LONDON, 19 August — Telecommunications, which has been in a consolidation phase since early 2000 and was one of the worst performing sectors during this period, is showing signs of healthier fundamentals. We see four developments that give us reason to be more positive on the sector:
First, with the exception of a few firms like Deutsche Telekom and France Telecom, operators are making genuine progress in strengthening their free cash flows and balance sheets. Thanks to cuts in capital expenditures and operating expenses as well as asset disposals, companies are able to reduce debt levels and/or pass on savings to shareholders, either in the form of share buybacks or increased dividends. We expect this trend to continue with further reductions in capex. The combination of industry consolidation and an economic downturn has substantially lessened the competitive pressure on operators to spend heavily on equipment. Consequently, the average capital intensity ratio (capex/sales) of telcos is set to fall from a peak of 28 percent in 2000 to 15 percent or less by 2005.
Second, more reasonable valuations. price/earnings ratios have returned to more reasonable pre-bubble levels. Indeed current multiples indicate that the market is now pricing some large incumbents as essentially utilities, with an option on wireless communications. This is particularly the case with the three big US Baby Bells or RBOCs (Regional Bell Operating Companies) — SBC Communications, Verizon Communications and BellSouth — which have both P/E multiples and dividend payout ratios that are in line with those of US electric utilities.
Third, another positive development was the recent announcement by Telefonica and Sonera that they will write off the value of their $8.4 billion joint German wireless business as well as some other European 3G licenses. This decision represents the first admission that phone companies overestimated the potential of UMTS services to generate sales and profits when they spent a combined $100 billion for licenses across Europe. We expect this action to trigger additional write-offs, especially by some of the smaller operators or by firms with weak positions outside their home markets.
Finally, regulators are becoming more accommodating by acknowledging the difficulties facing operators and expressing a willingness to help the industry back to health. In the US, in the wake of the WorldCom bankruptcy, FCC Chairman Michael Powell stressed the need to keep telecom networks operating in order to avoid service disruptions. To that end, he signaled the FCC’s openness to mergers involving any combination of operators and he is calling for federal legislation to make it easier for the RBOCs to offer high-speed data services over long-distance boundaries. In Europe, regulators have already begun to help ease the financial burden of wireless operators. The most recent example is in Italy where the government has agreed to extend the duration of the country’s five UMTS licenses from 15 to 20 years and although our view on telecoms has turned more favorable, we recognize that the industry still faces significant challenges, of which we have identified the two most important:
There is still potential for negative news flow from certain companies. One candidate is Qwest Communications, which has admitted to more than $1 billion in accounting errors and is the subject of fraud investigations by the SEC and the Department of Justice. Even if the company is exonerated and reaches a settlement with the SEC, the company still faces the danger of defaulting on $3.4 billion in loans (of its total $26.3 billion debt) that come due by the end of the year. In Europe, France Telecom and Deutsche Telekom are the two incumbents with the highest risk profiles since they have the largest debt burdens and have failed so far to come up with credible reduction plans. Further delays by these companies in addressing this issue would cause continued price weakness and may even prompt further credit downgrades.
In Europe and the US, 3G services will be introduced during the second half of this year and early 2003. Delays in rolling out 3G and/or lackluster demand for new services and handsets would run the risk of disappointing an already skeptical investment community. Even in Japan, where 3G has been available since October of last year, demand for mobile data remains modest and is below expectations. However, operators are hoping that new videophones, which have proven to be initially popular in Japan, will help stimulate demand for mobile data in other markets.
The Communications Equity Fund at Clariden Bank continues to adopt a defensive stance by favoring those large incumbents with solid balance sheets and reasonable valuations (e.g. BellSouth, SBC and Telecom Italia). We have also selectively increased our weighting in Asian-Pacific and emerging markets as we see some names in these regions offering attractive underlying growth at reasonable valuations. The fund remains well-diversified with broad exposure across regions and sub-sectors.
The near-term market outlook for telecommunications depends largely on the macroeconomic picture. The sector stands to benefit from improving investor sentiment as economic conditions rebound. On a medium- to long-term view, we remain positive on the sector given the growth potential in wireless and see both broadband and the transition to new mobile standards as key catalysts. At the same time, we caution that although 3G will soon be introduced in Europe and the US, the real impact on companies’ bottom lines is unlikely to come until at least the second half of 2003. This is because it typically takes several quarters for new mobile services and products to enter the mass market as the industry evolves from one standard to another.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management)