The global economic downturn continues to weigh on the fortunes of companies in almost every industry, including telecommunications. Nevertheless, we see a silver lining for the telecommunication industry in this challenging environment as the valuation level now reflects remedial conditions in the economy. Depressed stock prices may make investment entry points more favorable at this juncture, should stimulus plans improve worldwide economics.

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

According to our assessment, 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 the emerging and developed nations.

Telecom companies are starting to report some financial improvements in terms of revenue and earnings levels. In addition, 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 service providers and equipment manufacturers.

Companies in the telecommunications industry continue to be at the forefront in terms of mergers and acquisitions. Consolidation among the largest services-focused telecom companies has created an environment where equipment-focused companies are having to contend with fewer customers and reduced selling opportunities. This has prompted consolidation among equipment companies for enhancement of marketing value by broadening product offerings for converged fixed-mobile networks.

Capital spending constraints among carriers and limited availability of funds to sustain or grow telecom services over the next six to twelve months may result from financial uncertainty, particularly tighter credit markets. Despite this, we see a ray of hope as large telecom service providers are gradually expanding their fiber-based networks on the back of significant subscriber growth.

Several giant telecom operators globally are also funding huge projects to deploy next-generation (4G) high-speed network of WiMAX and LTE (Long-Term Evolution). Cable TV operators, which are major competitors to 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.

It is our belief that at this stage, companies with strong balance sheets and firm net cash positions, along with sustainable dividends, provide respectable risk/reward profiles. On the other hand, highly-leveraged companies should be avoided, at least at this point.

OPPORTUNITIES

Telecom carriers and equipment providers that offer the most attractive opportunities are focused on 3G wireless technologies, emerging 4G technologies, broadband (DSL) and fiber-to-the-home/premises networking. Last year’s collapse of the financial markets has left an indelible mark. We have seen that sector diversity is a less secure natural hedge in today’s increasingly correlated world markets.

However, 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 smart-phones: In spite of the challenging global economy, the growth in the smart-phone mobile market maintains its impressive trend. 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 massive 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 the aforementioned considerations include Qualcomm Inc (QCOM), Vodafone Group Plc (VOD), China Mobile Ltd (CHL), Amdocs Ltd (DOX), Vivo Participacoes S.A. (VIV) and Tellabs Inc (TLAB). Each one of these firms has a strong financial profile and has a unique exposure to wireless and international business, along with the financial wherewithal to sustain expansion initiatives.

WEAKNESSES

Generally, telecommunications companies that have been under pressure in the current 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. The telecommunications sector is highly interlinked with cable TV networks, since cable companies are now aggressively offering local exchange and Internet services. The relationship between the telecom and cable sectors has become even more complex as telecom service providers are now selling TV via IP (Internet protocol) services, competing directly against cable to provide consumers’ entertainment. Many of the cable operators have greater financial, technical and marketing capabilities, which may enable them to respond more proactively to emerging technologies and changes in customer requirements.
 
Companies that match well with the aforementioned considerations include Telephone & Data Systems Inc (TDS), ADC Telecommunications Inc (ADCT), United Sates Cellular Corp (USM) and P.T. Telekomunikasi Indonesia Tbk (TLK).Zacks Investment Research