When Moody’s decided this past March to downgrade its rating on the telecom sector from stable to negative, it was just one more body blow for an unloved set of stocks.
In fact, it’s been a forgettable half-decade for telecom. The iShares U.S. Telecommunications ETF (IYZ), for example, has lagged the S&P 500 by more than five percentage points annually during this time.
That underperformance has made telecoms the most inexpensive sector in the market, trading at a trailing price-to earnings ratio of just 12. And with dividend yields now hovering around 5 percent, telecoms now appear to be classic value plays. But are they cheap enough to offset the risks?
Telecoms have moved out of favor for multiple reasons. Many consumers are cutting their landline service, unraveling the revenue gains seen a decade ago when carriers could lure consumers to hold both wired and wireless accounts. And price wars have brought stiff revenue headwinds. The St. Louis Fed notes that prices for telecom services have plummeted 34 percent since March 2009.
For some strategists, the explosive growth seen in digital data traffic is a missed opportunity. “To a large extent, telecom companies have not succeeded in their efforts to monetize the flood of data running through their networks. Their services have become more commoditized,” strategists at PriceWaterhouseCoopers noted in their 2017 industry outlook.
In response to changing industry dynamics, telecom firms have moved aggressively into cable television. The firms spent $224 billion on M&A in 2016, a 137 percent spike over 2015 levels, according to Capital IQ. Reduced reliance on traditional telephone services is likely a wise move, although online streaming services appear to be chipping away at the cable operators’ large customer bases as well.
Still, the bundling of voice, internet and TV has created the kind of economies of scale that has helped these firms stay relevant and profitable. AT&T, for example, saw a 6 percent gain in free cash flow in 2016 as it began to reap the benefits of its merger with DirecTV.
Meanwhile, these firms are also moving quickly to lower their cost structures. Verizon Communications, for example, cut $3.5 billion in overhead last year, with plans for similar reductions this year. Capital spending on telecom networks has also begun to recede now that nearly 85 percent of American consumers have access to 4G wireless speeds.
Lower operating costs and capital spending refute Moody’s narrative that industry profits are on the cusp of declines. The moves to cut spending led telecom industry profits to actually rise 4.4 percent in the second quarter (on a 1.3 percent drop in revenue), according to FactSet Research.
Verizon sees those cost savings as a way to boost free cash flow from $5.66 billion last year to $13.02 billion in 2018, according to Merrill Lynch.