Take a Closer Look at ADC Telecom, Chungwha Telecom

As we start to gain a better perspective on the way 2008 is beginning to shape up, one group that looks to benefit from its attractive valuation at this point are the telecoms. But which stocks in this group are the best Buys? Zacks senior telecom industry analyst David Weissman, CFA stopped by to help us out with this.

Have we noticed a somewhat more favorable light being cast on the telecommunications industry these days?

If you have, it’s understandable as to why. The 2008 outlook for the telecommunications industry has become more favorable with recent valuation pullbacks of major telecom equity shares. The fundamental downturn may have reached a bottom, as telecommunication companies reduced spending and improved operating performance over the past several quarters.

In addition, telecommunications companies continue to be the largest group in terms of Mergers and Acquisitions [M&A]. Consolidation among the largest telecommunications services-focused companies has created an environment where equipment-focused companies now interact, on a relative basis, with fewer customers and reduced selling opportunities. This has incubated consolidation among equipment companies, as well to enhance marketing value by broadening product offerings for converged wireless and wireline networks.

Where are there pitfalls within this scenario?

The economic scale of consolidated telecom service companies is creating pricing pressure and margin erosion potential as equipment companies contend for contracts based on pricing and features. Long-term growth prospects for the sector are not nearly as favorable as in the early part of 2000, but are more attractive than in 2006, with continued consolidation expected.

What’s worse about the near-term outlook these days?

While telecom carriers plan to increase capital expenditures in 2008, they will be more selective on technology choices and identify cost savings synergies, such as streamlining purchasing arrangements and limiting the number of preferred vendors. In addition, shareholders continue to foster an environment where executives are held accountable to focus more on balance sheet improvements, financial discipline and improving free cash flow. This promotes greater diligence in investment decisions for long-term growth initiatives. Unfortunately for the equipment vendors, the conservative nature of tightened capital outlay remains the method of choice for improving free cash flow.

In recognition of spending constraints by carriers, telecom equipment vendors have already prepared by slashing expenses also in response to the previous protracted industry downturn. Now that expenses are under control and productivity is at higher levels, profit margins, in general, are expected to respond rapidly even with a modest pickup in demand.

Companies that offer the most opportunities are focused on third-generation (3G) wireless, broadband [DSL] and fiber-to-the-home/node networking. There are also a few market leaders that have proven able to survive the sometimes turbulent opportunity swings in the industry.

So, with all that said, where are your telecom Buy recommendations right now?

Well, in the past 30 days or so, we have only issued two Buy recommendations. One was upgraded from a Hold – ADC Telecommunications (ADCT). ADC Telecommunications is a global communications network infrastructure solutions provider, due to proliferating global fiber network connectivity which has considerably improved the company’s earnings visibility.

The other is for Chungwha Telecom Co. (CHT), the Taipei-based company which is the largest telecom supplier in Taiwan. We believe the gradual migration to 3G wireless technology is likely to benefit the company’s financials in 2008 and beyond.

Since the telecom subscriber base of Taiwan is near saturation, Chunghwa has undertaken initiatives, in synergy with its strong balance sheet, to implement a next-generation converged-IP network as it expands coverage outside Asia. This new endeavor enables the company to provide services in different regions of Europe and the U.S.

David Weissman, CFA is a senior analyst covering the telecommunications industry for Zacks Equity Research.