Sector spotlight: how and why to invest in telecoms

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18/11/2015
The widespread use of smartphones is just one reason investors have turned their attention to companies in the telecoms sector.

Large-scale mergers of British Telecom and EE, and O2 and Three have thrust the telecoms sector into the spotlight this year.

Consolidation can often be the hallmark of a struggling industry. However, the telecoms sector is not struggling.

Instead, it is experiencing significant growth globally driven by the popularity of smartphones, and technological advancements expanding the range and quality of services offered by telecoms companies.

A unique sector

Professional investors who are bullish on the sector note its “unique” qualities, which make it less susceptible to key current market headwinds.

“Telecoms stocks aren’t exposed to commodities, and their performance by and large isn’t affected by emerging markets,” says Mark Swain, co-manager of the Smith & Williamson UK Equity Income fund.

“There’s lots to worry about in markets at the moment as a generalist, but rather less to worry about in telecoms.  I’d rather have my money in stocks not affected by the movement of Chinese GDP or oil prices, or in sectors subject to ongoing investigations, fines or regulation.”

Telecoms are also significantly less cyclical than most other consumer industries.

The contractual nature of telecoms means a pretty much guaranteed, steady year-long income for providers. The majority of consumers view mobile phones as indispensable rather than a luxury.

Ian Forrest, investment research analyst at The Share Centre, says: “For most, a mobile phone is a critical element of their monthly spending.

“The ongoing development of apps means people are doing more and more things through their phones too, and this will only continue as technology develops. There are very small minorities resisting this trend, and some use cheap pay as you go handsets out of circumstance, but this has a tiny impact on profits.”

Headwinds

Another unique characteristic of the telecoms sector is that brand loyalty is virtually non-existent.

There is little differentiation between services, and consumers aren’t easily wooed by branding and marketing power. Their choices are almost entirely informed by which provider offers the best deal, and lowest price.

“Consumers are concerned about the data and talk time they’re getting for their money, rather than who supplies it,” explains Swain.

Investors may consider this attribute a curse, as it creates a highly competitive environment in which telecoms companies are constantly attempting to undercut one another.

Forrest observes that Vodafone’s aggressively competitive strategy could cause difficulties with both its margins and growth potential, while Swain says the current deflationary environment has exacerbated this pressure.

He adds that telecoms companies are bad at monetising technology. In some instances, UK telecoms providers have been quicker on the uptake than their European competitors – for instance, only 10 per cent of mobile users in Europe use 4G, creating expansion opportunities for 4G-ready firms in the UK such as Vodafone.

However, the UK has been inefficient at seizing opportunity in other areas.

Major telecoms firms in Europe and the US, for example, heavily promote ‘quad-play’ packages, which provide consumers with broadband, fixed line, TV and mobile phone access via a single provider.

Yet no company has gained a significant number of ‘quad-play’ customers in the UK so far, says Colin Morton, lead manager of the Franklin UK Managers’ Focus fund.

UK telecoms businesses have also been slow to protect themselves adequately from cyber risks, as the recent TalkTalk hack demonstrated. Shares in the firm have fallen 20 per cent since the scandal broke, and show little sign of improving in the short-term.

“We don’t know how the telecoms sector will look in ten years’ time and it seems difficult to predict where it is headed. Caution is advised when looking at this sector, as cyber security and attacks mean some companies may struggle and eventually get left behind,” says Morton.

Stock tips

The Share Centre’s Forrest recommends Vodafone. The company is sitting on a sizeable cash pile after the sale of its 45 percent stake in Verizon Wireless last year, and intends to fund two extensive expansion efforts with the proceeds – one national, the other international.

“Vodafone is focused on seizing high speed broadband market share in the UK, and has the infrastructure and the cash to do so – only 31 per cent of consumers have it at the moment, so it’s a massive opportunity to them,” he says.

“Vodafone is also focused on establishing operations in emerging markets. If this strategy is successful, the rewards would be significant, as there’s significant demand and much milder competition in developing regions.”

Morton is also a fan, from an income perspective.

“There are certainly many positives within the Vodafone story at the moment, with strong recent results, and an attractive dividend yield of 5.1 per cent,” he says.

“One area to watch though is the company’s £25bn of debt. While not hugely surprising given its relative size, it’s an area we’ll be watching for improvement next year.”

The UK’s other telecoms giant, BT, is also popular with professional investors.

“BT is often overlooked, but the firm’s Open Reach broadband service provides a vital source of income to the business as it supplies the copper wires to major brands such as Sky and TalkTalk. The company’s expansion into television also seems set to be a further success,” says Morton.

Morton’s sentiment is echoed by Forrest. He believes the BT/EE merger demonstrated the firm’s management are prepared to make bold decisions, think big and take calculated risks to improve their standing in the market.

BT is similarly engaged in an effort to step up its presence in emerging markets such as Africa and Asia-Pacific. It currently yields at 2.7 per cent.

At the mid-cap level of the sector, Forrest tips the FTSE 250 listed Telecom Plus. The firm runs Utility Warehouse, which offers bundled packages of gas, electricity, broadband and mobile services to consumers and businesses.

“The firm issued a profit warning in April, with results to be published in December. The warning knocked its shares down 20 per cent, which makes them a great value contrarian stock – the share offers a yield of 3.8 per cent,” he concludes.

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