Telecommunication Services Sector Rating: Underperform
What is the telecommunication services sector?
The telecommunication services sector contains companies that provide communications services primarily through a fixed-line, cellular or wireless, high bandwidth and/or fiber optic cable network.
Telecommunication services sector overview
Rising interest rates could hurt the telecom sector, whose relatively high dividends often attract investors in a low-interest-rate environment. Although demand for wireless services is rising, competition in the sector is rising, as well. Company debt loads could also be a problem if rates rise.
Market outlook for the telecommunication services sector
The telecom sector is certainly not what it was a couple of decades ago. The days of near-monopolistic control of landlines are long gone. These days the sector is driven by fierce competition, with new ways of communicating continually entering the market, and consistent—and expensive—upgrade cycles. To us, this reduces the traditional defensive appeal of the telecom sector.
However, the group did quite well in the period following the election as investors seem to be buoyed by hopes that the new mix in Washington will undue damaging net neutrality rules—defying our underperform call. That outperformance appeared to be fueled not so much by the core performance of the five companies within the sector, but rather by investor hopes that the regulatory environment will improve. But as we believed, that outperformance was short-lived and the group has returned to underperformance. We believe that an improving U.S. economy and increasing inflation will push interest rates at least modestly higher, leading to a continued reversal of some of the yield chasing that helped to fuel gains in the sector in the past. And we believe that there are some offsetting issues to the regulatory reform hopes, such as President Donald Trump’s apparent dislike of some the merger proposals that have benefitted the stock prices of some of the companies in the group.
That doesn't mean that there aren't some attractive qualities in the group, especially with the advances and changes occurring in the communications realm. The amount of information being transmitted across channels controlled by this group is staggering, and it doesn't seem to be slowing, meaning the sector is one that is seeing steady increases in demand.
However, the downside of that increase in demand is the onslaught of competition. As telecom businesses compete for increasingly budget-conscious consumers, pricing power has declined. In addition, companies in the wireless space are shifting their pricing structure away from long-term contracts and free equipment toward more flexible terms—potentially beneficial and more transparent for consumers, but likely squeezing profits in the sector to an even greater degree.
And while increasing consumer demand for wireless services is potentially positive for revenues, the flip side is that it can greatly increase costs for providers, due to the need for large equipment upgrades. As a result of this need to spend, the debt ratio on telecom companies has risen over the past several years, which could mean a double whammy should interest rates rise—debt service costs would rise as the companies roll over their loans, and the yield trade would likely reverse.
Factors that may affect the telecommunication services sector
Positive factors for the telecommunications sector include:
- Increasing wireless demand: Demand is rising as more communication and media devices move to the wireless arena, providing the potential for revenues to rise.
- Relatively high dividends: The dividends typically paid by telecom companies have attracted investors tired of paltry fixed income yields.
Negative factors for the telecommunications sector include:
- Falling profits: Net profit margins are declining for the telecom sector as competition squeezes margins.
- Rising expenses: Capital expenditures in the telecom space are increasing as companies look to improve and expand their networks. This could be a burden on profitability.
- Heavy debt loads: The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector.
Clients can see our top-rated stocks in the telecommunications sector.
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