LONDON, 25 November 2002 — The telecommunications sector, which has been in a meltdown since early 2000, is showing signs of improving fundamentals. On a selective basis, we see attractive investment opportunities both in equities and fixed income. Depending on a company’s risk profile, it may be more appropriate to favor one asset class over the other. In light of heightened volatility with individual securities and given the dynamic nature of the industry, we advise investing in a mutual fund, which offers the advantages of active investment management and diversification.
Although telecoms languished throughout 2001 and the first half of 2002, the sector has recently been one of the best performing, both in equities and bonds, in fact, telecoms were the second best performing bond sector in August, generating a total return of 1.80 percent. We see four developments that give us reason to have a more favorable outlook:
1. Improving Financials: The first development is healthier balance sheets. With the exception of a few firms like Deutsche Telecom and France Telecom, operators are improving their free cash flow and using the proceeds to strengthen their balance sheets. Thanks to capex reductions, cost controls and asset disposals, companies are reducing debt levels and passing on savings to shareholders, in the form of share buybacks or increased dividends. In fact, we see capex cuts as a secular trend that could last for at least another two or three years as industry consolidation and economic weakness has substantially lessened the pressure on operators to spend on equipment.
2. 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 incumbents as essentially utilities. This is particularly the case with the three big US RBOCs (Regional Bell Operating Companies) — SBC Communications, Verizon Communications and BellSouth — which have P/E multiples and dividend payout ratios in line with those of US electric utilities. However, these companies are not very attractive for fixed income investors given their low spreads.
European telecom bonds performed strongly in the third quarter in comparison to non-financial corporates. This solid performance was a more broadly based rally, with all sector issuers posting returns and can clearly be linked to company specific news. The solid performance of Telefonica and Portugal telecom owed much to the IMF rescue package for Brazil. With both companies generating more than 20 percent of EBITDA in this market, the deterioration in the Brazilian economy pushed bond spreads wider notwithstanding the companies’ robust financial profiles. Thus, getting it right on telecoms has been more a question of timing and most performance has been driven by relatively few (but large) issuers such as France Telecom, Deutsche Telekom, Olivetti and KPN.
3. Europe faces up to 3G reality: Another positive development is the recent announcements by Telefonica, Sonera and KPN that they will write off the value of their German wireless businesses. This decision represents the first admissions that operators overestimated the potential of UMTS services 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.
4. More benign regulatory environment: Regulators have become more accommodating by expressing a willingness to help the industry back to health. 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. 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. Although our view on telecoms has turned more positive, we recognize that the sector still faces significant challenges. 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.
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.
3G services will be introduced in Europe and the US during the second half of this year and early 2003. Delays in rolling out 3G and/or lackluster demand for new services and handsets run the risk of disappointing an already skeptical investment community. Even in Japan, where 3G has been available since October 2001, demand for mobile data remains modest and is below expectations, which have proven to be popular in Japan, will help stimulate demand for mobile data in other markets.
As already stated, telecoms, particularly incumbents, have been one of the most volatile, but also among the best performing sectors. The industry has undergone a readjustment process in which alternative carriers, whose debt is mainly in distress, are literally being driven from the market. Many firms show very weak balance sheets, most notably France Telecom and Deutsche Telekom. However, from a corporate debt perspective, they offer a very attractive risk/return relationship, with yields reaching levels comparable to those of riskier bonds.
When analyzing debt, political and institutional factors play a relevant role in the pricing of securities. In fact, some companies are likely not to default on their debt even if leverage is very high. For instance, if the French government is ready to bail out France Telecom, the stock might under perform, but the bondholder is still in a comfortable situation. A bondholder only looks at the ability of the company to repay principal and coupons until maturity. If macroeconomic and/or political factors overshadow company specific factors, the bondholder might be able to pick up the spread without taking on too much risk. Thus, if factors unrelated to the real credit situation of a company make the probability of default low, an investment in such a security offering spreads of 400 bp becomes very attractive.
Conversely, companies with a solid financial situation may not offer interesting value for bond investors since they tend to have low spreads — as in the case of Vodafone with a yield of only 60 bp. However, such a company may represent an attractive investment for stockholders given that a strong balance sheet is a competitive advantage in a sector undergoing consolidation. The bottom line is that the decision to invest in bonds should not be based solely on the absolute spread. Rather one should consider whether the trend is toward widening or tightening in the near future.
In conclusion, the telecommunications industry, which has been in a consolidation phase over the past two years, is showing signs of improving fundamentals. The sector offers attractive investment opportunities, both form equity and fixed income perspectives. However, the decision to invest in a company may differ from one asset class to another. In light of increasing volatility and the complexity of telecommunications, a simple buy and hold approach of individual securities is not a recommended strategy for investing in this sector.
Investing in a mutual fund, which provides the advantages of active investment management and diversification, offers the best way to participate in the sector’s growth potential.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information
