As a result of weakening macroeconomic indicators, telecom carriers' capital expenditures remain limited in 2008 and early 2009. There has been more selectivity on technology choices and leveraging cost-savings synergies, such as streamlining purchasing arrangements and reducing the number of preferred vendors. Shareholders continue to foster an environment where executives are held accountable to focus more on balance sheet improvements, financial discipline, and improving free cash flow.

Telecom carriers and equipment providers that offer the most attractive opportunities are focused on third-generation (3G) wireless, broadband (DSL) and fiber-to-the-home/node networking. There are also a few market leaders that have proven able to survive the sometimes turbulent opportunity swings in the industry. It is our belief that in this uncertain stage of macroeconomic events, companies with strong balance sheets and firm net cash positions, along with sustainable dividends, provide respectable risk/reward profiles. On the other hand, highly-leveraged companies should be avoided, at least at this economic juncture.

OPPORTUNITIES

The transient collapse of financial markets has become an indelible lesson to many of us. With this we have witnessed that sector diversity is a less secure planning tool in today's increasingly correlated world markets. However, there are some tactics and opportunities that may be appropriate to address the downturns in the telecom industry, should we be greeted with them again. We consider the following:

* Necessity for Telecommunications - The need for telecom in both rural and urban areas, and its role in the infrastructure of both developed and developing markets, continues to grow. Wireless infrastructures and/or low-cost integrated IP voice and data wireline networks are necessities. In fact, most global subscribers will not give up their wireless phones and services that easily, although upgrades to advanced (high-end) handsets/offerings may be sensitive to overall consumer/business budgets. This is accompanied by telecom carriers' continued quest for operational flexibility and streamlining * International Diversification - While country diversification offers only limited protection in the current highly-correlated world equity markets, it offers hedging capabilities from local economic weakness and associated currency exchange differentials. Therefore, a significant allocation of foreign telecom companies would be appropriate as part of a technology-focused portfolio * Balance Sheet Positions - In our view, companies showing significant net cash positions become attractive in volatile markets. It is important to consider balance sheet conditions that may limit the vulnerability of telecom companies in weak economies. This is perhaps at least as important as metrics that track earnings growth but often do not consider overall market declines. With the S&P 500 P/E between 10 and12 times earnings, valuation targets that were provided by analysts based on earnings growth parameters have not been effective in guiding investment recommendations during market tailspins

This leads us to recommend selected net cash positive companies able to weather financial market volatility. Companies that match well with the aforementioned considerations include Qualcomm (QCOM), China Mobile (CHL), Amdocs (DOX) and Chunghwa Telecom (CHT). These entities have significant cash and each has unique exposure to wireless and international business, along with strong balance sheet positions to sustain their expansions.

Other investment strategies to consider for telecom include:

* Investing in Dividend-Yielding Companies - Telecom service companies typically provide a disciplined return to investors over time with dividend payouts. Dividend payouts of many of the larger telecom service companies are yielding an average of 4 to 9% as stock prices reached their lower levels. When considering dividend rates, however, we emphasize the need to review company liquidity, debt levels, and cash flow conditions that permit their ability to pay debt obligations * Dollar Cost Averaging - Setting aside funds to spread out industry-specific investments over time represents a sound strategy. This can leverage lower valuations for better investment returns when market values improve over the longer time horizon

WEAKNESSES

Generally, telecom companies that have exhibited significant degrees of valuation decline have had high debt levels and large financial leverage ratios. These companies, while offering recurring cash flow to service their debt obligations, may have difficulties should overall business decline as consumers and businesses become more selective with their spending behavior. Risks that still remain include the following:

* Potential Business Slowdown - Lower overall top-line sales among carriers that would justify a proportional reduction in capital expenditures * Exacerbated Borrowing with Credit and Loans - Over the near-term, telecom companies may be exposed to high debt levels and limited liquidity * Economic Impact Straining Consumer and Business Spending - Telecom companies that would have free cash flow impacted by slowdown in demand. (Sustainable cash flow is required to service debt obligations and may be severely impacted by pessimistic business projections)

Risks are associated with Embarq (EQ), CenturyTel (CTL) and US Cellular (USM) in this group.

David Weissman, CFA is a senior analyst covering the telecommunications industry for Zacks Equity Research.

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