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After a lukewarm first half of 2017, most of the major telecommunications stocks performed well in the third quarter. The Federal Communications Commission (FCC) under President Trump has given indications of leniency compared with the Obama administration. The FCC is most likely to roll back a slew of stringent regulations of the previous regime. Its stance of being less restrictive will aid mergers and acquisitions, which are likely to spur growth in 2018.

Momentum to Continue in 2018

A growing economy speeds up the demand for real-time voice, data and video manifold. The escalation in demand has encouraged telecom service providers to undertake large network extensions while upgrading plans. The rising demand for technologically superior products has been a silver lining for the telecommunications industry in an otherwise tough environment. This in turn has given a boost to the demand for telecom equipment manufacturers.

Additionally, a major characteristic of the industry is that it is immune to international geopolitical disturbances, even when these lead to economic fluctuations. The need to remain connected springs from our earliest tendencies to communicate with our fellow human beings. An era of digitization and technology is essentially built on this human craving. It is here that telecommunications come to the fore as a necessary utility. Consequently, any non-U.S. economic volatility is not expected to have an immediate effect on the industry.

Furthermore, Trump’s proposed policy changes have made the overall economic outlook fairly bullish. Major proposals -- such as a pledge to spend $1 trillion in infrastructure projects over a period of 10 years, overhaul of the tax structure to reduce tax burden and easy regulatory policies -- are likely to spur higher consumer spending that may create about 25 million new jobs over a decade. This, in turn, will fuel long-term economic growth.

A Close Watch on Net Neutrality

On August 2017, the FCC closed the window for comments and replies after receiving 22 million comments on Net Neutrality rules. The regulatory body will examine these suggestions before taking a final call. Notably, in May 2017, the FCC voted 2-1 to start the formal process of unwinding the Net Neutrality rules.

In January 2017, Trump elected existing Republican commissioner Ajit Pai as the new Chairman of the FCC. Appointing Pai as the head of the regulatory body appears to have put Net Neutrality back on the front burner as he is a staunch opponent of the measure.

Trump himself is also a strong critic of Net Neutrality. There is little doubt that if the FCC scraps its laws either fully or partially, the ISP industry will be the major beneficiary. Leading ISPs such as AT&T Inc. (T - Free Report) , Verizon Communications Inc. (VZ - Free Report) and Comcast Corp. (CMCSA - Free Report) decided to challenge the Net Neutrality laws in the Supreme Court. All three above-mentioned stocks currently carry a Zacks Rank #3 (Hold). You can seethe complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Telecom – Media Convergence a Reality Now

Massive growth of smartphones and tablets, along with continuous development of high-speed data transfer technologies, has acted as a key driver of the convergence of the Telecom and Media sectors. Cable TV giant Comcast became a media mogul after acquiring NBC Universal in 2011. AT&T is currently awaiting the regulatory approval for its proposed $85.4 billion cash-and-stock deal to acquire media giant Time Warner Inc. Verizon has already acquired AOL and the internet-based assets of Yahoo to establish a strong foothold in the Telecom – Media space. The company is also mulling over buying out any powerful media giant to remain competitive.

Advertisement on the mobile video platform is gradually shifting from simple selling of banner ads on the mobile web to automated or programmatic ad selling. Pay-TV operators are steadily adopting the data-driven advertising technique that is already popular in the web-based advertisement arena. To derive maximum synergy from the combined video content and video-distribution platform, these companies are extensively penetrating the advertising technology market. Inclusions of dynamic ad-insertion, targeted audience advertising and data-driven TV advertisements are steps toward the same objective.

Wireline Industry – Going All Out on Consolidation

In the last decade, U.S. wireline phone companies have lost a significant number of customers to wireless service providers and cable multi-service operators (MSOs). In order to tackle this critical situation, wireline operators have decided to merge to gain economies of scale with respect to fiber optic cable networking and cloud-based network services. Meanwhile, small and medium business (SMB) services have become a high revenue-generating segment in the data communications industry.

In April 2016, Frontier Communications Corp. (FTR - Free Report) completed the purchase of Verizon’s wireline assets in California, Florida and Texas. Currently, the company operates landline business and provides broadband, video, voice and FiOS services in the three states. Recently, in a cash and stock transaction, CenturyLink Inc. (CTL - Free Report) has acquired Level 3 Communications Inc.

In February 2017, telecommunications and data service firm Windstream Holdings Inc. (WIN - Free Report) acquired EarthLink Holdings Corp. Additionally, in April 2017, the company entered into a deal to acquire Broadview Networks, a leading provider of cloud-based unified communications solutions to SMBs. In July 2017, Cincinnati Bell Inc. (CBB - Free Report) announced that it will buy Hawaiian Telecom Inc.

Pay-TV Spending Continues to Rise in Future

In June 2017, research firm Strategy Analytics estimated that annual spending on subscription video and TV services in the United States will reach $130.3 billion in 2019.Major pay-TV operators, who offer both traditionally managed TV services and next-generation online services, will have nearly 80% of the market share till 2022. They will continue to do so despite facing intensified competition from over-the-top (OTT) service providers.The pay-TV operator’s average revenue is still 10 times higher than that of the online-video-streaming service providers.

Valuation Indicates Strong Upside

Going by P/E (price to earnings per share) valuation metrics, which is often used to value telecom sector stocks, the industry looks stable at this stage. The industry currently has a trailing 12-month P/E ratio of 15.79x, which is below the median value of 16.74x and the S&P 500’s trailing 12-month P/E ratio of 20.67x.

Additionally, the reading compares favorably with the market at large, as the current P/E for the S&P 500 is pegged at 20.48x and the median level is 19.40x. On the other hand, current P/E of the telecom industry is 14.70x with a median of 15.33x. Therefore, at present, the telecom industry looks undervalued compared to the overall market. This indicates a near-term upside potential for the stocks.

Another commonly used valuation metric for this sector is P/S (price to sales) which also depicts the same picture. The industry’s current P/S of 1.46x compares favorably with the market at large, as the current P/S for the S&P 500 is at 3.40x and the median level is 3.10x.

What the Zacks Industry Rank Indicates?

Within the Zacks Industry classification, Telecommunications is broadly grouped in the Computer and Technology sector (one of the 16 Zacks sectors) and is further sub-divided into 12 industries at the expanded level: Communications Infrastructure, Communications Components, Satellite Communications, Cable TV, Diversified Communications Services, Internet Services, Wireless Equipment Supplier, National Wireless Service Provider, Rural Wireline Operator, Non-U.S. Wireless Operator, National Wireline Operator and Non-U.S. Wireline Operator. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank 265 industries in the 16 Zacks sectors, based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

Earnings Trend in the Sector

The broader Technology sector, of which the telecommunications industry is part, delivers a strong show with respect to earnings. So far, 77.7% of the sector participants have reported third-quarter 2017 financial results, which have been impressive in terms of beat ratios (percentage of companies coming up with positive surprises).

Total earnings have shown a strong 23.3% year-over-year increase on a 10.9% rise in revenues. This compares favorably with earnings growth of 17.1% in the second quarter of 2017. Revenues witnessed a rise of 7.7% in the second quarter.

However, the consensus earnings expectation for the next two quarters depicts a lukewarm trend. While earnings growth is anticipated to grow 12.7% in the fourth quarter of 2017, it is likely to grow 13.6% in the first quarter of 2018. Similarly, revenue is expected to grow 7.6% in the fourth quarter of 2017 and 10.4% in the first quarter of 2018.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Preview reports.

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