Fundamentals Of Telecom, Part I - If You Love Dividends, Time The Capex Cycle

Jul. 31, 2019 2:05 PM ETIridium Communications Inc. (IRDM)T, VZ, BT6 Comments


  • Our first Fundamentals of Telecom article deals with the perils of the capex cycle for telco investors.
  • We couple this with a single-stock thesis on Iridium Satellite Communications.
  • We're moving to Buy - Long Term Hold on Iridium.
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DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.


The theme of our “Fundamentals of Telecom” series is to help our readers and subscribers understand telecom investing better, in order to make sharper investment judgment about your own actual and potential telecom portfolio. (We’ve commenced our “Fundamentals of Software” series in the same vein. You can read the first two notes in that series here - Beating The Fade - Why Product Cycle Innovation Has Kept Microsoft On Top and here - More Cash In The Cloud Than You Might Think ).

We come to this article with a long history in telecom. We’ve invested in a number of carriers and sat on the board of directors of a number of telecom companies. We believe telecom to be a very attractive industry for shareholders when run as infrastructure plays. We don’t like our telcos getting carried away with themselves, believing themselves to be Netflix competitors, IT consultants, or anything else that involves doing much other than sending and receiving signals. We’ve seen it happen a lot over 20+ years and we haven’t seen it generate value very often.

We see telcos as cyclical businesses from a cashflow perspective – not necessarily pro-cyclical with the general economy but certainly pro-cyclical with the technology cycle. To best ride out such cycles, we think the best telco business model is to be as reductionist as possible: spend capex, build network, receive signal, transmit signal, and along the way, send bill, collect cash, ideally before the signal is sent. Provide good customer service to limit churn. Win new customers where you can but don’t discount too heavily in pursuit of those customers, lest you destroy margin for you and all around you. Build new network with new capex investments, as successive technology waves come along. A little bit later than you really should. Not so late that customers leave in material numbers. But not so early that the technology doesn’t work, or that customers don’t yet realize their want or need for the new tech. Now rinse and repeat ad infinitum. That’s pretty much a fifty-year business plan for a telco.

Many investors come to telco in pursuit of income. Most know that telco offers pedestrian growth compared to tech proper; but most also know that cash generation by mature, well-run telcos is prodigious. They tend to produce more cash than they can safely invest and therefore feel compelled to hand it back to shareholders by way of dividends and buybacks.

We believe that shareholders can best enjoy solid income streams if they become shareholders in telcos in between capex cycles. We believe shareholders may benefit from capital gains if they hold during capex cycles - but that is a much riskier business. If you’re an income-oriented investor, capex is bad for you. If you’re chasing capital gain the story is perhaps a little more complicated every now and then. But for most of the last thirty years or so, our observations are: capex up – returns down; capex down – returns up.

We expand on this below.

Our single-stock thesis in this first ‘Fundamentals of Telecom’ article is that Iridium Satellite Communications (NASDAQ:IRDM) is in essence a bare-bones telco and can be invested in as such. We’ve been at Neutral on IRDM since we commenced coverage here - Timing The Temporary Monopoly - Initiating Coverage On Iridium. The stock has risen since then as the business has garnered a firmer footing and put out its Q2 results. The risk has reduced following those results – and following an upgraded credit rating from S&P on 30 July, keeping a B- rating but moving from ‘Stable’ to ‘Positive’ status. We believe now is a good time to enter the stock in order to ride the wave of cashflow resulting from the muted capex in the coming 5-7 years. So we’re moving to Buy – Long Term Hold on IRDM. We set out our logic below, explain where we think some near-term catalysts could be on the stock, and explain what could change in the future to cause us to move to Sell.

The Boredom and Joy of Temporary Monopolies

Telecom is infrastructure in our view. Just like roads, rail and shipping. Indeed facilities-based telco, as it was called when we were young business analysts, is a kind of temporary monopoly – usually geographic. There’s usually only one wireline carrier of any heft in any one region. And wireless carriers have consolidated so much that there are few enough of them that they carry some pricing power with suppliers and customers alike. Now, temporary monopolies come under attack frequently and sometimes those attacks succeed. But whilst the monopoly is in existence, monopoly rents are on offer. That is a juicy prospect for the 99% of the companies in the world that do not enjoy such status. But telcos tend to take it for granted because it has always been thus. And so, rather bored perhaps, telco teams the world over occasionally elect to do something they call “moving up the value chain”. This is a phrase they have seen on a consultant’s slide and it means “capture more of the customer wallet”. It’s a Siren-like promise, particularly to execution-oriented management teams whose goals are to do things like shave a third of a point of gross margin here, or eke out another few dollars of interest benefit there – a day job which offers little high-five-at-the-end-of-the-week stuff. (We don’t mean to be pejorative here. We like telco teams who spend their days eking out a few dollars here and a few dollars there. That’s how you succeed for shareholders in telco). But Siren-like results can often follow from “moving up the value chain”. It is in our view a misleading phrase because if you think about the value chain as the allocation of margin, as opposed to revenue, then bare-bones transmission of electrons along wires, photons along fibers, and radio waves between towers or satellites is a much simpler, less manual, less contingent and therefore more profitable business than (for instance) developing or buying content to send over that network, because making money from content depends on guessing what kind of content people – fickle, fickle people! – want to buy. Wires, fibers and towers don’t fret about content. They just receive the signal and send it on again. And that’s why boring is so profitable in telco.

The El Dorado of Moving Up The Value Chain

Here’s why we don’t like telcos that respond to the Sirens’ call. They tend to develop delusions of grandeur. We’ve used British Telecom in the UK as the example below because it is a fairly clean instance of both an infrastructure play until 2006 and then a “move up the value chain” play thereafter. BT is the national wireline incumbent in the UK – think of it as a mini-Verizon - and it has very little facilities-based competition. It is price-regulated by the state and subject to a universal service obligation but manages to evade most regulatory censures.

