The Telecom Sector

Dear Reader,

Recently we have been attracted by the relatively stable market structure, high dividends and continuously decreasing stock price over the last decade of the telecom sector. The latter, combined with a lack of growth from such companies in developed economies over the years, has reduced interest from investors and speculators. It is for this reason that we went to have a look.

Generally, we have veered away from this sector due to our lack of in depth understanding of; 1. the technology, 2. the regulation. As a result, though we were aware free cash flow yields relative to market capitalisation were high recently, we were not confident in determining the earning power of such companies, or valuing their fixed assets, hence mainly stayed away.

Currently we are familiarising ourselves with the sector. Let me summarise our recent findings:-

1. The telecom sector is asset heavy. It requires much capex, and therefore incurs large depreciation charges on the income statement. We find different companies approach this non cash accounting term with various degrees of aggression. We find this to be true also for amortisation. As a result, our modified owner earnings can be quite different from accounting net income

2. Large fixed costs exist, hence economies of scale are relevant. We find dominant players in a market have noticeably larger margins

3. Dominance in one market does not help dominance in another. Economies of scale are only relevant locally. Telefonica understood this very well. Deutsche Telekom less so. However, the latter is making positive developments

4. We have always worried on the size of capex requirements in the telecom sector. However, the question is irrelevant if economies of scale is relevant and you have a monopoly of a technology. Hence if capex is 10 bln, but profits over 10 years are 300bln, what does it matter what the capex is? What matters is what you get out of the capex in terms of profit. If market structure is stable, there may be opportunities

5. Our second fear has been a company invests large sums to make a technology, as a result it belongs only to them, but then regulation forces them to open the technology such that competitors can use it at a minimum cost (to ensure there is no monopoly in a strategic sector). This implies the cost of one are enjoyed by all. This is not a highly profitable endeaver

6. Regulation, technological change and the continuous erosion of technological advantages and hence forced capex spending. These are our fears in this sector. If everyone has access to the technology due to regulation enforements, only the consumer gains, not the industry in terms of profit

7. In theory, the owner of the network always makes money, whether they are providing the service, or allowing someone else to use their network to provide the service (which may be forced by the regulator). BT is an example, in the UK, But you must be aware of the ranges of their margin, and hence the affect on valuation

8. There has been a powerful price war in the UK. This is evident from decreasing margins recently, and the services provided by wireless and wireline network providers. Recently, T mobile and Orange in the UK have said they will form a joint venture. This is an interesting development. Is it a signal that they don’t want to carry on with a price war. Their size being the weapon they can unleash if someone decides to go against them? We were curious to see in London adverts promoting the joint venture was focused on a higher quality of service rather than a lower price. We believe they are signaling to competitors that prices have reached a bottom, they want to have price stability and focus on making money rather than simply stealing market share

We look forward to update our clients in greater detail with regards to the conclusion of our study of the telecom sector.


Yours sincerely,

Alessandro Sajwani