For the past few years, telecom stocks have been an extremely popular way for investors to generate solid yields in a very low interest rate environment. These types of stocks are seen as "safe" blue chips and the yields provided certainly beat what is offered in money market or savings accounts. The thirst for yield has pushed many dividend stocks higher and even to historical records in some cases. While investors in the telecom sector have generally enjoyed strong dividends and even significant capital appreciation for the past few years, this could all be about to change going forward as multiple challenges appear to be mounting for telecoms. Here are a few reasons why popular telecom stocks like Verizon Communications, Inc. (NYSE:VZ) and AT&T (NYSE:T) could be poised for significant declines in the future:
1) Telecom stocks are overvalued: Companies in this sector traditionally grow at a very slow pace and therefore typically deserve a below market price-to-earnings ratio. It seems that many retail investors are ignoring this historical data; however, it is easy to find more sophisticated analysts who are warning that telecom valuations are extended. One analyst at Alliance Bernstein believes that valuations are stretched for stocks like Verizon since it now trades for around 18 times earnings.
A Barron's article also notes that the price-to-earnings ratio valuation for some telecom stocks is now more than double the historical norm and it states:
When this bull run began in March 2009, telecom stocks fetched just 9.2 times what phone companies had earned over the preceding 12 months, according to data from Bespoke Investment Group. By last week, that had jumped to 23 times-the biggest increase of any sector excluding financials, and a sign that telecom stocks are rising much faster than their earnings.
2) Interest rates are rising: Telecom stocks were huge beneficiaries
of low interest rates since investors flocked to these stocks for yields of about 4-5%. Investors also have seemed to ignore the fact that companies in this sector have very low growth rates. Growth has been hard to come by in many sectors over the past few years due to the financial crisis and recession. However, with signs that the housing market is rebounding and with the jobs picture improving, growth is accelerating in certain sectors. This means that investors might be better off seeking sectors that can benefit from the re-accelerating growth in sectors outside of telecom. It also means that interest rates (which have already started to jump) could be poised to climb higher over the next couple of years. This could make the dividend yields offered by Verizon and AT&T far less attractive in the future and this could lead to lower share prices.
3) Competitive threats are on the horizon and real: A number of new companies and technologies could pose real competitive threats against Verizon and AT&T. If you think these companies are too big to be impacted by some little upstart just take a look at what Iliad has done in France. Iliad started to offer low cost mobile phone plans in France only about a year ago and it already has captured over 5 million customers or about 6% of the market. It continues to grow fast so there is a strong chance that Iliad will capture an even larger percentage of the mobile phone market in France. This new competition has forced France Telecom (FTE) to cut prices and that has hurt profit margins. These woes have even caused the company to reduce its dividend.
There are a few much smaller companies that could pose this type of threat to Verizon and AT&T. For example, a relatively new company called "Freedom Pop" is now offering extremely low-cost mobile phone services and very cheap data rates. As phone services became less profitable for major carriers, data plans helped to offset weaker profit margins but that could be about to change. A company that offers cheap data plans could force painful cuts for the major carriers. That could lower profit margins, which in turn could limit dividend increases or even cause cutbacks in dividend payouts in the future. It's very possible that earnings growth will be impacted in the future by data plan competition and that could mean earnings have peaked for now with these companies.
Analysts expect Verizon to earn $2.80 per share in 2013. That puts the price-to-earnings ratio at more than 18 times earnings. Verizon yields just about 4% and AT&T yields around 5%. AT&T is expected to earn about $2.50 per share in 2013, which implies a PE ratio of about 15 times. This means that Verizon appears to be even more overvalued, especially when considering that the average stock in the S&P 500 Index (NYSEARCA:SPY) currently trades for about 15 times earnings and could have better growth prospects than the telecom sector. With all these major headwinds looming, investors should consider that the best days might be over for telecom stocks.
Here are some key points for AT&T:
Current share price: $36
The 52-week range is $32.71 to $39
Earnings estimates for fiscal year 2013: $2.50 per share
Earnings estimates for fiscal year 2014: $2.69 per share
Annual dividend: $1.80 per share, which yields about 5%
Here are some key points for VZ:
Current share price: $51.20
The 52-week range is $40.51 to $54.31
Earnings estimates for 2013: $2.80 per share
Earnings estimates for 2014: $3.23 per share
Annual dividend: $2.06 per share, which yields 4%
Data sourced from Yahoo Finance. No guarantees or representations are made.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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