3 Communication Stocks Likely to Transcend Margin Blues

The Zacks Diversified Communication Services industry appears to be mired in demand volatility as consumers prefer to switch to low-priced alternatives to tide over the macroeconomic challenges induced by high inflationary pressure. Moreover, high capital expenditures for 5G infrastructure upgrades, unpredictable raw material prices, chip shortage-led supply-chain disruptions and margin erosion due to price wars have dented the industry’s profitability.

Deutsche Telekom AG DTEGY, TELUS Corporation TU and Telefónica, S.A. TEF should benefit in the long run from higher demand for scalable infrastructure for seamless connectivity amid the wide proliferation of IoT, driven by a faster pace of 5G deployment.

Industry Description

The Zacks Diversified Communication Services industry comprises firms that provide a wide array of communication services, including wireless, wireline and Internet, to business enterprises and consumers. These companies offer mobile and wireline telephone services along with high-speed Internet, direct-to-home satellite television and other value-added services. In addition to providing integrated information and communications technology services to businesses and governments, some of these companies operate as local exchange carriers or full-service providers of data center colocation and related managed services in state-of-the-art data center facilities. Some industry participants also provide IP networks, private lines, network management and hosting services, along with sales, installation and maintenance of major branded IT and telephony equipment.

What’s Shaping the Future of the Diversified Communication Services Industry?

Persistent Demand Erosion: Efforts to offset substantial capital expenditure for upgrading network infrastructure by raising fees have resulted in reduced demand, as customers prefer to switch to lower-priced alternatives. Moreover, the local-line access for traditional telephony services continues to decline among large customers due to higher wireless substitution and migration to IP-based services. This is reflected in the persistent erosion in overall network access services on a year-over-year basis, hurting revenues of local and long-distance operations. With Digital Subscriber Line and cable modems gaining widespread acceptance, customers are deactivating extra phone lines that were earlier used to access the Internet via dial-up modem. In addition, a shift toward wireless services and the aggressive rollout of VoIP and long-distance services by Tier-1 competitors have resulted in access line erosion. These adverse impacts have become more pronounced with fresh lockdown restrictions in China and oil price volatility, triggered by the prolonged Russia-Ukraine war.

Supply Chain Woes: The industry continues to face an acute shortage of chips, which are the building blocks for various equipment used by telecom carriers. Moreover, high raw material prices due to inflation and economic sanctions against the Putin regime have affected the operation schedule of various firms. Although various steps have been taken to address the global shortage of semiconductor chips and devise ways to increase domestic production, the demand-supply imbalance has crippled operations and largely affected profitability due to inflated equipment prices. The government has also pledged bipartisan support to ramp up production capacity and reduce supply bottlenecks while eliminating dependence on countries like China. However, unless the policy guidelines assume a tangible effect, the industry firms are likely to face short-term challenges, affecting their cash flow.

Depleted Margins for Infrastructure Upgrade Investments: Video and other bandwidth-intensive applications have witnessed exponential growth owing to the wide proliferation of smartphones and increased deployment of the superfast 5G technology. This has forced the industry participants to invest considerably in LTE, broadband and fiber to provide additional capacity and ramp up the Internet and wireless networks. These companies are rapidly transforming themselves from legacy copper-based telecommunications firms to technology powerhouses, with capabilities to meet the growing demand for flexible data, video, voice and IP solutions. At the same time, the industry participants continue to focus on leveraging wireline momentum, expanding media coverage, improving customer service and achieving a competitive cost structure to generate higher average revenue per user while attracting new customers. Also, these firms offer the flexibility to better manage data traffic by leveraging indigenous software-defined networks to enable low-latency, high-bandwidth applications for faster access to data processing. Although these infrastructure investments are likely to prove beneficial in the long run, short-term profitability has largely been compromised.

Integrated Customized Offering to Mitigate Risks: In order to improve profitability, the companies are increasingly focusing on providing support services to various small and mid-sized businesses (SMBs) with an integrated portfolio of voice, data and technology services. The firms are tailoring their services to suit individual business needs and are facilitating SMBs to better adapt themselves to necessary technology advancements. At the same time, the industry is battling hard-to-mitigate operating risks stemming from volatility in demand, an unpredictable business environment led by the virus outbreak and challenging geopolitical scenarios by offering free services to low-income families and seamless wireless connectivity to the masses.

