Emerging markets and cloud-based services could balance-out the telecom sector's poor pricing power, finds Anthony Harrington
Equity managers looking for somewhere solid to park money are sometimes tempted by telecoms: they resemble utilities sweetened with some capital growth and, in a number of instances, very attractive dividends. But as those who know it well attest, this is one sector that simply cannot be played as if it was a homogenous block. Alan Bezoza, telecoms analyst with Janus Capital sums it up succinctly: "This is no place for DIY."
A beginner might start by splitting the sector into fixed line and mobile, but would quickly run into hybrids that do both.
Voice and data would be another differentiation, with broadband connectivity and video viewed as a massive data-demand generator. But voice traffic is morphing into just another data set - with severe pricing implications for incumbents. Then there are the various country plays, each with its own favourable or unfavourable (for the moment) regulatory environment. Regulators have the ability to limit pricing, and the power to protect incumbents - or expose them to fierce competition.
Then there are technology trends to be grasped, not to mention the implications of the still unfolding battle between fibre optics to the home versus video over wireless networks. Layer after layer of ever-increasing and dynamic complexity must be sifted and analysed.
Bezoza points out that the sector has had its share of false dawns. 3G has taken a decade to mature, and the equally massively hyped voice over internet protocol (VoIP) has yet to generate real revenue. But the underlying power of technology promising massive connectivity continues to unfold and remains extremely attractive to investors - if only telcos could resolve the issue of how to grow their revenue base.
"Telecoms looks defensive because it is infrastructure-related and is quite cash generative, and some stocks have done well on a boring story of not much growth but good cash generation," says Steve Cheetham, telecoms analyst with AllianceBernstein. But what makes the sector tricky in addition to the inherent complexity, he observes, is the regulatory framework. "Investment and politics make uneasy bedfellows - politics is essentially unpredictable."
A good country market can be spoilt by a regulator that stokes up competition to the point where no one makes money and everyone comes under threat. "Unless we feel that we have a very firm grasp of the economic fundamentals around a particular stock, and feel that these fundamentals are strong enough to deter political interference, we stay away," says Cheetham.
As it stands, the consumer is getting a better deal all the time, with the unstoppable trend of more data for less cost. Cheetham likes Vodafone's answer, which has been to go ‘gung ho' for emerging market growth while seeking to hold on to its European base with a utility type approach. "Structurally, Vodafone may not be great, but it is generating cash," he says.
The real problem for the larger players is shrinking revenue growth in advanced markets. Smart bundling of products has staunched the revenue ‘bleed' for many telcos, but their most cash generative play, SMS, is slowly being arbitraged away by that same bundling.
Cheetham warns that even a pure utility play "only has so much juice". KPN, the Dutch incumbent, has pursued a cash maximisation strategy for a while, but its top line is now shrinking and competition is getting tougher, he observes.
Ian McKenzie, senior adviser with the European communications specialist private equity firm, GMT Communications Partners, says that the general trend for businesses to site IT remotely or to use applications software provider services from the ‘cloud' is already huge for the sector. It takes the focus off the idea of content provision and instead prioritises ‘fat pipes', where volume, latency and price are the key plays.
"There was a glut of fibre and infrastructure in the early 2000s, but this is starting to run out so there is a huge amount of upgrading and growth required over the next few years heres," he says.
Technology changes have put hosted services front and centre of business strategic thinking, and there are plenty of consumer related cloud services to come that will drive bandwidth demand for the telcoms sector. These consumer-facing services include video on demand, gambling, computer games and high definition video teleconferencing with friends and family. Demand pressures like these will keep the telco sector, at least, interesting for investors through the next few years, he says.