For the last couple of years now, telecoms have been a very hot sector of the market on account of their stability and the size of their dividends. The price run-ups in U.S. telecom giants Verizon (VZ) and AT&T (T) were so great that it got to be really hard as a value investor to look at these firms. All of that changed over the course of the last month or so as Fed tapering fears, however irrational they may have been, decimated these stocks.
As a result of these stock price declines, long term investors, particularly those interested in income producing stocks, may wish to take another look at the telecom sector. In this article, I highlight one telecom in particular that I think the market has been overlooking, and which seems poised to benefit from the nascent economic recovery.
Importantly, for the purposes of this article, I distinguish between telecom giants like AT&T which are not very speculative (at least as stocks go) and smaller telecoms like Sprint (S) which are clearly much more speculative. This article focuses only on telecom giants, both foreign and domestic. This is not to denigrate firms like Sprint - I just think that they require a different type of analysis.
Now let's start by taking a look at a list of major telecom operators that are easy for U.S. investors to invest in (note that I have not included OTC firms like Deutsche Telecom on this list because of the relative illiquidity of the OTC markets). The chart below shows seven prominent telecom giants, their market caps, yields, and consensus fair value estimates by analysts.
Consensus Fair Value
* TEF temporarily suspended its dividend, but it is supposed to be reinstated late this year.
The first thing you should probably notice about this list of firms is that the traditional fall back valuation measure, the P/E ratio, has little relevance for these companies. P/E ratios simply don't work well for telecom companies which have huge asset bases leading to all sorts of non-cash charges and credits which aren't particularly useful for investors to consider. For this reason, Verizon's P/E ratio appears absurdly high, while Vodafone had such a large non-cash charge in the last year that its P/E isn't even meaningful.
Given this issue, investors could consider cash flow, but this measure is necessarily backward looking. Instead, I prefer to look at the consensus fair value suggested by analysts covering each firm. Looking at this fair value versus the recent price for each stock above shows that while most telecoms were overvalued a month ago, many have now come back down close to their fair value. And two of the firms stand out as being significantly below their consensus fair value; Vodafone (VOD) and Telefonica (TEF).
This discount to fair value makes some sense in the case of Telefonica which is based in Spain and has a significant debt load which forced the company to halt its dividend a while back. While that dividend is supposed to be reinstated later this year, there is a certain degree of risk surrounding the firm that perhaps warrants the current low price. Further, if fears of a Latin America slowdown prove to be accurate, this would hit TEF and Latin American competitor America Movil (AMX) particularly hard.
Yet Vodafone seems like an anomaly in this group. While based in the UK, the firm owns nearly half of the Verizon Wireless business, as well as significant European assets. Indeed, the 45% stake in Verzion Wireless alone is worth at least $100B by Verizon's own estimates, and it may well be worth $120-140B, suggesting that investors are getting the firm's assets in 29 other nations outside the US nearly for free (admittedly less the firm's debt which we will get to in a minute). VOD has slimmed down in recent years selling stakes in China Mobile (CHL), Softbank, and others, but the firm still maintains a robust presence in most major markets and of course in its home country of England.
What's more, with the UK economy finally taking significant steps in the right direction, and even Spain looking slightly better, the future is starting to look brighter for Vodafone and its European operations. Yet despite these positives, VOD carries the significant discount to fair value noted above, and it has a substantial ~5.5% dividend. The firm's dividend varies annually and is paid out semi-annually as is traditional with European equities, but Vodafone has by and large managed its dividend well over the last few years.
Since 2008 when the firm paid out $1.37 in dividends, VOD has consistently paid out large dividends each year including $1.54 in 2012. The firm's June semi-annual payment was $1.05, making it likely that VOD will pay out even more in total this year when it announces its second dividend in November of this year. Since 2007, Vodafone has paid out an average of $1.48 each year, giving it an average yield of over 5% at current market prices.
Now the response from VOD bears of course will be that the firm's dividends are not sustainable and that the Verizon Wireless stake will be difficult to cash out (assuming VOD wants to cash it out). Yet, the asset still has considerable value, and both parties certainly have the ability to come to agreement if desired.
Let's take a look at the firm's financials to assess the firm's debt load.
Fiscal Year Ending:
% LT Debt of Capitalization
Common Shares Outstanding
* November dividend still to be paid, June dividend was $1.05
The table shows that Vodafone's revenues have remained broadly similar over time, but its net income was decimated this year after impairment charges related to its European operations hit its bottom line. These impairment charges, while obviously never desirable, have no material effect on VOD's ability to pay out dividends. Yet investors have been spooked about the stock, with the firm trading more like a junk-bond company than one of the world's largest telecoms with an A- credit rating, and substantial resources.
Further, VOD's debt levels look highly manageable given its asset base and cash holdings. Indeed, VOD may even have an advantage over its American peers in that US interest rates are almost certain to begin going up sooner than UK interest rates, given the state of both economies. With dovish Mark Carney taking over the bank of England, and the economic recovery there at least 12 months behind the US' recovery, VOD shareholders should be able to benefit from central bank largesse for an extended period of time.
What's more, analysts have recently begun to turn positive on the stock suggesting that investors may have an opportunity to invest while the firm is still cheap. A deal with Verizon would surely act as a major positive catalyst for the stock price, but I believe a general restructuring of VOD's European operations could also yield a major share price boost. The firm's move to bid for Germany's Kabel Deutschland suggests Vodafone could be moving in this direction, which would help to improve efficiency across the firm. Indeed, European regulators seem to be pushing all telecoms in this direction, and over time, this should help the firm cut expenses and improve profitability. One example of a potential restructuring cost savings includes using KD's cable and wireless networks to move mobile traffic rather than paying British Telecom (BT) to do it.
Given Vodafone's improving prospects, one would think that the stock price would have risen significantly in the recent past, but as the chart below shows, this is hardly the case. Instead, the stock has been lackluster of late as the chart below shows, suggesting investors still aren't convinced about VOD's prospects. Yet the improving trend for the company is clear and for long term income-oriented investors, VOD seems to offer a nice fixed income stream from a stable firm with ready access to cheap QE-fueled debt.
In summary, of all the major telecom players, Vodafone stands out right now for its inexpensive shares and impressive dividend. The firm has multiple catalysts that could help its stock move higher in the near-to-medium term including a buyout of its Verizon Wireless stake, a restricting of its Europe Operations around the purchase of Kabel Deutscheland, and an improving British economy. With cheap debt conditions likely to persist in the UK longer than in America, and the brunt of the recession likely over, investors should consider VOD's shares at current levels.