The Zacks Diversified Communication Services industry appears to be mired in demand volatility as consumers prefer to switch to low-priced alternatives to tide over the coronavirus-induced adversities. Moreover, high capital expenditures for 5G infrastructure upgrade, unpredictable raw material prices, supply-chain disruptions owing to chip shortage, and margin erosion due to price wars have dented the industry’s profitability.

Swisscom AG (SCMWY Quick QuoteSCMWY - Free Report) , VEON Ltd. (VEON Quick QuoteVEON - Free Report) and Cincinnati Bell Inc. are likely to benefit in the long run from higher demand for scalable infrastructure for seamless connectivity amid wide proliferation of IoT, driven by faster pace of 5G deployment.

Industry Description

The Zacks Diversified Communication Services industry comprises firms that provide a wide array of communication services, including wireless, wireline and Internet to business enterprises and residential consumers. These companies offer mobile and wireline telephone services along with high-speed Internet, direct-to-home satellite television, and other value-added services. In addition to providing integrated information and communications technology services to businesses and governments, some of these companies operate as local exchange carriers or full-service providers of data center colocation and related managed services in state-of-the-art data center facilities. Some industry participants also provide IP networks, private lines, network management and hosting services along with the sale, installation and maintenance of major branded IT and telephony equipment.

What's Shaping the Future of the Diversified Communication Services Industry?

Chip Shortfall Affecting Profitability: The industry is currently facing acute shortage of chips, which are the building blocks for various equipment used by the telecom carriers. Although the Biden administration is trying to address the global shortage of semiconductor chips and devise ways to increase domestic production, the demand-supply imbalance has crippled operations and largely affected profitability due to inflated equipment prices. The $1.2 trillion infrastructure bill, which includes a $65 billion provision to significantly expand broadband access to the Americans, is on track for final passage by the House by Sep 27. The government has also pledged bipartisan support for funds of $50 billion to ramp up production capacity and reduce supply bottlenecks while eliminating dependence on countries like China. However, unless the policy guidelines assume tangible effect, the industry firms are likely to face short-term challenges, which in turn will affect their cash flow.

Evolution From Legacy Networks to Cater to Data Upsurge: Video and other bandwidth-intensive applications have witnessed exponential growth owing to the wide proliferation of smartphones and increased deployment of the superfast 5G technology. This has forced the industry participants to invest considerably in LTE, broadband and fiber to provide additional capacity and ramp up the Internet and wireless networks. These companies are rapidly transforming themselves from legacy copper-based telecommunications firms to technology powerhouses, with capabilities to meet the growing demand for flexible data, video, voice and IP solutions. At the same time, the industry participants continue to focus on leveraging wireline momentum, expanding media coverage, improving customer service and achieving a competitive cost structure to generate higher average revenue per user while attracting new customers. Also, these firms are offering the flexibility to better manage data traffic by leveraging indigenous software-defined networks to enable low-latency, high-bandwidth applications for faster access to data processing. Utilizing machine learning techniques and artificial intelligence capabilities, these networks are likely to transform the way data-intensive images and videos are transferred across the industry on a real-time basis. All these efforts have particularly helped firms in the industry to cater to the upsurge in data demand, with digital sustainability becoming the norm of the day as the majority of the population is forced to work from home.

Low-Priced Alternatives Resulting in Demand Erosion: Efforts to offset substantial capital expenditure for upgrading network infrastructure by raising fees have led to reduced demand, as customers prefer to switch to lower-priced alternatives. Moreover, the local-line access for traditional telephony service continues to face a decline among large customers due to higher wireless substitution and migration to IP-based services. This is reflected in the persistent erosion in overall network access services on a year-over-year basis, hurting revenues of local and long-distance operations. With Digital Subscriber Line and cable modems gaining widespread acceptance, customers are deactivating extra phone lines that were earlier used to access the Internet via dial-up modem. In addition, a shift toward wireless services and the aggressive rollout of VoIP and long-distance services by Tier-1 competitors have resulted in access line erosion. These negative impacts have become more pronounced as the coronavirus pandemic has hurt global economic growth, triggering large-scale unemployment.