Zacks Industry Rank Indicates Bearish Trends

The Zacks Diversified Communication Services industry is housed within the broader Zacks Utilities sector. It carries a Zacks Industry Rank #170, which places it in the bottom 32% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings growth potential. Before we present a few diversified communication stocks that are well-positioned to outperform the market based on a relatively modest earnings outlook, let’s take a look at the industry’s recent stock market performance and valuation picture.

Industry Outperforms S&P 500, Lags Sector

The Zacks Diversified Communication Services industry has outperformed the S&P 500 composite over the past year but lagged the broader Zacks Utilities sector largely due to macroeconomic challenges.

The industry has lost 5.2% over this period compared with the S&P 500’s decline of 10.2% and the sector’s rally of 7.9%.

One Year Price Performance

3 Communication Stocks Likely to Transcend Margin Blues

Industry’s Current Valuation

On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA), which is the most appropriate multiple for valuing telecom stocks, the industry is currently trading at 14.24X compared with the S&P 500’s 12.55X. It is trading below the sector’s trailing-12-month EV/EBITDA of 18.97X.

Over the past five years, the industry has traded as high as 15.87X and as low as 7.11X and at the median of 11.63X, as the chart below shows.

Trailing 12-Month enterprise value-to EBITDA (EV/EBITDA) Ratio

3 Diversified Communication Services Stocks Likely to Move Ahead of the Pack

Deutsche Telekom AG: Headquartered in Bonn, Germany, Deutsche Telecom is one of the largest telecommunications service providers in Europe. In addition to its strong position in the domestic market, the company is likely to benefit from the accretive post-merger integration of T-Mobile US Inc. and Sprite in the United States, in which it owns about 43%. The removal of forced cable TV access in multiple dwelling units in Germany through telecom legislation is likely to help the company expand its broadband market. Moreover, an aggressive fiber rollout strategy across the country is expected to augment its domestic market hold. The Zacks Consensus Estimate for current-year earnings has been revised 3% upward since July 2022. The stock carries a Zacks Rank #3 (Hold). It has a VGM Score of A and a long-term earnings growth expectation of 17.4%. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Price and Consensus: DTEGY

TELUS Corporation: Based in Burnaby, British Columbia, TELUS is one of the largest telecom carriers in Canada. It provides wireless, wireline, and Internet communications services for voice and data to businesses and consumers. TELUS has launched 5G networks in several places across Canada. The company has made a series of investments to launch its PureFibre and 5G network that will likely help to boost its subscriber base. TELUS’ 4G LTE network covers 99% of the country’s population and the addition of the 600 MHz spectrum will help it increase urban capacity, while expanding the rural availability of wireless broadband service. It is well positioned to benefit from the increasing penetration of smart devices, wireless data services and wireline fiber optic networks. TELUS expects balanced growth in its TTech and Digitally-led customer experiences, backed by investments in high-speed broadband technology. This Zacks Rank #3 stock has a long-term earnings growth expectation of 10.2% and delivered an earnings surprise of 2%, on average, in the trailing four quarters. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 4% and 5.5%, respectively, over the past year.

Price and Consensus: TU

Telefónica, S.A.: Based in Madrid, Spain, Telefonica provides mobile and fixed communication services in Europe and Latin America. In recent years, it has invested heavily in the deployment and transformation of its network to provide excellent connectivity in terms of capacity, speed, coverage and security. Telefonica aims to optimize value creation by prioritizing investment in its core operations. The company intends to optimize its Hispam operations to streamline the Group structure, reduce exposure to emerging markets and foreign exchange volatility, and accelerate deleveraging. Telefonica has restructured its Latin American business while remaining focused on other key European markets and the United States. With a major upheaval in eight Latin American markets, the company aims to “reinvent” itself. It is augmenting its 5G network infrastructure in Spain by reinforcing the long-term partnership with Huawei. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 19.4% and 11.8%, respectively, over the past year. The stock carries a Zacks Rank #3 and has a long-term earnings growth expectation of 15.9%.

Price and Consensus: TEF

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