Greater demand for data and innovation will provide growth drivers for telecom in the years ahead. The race to monopolize the market will result in an aggressive takeover environment that is sure to make winners and losers. Fortunately, I have been pretty accurate in my bullish outlook on the sector. Since I first disclosed my bullish outlook on Verizon (VZ) here, the stock has gained by 18.6% and outperformed the S&P 500 by 818 basis points. My optimistic take on AT&T (T) here was also reinforced by a subsequent 22.5% gain and 1,531 outperformance of the S&P 500. Investors may consider going long AT&T and Verizon while shorting Sprint (S) to benefit from both the spread and high dividend yields.
There are several reasons to be optimistic about AT&T. First, the company is led by top management that I believe understands how crucial expansion is to survival in telecom. Carlos Slim of America Movil (AMX) has taken this strategy for years in the Latin American market, it makes sense that American producers aggressively pursue the same thing in domestic markets (to say nothing about emerging ones.) The failed takeover attempt of T-Mobile may have highlighted the nightmarish hurdles to value creation in the face of the "Department of Justice", but the firm maintains the right approach.
Despite a challenging environment, earnings have also been decent. First quarter results were 5.3% ahead of consensus, but the preceding one was a 2.3% miss. The 4.9% dividend yield also leads Verizon and comes with the added bonus of greater scale.
With that said, multiples and earnings momentum are not the most attractive. If the firm yields a conservative $2.50 in FY2013 and trades at 16x earnings, the future value will be $40. Discounting backwards by a lenient WACC of 5% yields a target price that is roughly around the current price. The 5-year average PE multiple is 20.5x, however, and by this metric, the target price would rise to $46.49 - a 30%+ margin of safety (but be mindful of the generous 5% discount rate)
In light of the limited value creating prospects in the next few years, I recommend AT&T only as a solid income investment. The company is incredibly safe with nearly half the volatility of the broader market, excellent management, and a high dividend yield.
Ditto for Verizon, which trades at a respective 46.7x and 15.6x past and forward earnings. Like AT&T, earnings have been generally better-than-expected against a poor backdrop but not excellent. The firm's 5-year average PE multiple stands at 29.2x, and EPS is expected to grow annually by 9.3% over the next five years. If 2016 EPS comes out to $3.57 and the stock trades at just a 15x multiple, the future value of the stock is $53.52. Discounted backwards by 10%, the present value ($33.23) is well below the current $43.55 price. Volatility is still complemented by the 4.6% dividend yield. Accordingly, the Street only rates the firm a "hold", and the price target is below current valuation.
Sprint is the precarious player in telecom. From the sales tax blunder to desperately attempting to block the failed AT&T - T-Mobile merger, the cell phone carrier appears to be hanging on its last few lines. Free cash flow narrowed from $2.4B in FY2010 to just $303M in FY2011. On the other hand, earnings has been substantially better than expectations over the last five quarters. In fact, Sprint has beat consensus by an average of 35%. While shorting the stock in the context of going long AT&T and Verizon seems like an attractive way to lock in returns and 4.5%+ income gains, the strategy also has its risks. With so much negativity factored into Sprint's stock price, signs of entering positive territory quicker-than-expected would drive substantial outperformance.