamics may shift in favor of the telecommunications industry, although at a very slow pace, primarily due to its basic nature of being a major infrastructure product for both emerging and developed nations. Economic stimulus plans throughout the world — including the U.S. broadband infrastructure development program and similar structural subsidies in China and India — may be a boon for selected telecom service providers and equipment manufacturers.

Capital spending constraints among carriers over the last couple of years due to severe recessionary conditions was the main hindrance for the growth of this industry. However, with the economic recovery firmly in place, large telecom service providers are gradually expanding their fiber-based networks on the back of significant subscriber growth.

Major recovery in the telecommunications sector is coming from a significant increase in demand for mobile data and other value-added services. As of now, there are more than 1 billion 3G subscribers worldwide, with steady growth expected for quite some time. Various industry sources estimate that smartphone shipments as a percentage of total mobile handset shipment are expected to increase from 20% in 2009 to nearly 40% by 2014. Smartphones are taking market share from basic mobile handsets. These devices are generally characterized by powerful operating systems capable of supporting a variety of services and applications that need very high-speed network infrastructures.

Several giant telecom operators globally are funding projects to deploy next-generation (4G) high-speed networks of WiMAX and LTE (Long-Term Evolution). Cable TV operators, which are major competitors to the telecom giants, are also upgrading their networks with high-speed DOCSIS 3.0 architecture. These developments are likely to help telecom equipment manufacturers consolidate their top-lines.

The growth of high-speed Internet and video services leads to continued upgrades of telecommunications networks. As of now, both the telephone service providers and cable TV operators are offering cable television, high-speed Internet, and phone services. This, in turn, is favorable for the demand for telecom equipment, which is expected to benefit equipment manufacturers.

OPPORTUNITIES

Telecom carriers and equipment providers that offer the most attractive opportunities are focused on 3G wireless technologies, emerging 4G technologies, broadband and fiber-to-the-home/premises networking. We have seen that sector diversity is a less secure natural hedge in today’s increasingly correlated world markets. The telecommunications industry as a whole offers a number of attributes that are difficult to ignore for most 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, continues to grow. In addition, economic stimulus plans in the U.S. and throughout the world should boost selected service providers and equipment manufacturers.
  • Massive growth of smartphones: In spite of the challenging global economy, the growth in the smartphone mobile market remains impressive. This primarily reflects a shift in consumer preference towards feature-enhanced PDA devices from ordinary mobile handsets used primarily for voice telephony. This opportunity provides scope for telecom service providers, equipment manufacturers, chipset developers and wireless tower operators to retain new users and grow revenues moving forward.
  • International diversification: While country diversification 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. Therefore, a significant allocation of foreign telecom companies would be appropriate as part of a technology-focused portfolio.

Companies that match well with these considerations include BCE Inc. (BCE), CenturyTel Inc. (CTL), Rogers Communications Inc. (RCI), Qualcomm Inc. (QCOM) and American Tower Corp. (AMT).

WEAKNESSES

Generally, telecommunications companies that have been under pressure in the recent downturn have high debt levels and large financial leverage ratios. These companies, while offering recurring cash flows to service their debt obligations, may have difficulties should overall business activities take longer to come back as consumers and enterprises become more selective with their spending. Other risks that remain include the following:

  • Potential business slowdown: Lower overall top-line sales among carriers are expected to continue weighing on capital spending decisions — a major problem for equipment vendors. Companies are expected to remain focused on balance sheet improvements, 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 impacted by a slowdown in demand.
  • Increased competition: The markets for broadband wireless solutions are emerging rapidly in terms of technological innovation. While the pure wireless/wireline service providers started entering into video services market for cable operators, the cable MSOs are in turn starting to enter the telephone business for the small & medium sized business enterprises.

Companies that match well with these considerations include Sprint Nextel Corp. (S), Telephone & Data Systems Inc. (TDS), France Telecom (FTE) and Telesp (TSP).Zacks Investment Research