Modest Expectations

Fund managers seeking steady income and reliable growth can find opportunities in the telecom services sector.

Once upon a time telecommunications stocks were a favorite growth play. In the late 1990s investors bet that surging demand for fixed-line and wireless broadband services would generate big profits for operators. But many took on enormous debt, and competition from alternative providers like cable companies intensified. Then the tech bubble burst and the telecom sector nose-dived.

Now, after a very long winter, there are fresh signs of life for telecom operators. Fundamental changes in the competitive and regulatory climate have improved the outlook for U.S. providers. Across the Atlantic, European operators are recovering from dubious acquisitions and excessive bids for 3G licenses, which had triggered massive borrowing.

Suddenly telecoms are back in favor. Through September 27, telecom services was among the top-performing global equity sectors this year, climbing nearly 15 percent, according to Standard & Poor’s. This isn’t a return to the heady days of the late ’90s, however. Instead, some portfolio managers now view these stocks as they did before the tech bubble: as a source of above-market income with the potential for moderate price appreciation.

“As late as last year, declining earnings was a secular trend,” says Laton Spahr, co–portfolio manager of the $1.34 billion Riversource Dividend Opportunity Fund, based in Minneapolis. “Now observers think that the U.S. regulatory and competitive environment will allow the maintenance of steady, albeit modest, growth.”

European analysts also report a positive shift. The return to a strategy of “retrenchment, downsizing, cost-cutting, asset disposals and enhanced shareholder returns,” says Thierry Cota, an analyst at Société Générale in Paris, is more pronounced than it has been in several years. This restructuring is “creating a solid floor for future market performance,” he adds.

Investors can afford to be patient. According to Spahr, the dividend yields on telecom service providers’ stocks have been 250 to 300 basis points above that of the S&P 500. That’s because these companies are highly cash-generative and, like utilities, own their infrastructure, which can be maintained at relatively low cost. Roughly two thirds of revenue comes from wireline businesses, Spahr estimates. Although more capital will be required as telecoms focus increasingly on wireless and broadband, he expects merger synergies and technological efficiencies to help the companies sustain their generous payouts, which are running at 50 to 60 percent of earnings.

The U.S. regulatory environment hasn’t been this benign since the 1984 breakup of the original AT&T, according to some fund managers. In the wake of the 1996 Telecommunications Act, many incumbents were required to share their infrastructure with competitors, but could charge them only variable costs. Since then, however, judicial interpretations of the act have effectively freed incumbents from such unprofitable obligations. At the same time, cable companies are competing more vigorously in the same arena, eliminating much of the concern on the part of the Federal Communications Commission regarding industry consolidation. Instead of requiring telecom companies to share merger synergies with customers, the FCC appears more willing to let providers profit from consolidation.

Several fund managers, including Spahr, are betting big that the new AT&T, formed by the 2005 merger of SBC Communications and AT&T Corp., will be a prime beneficiary. (Of his fund’s 11.3 percent stake in telecom stocks, AT&T accounts for 5 percentage points.) Although it’s too soon to discern the financial impact of that merger and AT&T’s pending acquisition of BellSouth Corp., the company is already benefiting from improved pricing power in business and wireless operations, as well as stable residential line performance. This year through September 26, AT&T stock was up 33 percent, helping Spahr deliver a 13.10 percent return, versus the S&P 500’s 7.73 percent return. AT&T shares yield more than 4 percent.

Verizon Communications has been a less aggressive acquirer of telecom assets. Nonetheless, Spahr sees the company benefiting from the same improved conditions that are driving AT&T’s share performance. When he took the reins of the fund in February 2004, Spahr inherited a 2 percent position in the company. He bought more shares over the past two and a half years at an average cost of $33, boosting Verizon’s weighting in the portfolio to 2.25 percent. The stock was trading at $37.96 as of September 26 and yielded a solid 4.4 percent.

Portfolio managers are also eyeing telecom plays abroad. Brian Younger, manager of Fidelity’s $388 million Select Telecommunications Portfolio, based in Boston, owns a $3 million stake in Telenor. The Norwegian telecom provider hiked its dividend from 0.35 to 2.0 kroner ($0.31) between 2001 and 2005 on the back of solid earnings growth.

Younger, whose fund was up by about 20 percent from January through September 26, began buying Telenor stock in late 2005. He was attracted by the company’s increasing exposure to emerging markets in Southeast Asia and Central and Eastern Europe, where profit margins are higher than in its home market. In this year’s second quarter, for instance, the margin on Telenor’s earnings before interest, taxes, depreciation and amortization in the Ukraine was almost 62 percent, compared with less than 42 percent in Norway. Emerging markets contributed nearly 50 percent of total ebitda, up from 38 percent in the second quarter of 2005.

Telenor’s share price rose nearly 27 percent in local currency terms — and more than 30 percent in dollar terms — between January and late September.

P. Robert Bartolo, manager of T. Rowe Price’s $1.16 billion Media & Telecommunications Fund, which was up 21.01 percent in the 12 months ended September 25, has also been shopping abroad. One standout in his portfolio is Telus, a Canadian service provider in British Columbia and Alberta. Canada’s strong economic revival over the past few years, fueled by rising commodities prices, is accelerating the telecom’s growth. “In addition to being a solid, well-run company, Telus will continue to benefit from expanding wireless penetration, which is only 50 percent across Canada,” says Bartolo. (The comparable figures in the U.S. and Europe are 70 percent and nearly 90 percent, respectively.) Attacking this market has helped Telus’s ebitda expand at an annualized rate of 9 percent over the past three years. In that period earnings per share jumped nearly 40 percent annually. With cash flow up from C$1.2 billion ($1.08 billion) to C$1.6 billion, Telus’s dividend has nearly doubled from C$0.60 to C$1.10.

Bartolo began buying Telus ADRs in October 2004 at a price of $20.50, when the stock was yielding 3.3 percent. By the end of this summer, he had allocated 3.3 percent of his fund to the stock at an average cost of $27.50. Shares closed on September 26 at $55.96.

Even if the growth projections don’t pan out, strong payouts can lend support to valuations. Todd Burchett, manager of the $87.4 million ICON Telecommunications and Utilities Fund in Englewood, Colorado, has 2.69 percent of his fund’s assets invested in British Telecom. The U.K. operator saw earnings per share plummet dramatically from 2002 to 2004. Between June and August of this year, Burchett bought its ADRs at an average price of $44.62, after estimating the intrinsic value to be about $54 a share based on a quantitative model that discounts long-term earnings growth projections by Aaa-rated long-term bond yields adjusted for volatility. As of September 26 the stock was trading at $49.22, but the yield was 4.2 percent. “Whether British Telecom is past the worst is difficult to say,” says Burchett. “But even if we assume negative growth, we still see value supported by an attractive dividend.”

Of course, investors must choose carefully. “Telecommunications remains a highly competitive industry,” cautions T. Rowe Price’s Bartolo, who adds that national markets still vary significantly by regulation, competition and market penetration. Still, Bartolo says sifting through the sector is worth it. “It can reveal opportunities masked by the investor wariness that still pervades an industry trading at half its 2000 peak value,” he asserts.