Integrated Customized Offering to Mitigate Risks: In order to improve profitability, the companies are increasingly focusing on providing support services to various small and mid-sized businesses (SMBs) with an integrated portfolio of voice, data and technology services. The firms are tailoring their services to suit individual business needs and are facilitating SMBs to better adapt themselves to necessary technology advancements. At the same time, the industry is battling hard-to-mitigate operating risks, stemming from volatility in demand, unpredictable business environment led by the virus outbreak and challenging geopolitical scenario by offering free services to low-income families and seamless wireless connectivity to the masses.

Zacks Industry Rank Indicates Bearish Trends

The Zacks Diversified Communication Services industry is housed within the broader Zacks Utilities sector. It carries a Zacks Industry Rank #188, which places it at the bottom 26% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings growth potential. Before we present a few diversified communication stocks that are well positioned to outperform the market based on a relatively modest earnings outlook, let’s take a look at the industry’s recent stock market performance and valuation picture.

Industry Lags S&P 500, Sector

The Zacks Diversified Communication Services industry lagged the S&P 500 Index and the broader Zacks Utilities sector over the past year largely due to COVID-19 woes.

The industry has rallied 12.8% over this period compared with the S&P 500’s growth of 30.2% and the sector’s rally of 13.1%.

One Year Price Performance

Industry's Current Valuation

On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA), which is the most appropriate multiple for valuing telecom stocks, the industry is currently trading at 13.33X compared with the S&P 500’s 16.13X. It is also below the sector’s trailing-12-month EV/EBITDA of 18.82X.

Over the past five years, the industry has traded as high as 14.86X and as low as 6.9X and at the median of 11.64X, as the chart below shows.

Trailing 12-Month enterprise value-to EBITDA (EV/EBITDA) Ratio

3 Diversified Communication Services Stocks Likely to Move Ahead of the Pack

Swisscom AG: Headquartered in Bern, Switzerland, Swisscom offers mobile and fixed-network telecommunications services across the country and Italy. A wealthy domestic market with stable economic conditions, a relatively lax regulatory environment compared to the EU, its dominant market position and a strong leadership team are some of the key growth drivers of the company. With a complete spectrum of state-of-the-art data services, from leased lines to integrated solutions for corporate and residential customers, Swisscom’s healthy growth momentum is likely to continue. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 18.3% and 8.4%, respectively, over the past year. The stock carries a Zacks Rank #2 (Buy) and has gained 6.5% in the past year. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here. It has a VGM Score of B.

Price and Consensus: SCMWY

VEON Ltd.: Headquartered in Amsterdam, the Netherlands, VEON offers voice, data, and other telecommunication services through a range of wireless, fixed, and broadband Internet services across Russia, Pakistan, Algeria, Uzbekistan, Ukraine, Bangladesh, Kazakhstan, Kyrgyzstan, and Georgia. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 53.8% and 55.2%, respectively, over the past year. Continued investments in digital capabilities and services remain a key strategy for the company as it aims to transform lifestyles through technology-driven services in some of the world's fastest-growing emerging markets. The stock carries a Zacks Rank #2 and has gained 49.3% in the past year. It has a VGM Score of A. Its earnings are expected to grow 15.1% over the long term.

Price and Consensus: VEON

Cincinnati Bell Inc.: Based in Cincinnati, OH, Cincinnati Bell is a full-service regional provider of data and voice communications services over wireline and wireless networks. It also provides business customers with outsourced data center colocation operations and related managed services in world class, state-of-the-art data center facilities. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 75.8% and 65.8%, respectively, over the past year. The company is emphasizing on speeding up the migration of customers onto its fiber network and into products like managed VoIP. The expansion of its regional footprint in IT services has brought enhanced scale and client diversification, supporting its transformation to a hybrid IT solutions provider. Cincinnati Bell intends to continue investing in Fioptics networks to enhance customer experience and improve ARPU. Tailored TV channel packages are likely to drive top-line growth and check churn to traditional pay TV operators. The stock carries a Zacks Rank #3 (Hold) and has a VGM Score of A. It delivered an earnings surprise of 13.8%, on average, in the trailing four quarters.

Price and Consensus: CBB