Telecom Industry

Maintain Positive Outlook (Changed from Neutral - March 2009)

Based on extreme industry weakness in late 2008 and early 2009, we believe valuation levels now reflect remedial conditions in the economy. Depressed stock prices foster more favorable entry points at this juncture as government stimulus plans and restricted operating expenses may drive opportunities for improved earnings.

Telecom companies are starting to report minimal financial improvements in terms of revenue and earnings levels. In addition, economic stimulus plans throughout the world, including the U.S. broadband infrastructure development program -- and similar structural subsidies in China and India -- may be a boon for selected service providers and equipment manufacturers.

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 at 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 possible economic inflection point.

OPPORTUNITIES

The transient collapse of financial markets has become an indelible lesson to many of us. With this, we have seen 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 and 12 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 - Analyst Report) and China Mobile (CHL - Analyst Report). These entities have significant cash, and each has unique exposure to wireless and international business, along with strong balance sheet positions to sustain their expansion initiatives.

RISKS AND 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 & Loans - Over the near-term, telecom companies may be exposed to high debt levels and limited liquidity.

Economic Impact Straining Consumer & 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).