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The economic downturn has been weighing on the fortunes of companies in almost every industry, including telecommunications. The industry by definition encompasses a lot of technology-related businesses. Besides the traditional local and long-distance wireline telephone services, telecommunications also include wireless communications, Internet services, fiber optics networks and satellites communications.
Companies in the telecommunications industry continue to be at the forefront in terms of mergers and acquisitions. Consolidation among the largest telecommunications services-focused companies has created an environment where equipment-focused companies have contend with fewer customers and reduced selling opportunities. This has prompted consolidation among equipment companies as well to enhance marketing value by broadening product offerings for converged fixed-mobile networks.
Capital spending constraints among carriers and limited availability of funds to sustain or grow telecom services over the next six to twelve months may be the outcome of financial uncertainty, particularly tighter credit markets. Telecom and Internet service providers often approach the credit markets for funding capital projects, while telecom equipment companies conventionally use equity share offerings in lieu of debt instruments. Overall access to capital has been constrained, regardless of the financing mechanism chosen.
Given the dismal economic backdrop, operators have been reining in capital outlays, and focusing more on extracting greater savings from existing operations. There seems to be more selectiveness on technology choices and leveraging of cost-savings synergies, such as streamlining purchasing arrangements and reducing the number of preferred vendors.
Moreover, the economic scale of consolidated telecom service companies is creating pricing pressure and margin erosion potential as equipment companies contend for contracts based on pricing and features. Long-term growth prospects for the sector are not nearly as favorable as they were in the early part of this decade.
It is our belief that at this uncertain economic stage, 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.
Telecom carriers and equipment providers that offer the most attractive opportunities are focused on 3G wireless technologies, emerging 4G technologies, broadband (DSL) and fiber-to-the-home/premises networking. Last year’s collapse of financial markets has left an indelible mark on many of us. We have seen that sector diversity is a less secure natural hedge in today’s increasingly correlated world markets.
However, the telecommunications industry as a whole offers a number of attributes that are difficult to ignore for most investors.
- Telecommunications is a necessary utility: 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 in importance. 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.
- Massive growth of smart-phones: In spite of the challenging global economy, the growth in the smart-phone mobile market remains on its impressive trend. This primarily reflects a shift in consumer preference towards feature-enhanced PDA devices from ordinary mobile handsets used primarily for voice telephony. This grand opportunity provides massive scope for telecom service providers, equipment manufacturers, chipset developers and wireless tower operators to retain new users and grow revenues moving forward.
- 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.
Generally, telecommunications companies that have been under pressure in the current downturn have had high debt levels and large financial leverage ratios. These companies, while offering recurring cash flows to service their debt obligations, may have difficulties should overall business activities take longer to come back as consumers and enterprises become more selective with their spending. Other risks that still remain include the following:
- Potential business slowdown: Lower overall top-line sales among carriers are expected to continue weighing on capex decisions, a major problem for equipment vendors. Companies are expected to remain focused on balance sheet improvements, financial discipline and free cash-flow generation. Unfortunately for the equipment vendors, the method of choice for improving free cash flows remains disciplined capital outlays.
- Weak credit profiles: Over the near-term, telecom companies may be exposed to high debt levels and limited liquidity, which puts a premium on sustainable cash flow to service debt obligations. As a result, telecom companies may have free cash flow impacted by slowdown in demand.
- Increased competition: The markets for broadband wireless solutions are emerging rapidly in terms of technological innovation and market demand. The telecommunications sector is highly interlinked with cable TV networks, since cable companies are now aggressively offering local exchange and Internet services. The relationship between the telecom and cable sectors has become even more complex as telecom service providers are now selling TV via IP (Internet protocol) services, competing directly against cable to provide consumers' entertainment. Many of the cable operators have greater financial, technical and marketing capabilities which may enable them to respond more effectively to emerging technologies and changes in customer requirements.
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