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Telecommunication (telecom) stocks have long been a core holding of conservative investors. Some investors like to own stocks in this sector because of their predictable earnings and high dividends. The companies typically don't grow much, but that isn't what these investors are looking for from the investment. They are looking for predictable income. Yep, telecom stocks are about as close to a "widows-and-orphans" bond portfolio as you can get in the stock arena. Four reasons outlined below suggest these companies could be risky investments going forward.

Why would I say such a thing about AT&T (T), Verizon (VZ), Sprint (S), and T-Mobile (TMUS)? First and foremost, because a price war has broken out. This price war could not have come at a worse time for the biggest players in the US cellular space. The war began to hit a fevered pitch last year, when T-Mobile announced that it would pay the switching/buyout costs of current AT&T customers who switched their service to T-Mobile. (Business Week articles are linked to the various developments). T-Mobile then announced that it would also cut all manner of fees for American customers traveling abroad, and eliminate service contracts. Those fees provide great profit margins for carriers. Many immediately, and I feel accurately, saw this as an attempt by T-Mobile to sacrifice profits to buy US market share.

Not to be outdone, AT&T responded with a deal to pay current T-Mobile customers $450 to switch their service to AT&T. So what's the big deal, you ask? Well, those service contracts encourage the stable customer base that service providers have always relied upon. They keep customers locked in their current plans, with a particular service provider, for years. Without high switching costs, phone cell providers become just another commodity business. I don't often invest in commodity businesses, because they lack pricing power. I can assure you that I (personally) don't care whether my cell phone provider is AT&T or Verizon, I just want a functional system at the lowest possible cost. Now, I receive weekly offers in the mail for low-cost phone service from all four of the large legacy carriers (AT&T, Verizon, Sprint, and T-Mobile). Each company offers plans that would have been unimaginable a few years ago. The latest from AT&T is a good example. I was offered a contract-free $40 per month plan that included Unlimited Talk and Text, plus 2 MB of data. It was only two years ago that I had a $40 per month plan with AT&T that only included 450 anytime minutes and unlimited mobile-to-mobile minutes. Unlimited text messages would have cost another $20 per month, and much more for a data package. So I have to ask myself, if these companies cut their plan premiums by so much, are they adding enough new customers to make up the difference?

The four primary issues I see for US cell phone providers are as follows:

  1. Increased Competition. As with the examples I have outlined above, the major players are utilizing aggressive pricing in order to try and grow market share. This is happening at the same time that new, less expensive providers (such as Metro PCS, Republic Wireless, US Cellular, Scratch Wireless, and others), often with newer technology, have entered the market. Many of these lower-cost options utilize local wireless (wi-fi) networks in order to keep costs down by keeping the phone calls off of cell towers. Republic Wireless, for instance, offers wi-fi-only plans for $5 per month, and other more typical cell plans starting at $10 per month. Republic Wireless is a fairly small company, but do you think consumers will notice when they are offered plans for 75% less than the competition? I do, and I know several satisfied customers! Increased competition is always good for consumers, but not for service providers.

  2. Limited Wireless Spectrum. The linked Denver Post article accurately portrays that even back in 2012, available cell phone spectrum capacity in the US was running out. In the article, it was suggested that cell phone companies would pay more and more to use the available cell phone spectrum, and pass along those costs to consumers. As we now know, service providers have actually had to cut plan premiums in order to fight competition. It is my belief that the cost to license available cell phone spectrum will continue to rise, but cell phone providers will not be able to pass those costs along to consumers. Which will squeeze profit margins.

  3. Higher Data Usage Requirements. To exacerbate the limited wireless spectrum issues listed above, consumers are using ever-increasing amounts of data bandwidth. We don't need a newspaper article to know this, we all see it every day. As more powerful "smart" cell phones have become available, consumers have found more uses for those powerful phones. (For all the techies out there, doesn't this remind you of the law of Andy and Bill?) The Law of Andy and Bill was the idea that the more powerful computer chips Andy (Grove, the CEO of Intel) provided... the more power Bill (Gates, founder of Microsoft) would consume with his new software programs. The most obvious manifestation is the popularity of watching viewing video content on cell phones. Were you watching videos on your cell phone four years ago? Probably not, but now... How many times per week do you watch a news or YouTube clip on your phone? How about a Facebook (FB) video? All that video requires far more of the data spectrum than typical (voice) phone calls. The only way that the increase in video utilization has not eroded the available spectrum capacity further is if there are less cell phone users (with fewer smartphones). Do you really think there are fewer users?

  4. Flat Consumer Wages. The final piece of this perfect storm is the lack of wage growth for the average consumer who uses cell phone plans. In order for service providers to be able to pass along higher costs to the consumers, those consumers have to be able to pay those higher costs. The fact is that many consumers have lower wages today than they did 5 years ago, when adjusted for inflation. These "squeezed" consumers have less disposable income, and therefore, less money to spend on cell phone luxuries. These consumers have also contributed to the dramatic expansion of the prepaid cell phone market. Which, again, has led to more competition and reduced pricing power for cell phone providers.

Conclusion

It is my belief that until there is dramatic consolidation within the US service provider sector, cell phone companies will continue to see pricing power erode and margins get squeezed. Therefore, I am not a buyer of any of the service provider stocks mentioned in this article. Past experience with commercial air carriers suggests that when enough of the companies merge or go bankrupt, pricing power will return. We are, however, a long way from this much-needed consolidation. The final sentence in this article reiterates these companies' most telling struggle. Please note that the 5-year operating margin trends for both AT&T and Verizon have been skewed by very positive 2013 results. The long-term and 5-year growth in operating margins (according to GuruFocus.com) are as follows: Verizon (-1.89% long-term, 10.31% 5-year); AT&T (-3.28%, 2.24%); Sprint (N/A, -14.5%); T-Mobile (N/A, -0.96%).

Source: Look Out Below! These Telecoms Are Going Lower