From December 2006 onwards it decided to spend big building out a TV service to compete with BSkyB (the dominant UK pay-TV operator which had itself moved into telecom, reselling voice and broadband to consumers). BT then began buying expensive soccer- and other sports rights so that it could develop and produce its own content to deliver over that new TV service.

Here’s what happened to the stock and the dividend.

Firstly the stock took a beating. It took six plus years to recover, and then only fleetingly. (It’s not fair to lump the 2014-present day decline solely on the company overspending on TV. Along the way they had a malfunctioning IT services business too – but we think that rather supports our argument which is – in telecom, keep it simple).

Secondly, look at the dividend – the cash actually paid out per share, not the yield. It plunged as cash was sucked into content acquisition, and has never recovered.

Capex Is Bad For Your Dividend’s Health

Now to look at some other examples, just in chart form this time. Our working thesis is – when capex is low as a percentage of sales, total shareholder returns – capital gain and dividends - are good.

Here’s Verizon (VZ):

AT&T (T):

And as we’ve already had one overseas telco, let’s include another, NTT (the Japanese incumbent):

These charts all tell the same story. They say – there was period in the late 1990s, through 2000, when big capex looked like “investing in the future” and that pushed up total shareholder return. But since then, there has been an inverse relationship between capex levels and total shareholder return. In other words – when the gold rush was on, shareholders rewarded telcos for spending big – because they hoped and expected that big spend would deliver huge financial returns. As we now know about that period, capex levels became unsustainable and uneconomic; fiber overcapacity abounded; bondholders were burned very badly; shareholders in risky carriers such as Worldcom lost it all; and shareholders in even the most staid of telcos felt the pain. In the more rational times that followed the dot com bust, as capex levels fall, total shareholder returns rise.

We wondered whether we could break this down further, to isolate the gold rush effect. We found the simple truth in dividend yields. This one chart tells the story.

Capex, to state the obvious, is the enemy of the dividend. Capex up, dividend yield down. Capex down, dividend yield up.

Now, you can’t not spend capex in telco. If you don’t, although you’ll have a fat dividend for a while, in the end the revenue will decline, then the profit declines, as customers go elsewhere. So the game here is all about being a shareholder during periods of low capex intensity.

Our message is: if you are an income-hungry investor, as much as telecom looks a glittering sector with tales of high dividend yield from apparently very stable companies, look carefully at the capex plans of the telco you’re considering taking a stake in – and indeed the telcos you already have a stake in. You might take this as a cautionary note as regards the pending 5G wireless buildout. In which case you may want to look closely at the capex forecasts of your favorite telcos to see what that might do for your dividend and you might think to time your entry and exit into / out of the stock accordingly.

Our purpose here today though is a rather more positive one. We want to highlight in the above context our move to Buy – Long Term Hold on Iridium. Here’s a company where the capex has been spent, nobody is talking about buying movie or sports rights, and the job at hand appears to be – grow core business at a reasonable rate, collect cash, pay down debt, commence shareholder-friendly actions. Now this sounds good to us.

Iridium – The Purest of Pureplay Telcos

Iridium is a satellite comms business – don’t let that alarm you. Satellites are like small telecom towers in the sky which are particularly pricey to put in place. (But [Introduction To Investing In The New Space Race ] – a lot less pricey than they used to be). IRDM is really just a global wireless carrier that handles a limited service set and doesn’t have to hand over great gobs of cash to handset vendors in order that its customers can pretend to be able to afford the supercomputer in their pocket, aka. the latest and greatest phone.

Here’s Iridium’s business model. Buy fleet of satellites. Pay someone to put satellites on orbit. Beam signal to satellite from ground station or direct from handset. Beam signal from satellite to satellite. Beam signal back down to ground. Send bill. Collect cash. Buy the occasional replacement satellite when one fails and have someone put it on orbit. Continue to beam signals. Collect cash. Wait seven years. Buy another fleet of satellites. Repeat.

Now, as you can read in the article we linked above, Iridium’s service isn’t the same as that which will be operated by OneWeb, SpaceX, Amazon or any of the other “new constellation” service providers you keep reading about. No, Iridium is a different beast. It offers low bit rate, high reliability communications. The aforementioned vendors will offer high bit rate, lower reliability communications. IRDM operates in L-band spectrum (1-2GHz frequency range), the others in Ka-band (26.5-40.0GHz frequency range). If you are an old telco type like us, the best analogy for this is to think of IRDM as offering X.25 or ATM type services, which is to say service-assured, high-cost high reliability services; and the others as offering IP type service, which is to say low-cost lower-reliability services. There are some sorts of data you want to send over ATM/L-band – basically machine-to-machine safety-critical data, and business-critical voice - and some sorts you want to send over IP/Ka-band – basically consumer voice, data and video. We are simplifying for effect here but you get the point. If the data has to get there, whatever the weather, and you don’t mind it taking awhile, send it over L-band spectrum. If the data really ought to get there but nothing too bad happens if it doesn’t – but it can get there quickly if it’s not raining – send it over Ka-band.

IRDM does offer a couple of “value-added services” as they were called in the 1990s, including ‘hosted payload’ which is basically renting out satellite real estate to third parties so those third parties can use their own antennae on IRDM’s satellites to do as they please. But in essence – IRDM is telco reductio ad absurdum. It’s as simple as it gets. We love simple.

Let’s look at some numbers. Here’s the ten years running up to the end of 2018.

Wait – wasn’t this a note about dividends? Where’s the cashflow? Negative unlevered pretax cashflow AND heavy indebtedness? That’s right. This is what we’re talking about. Check the capex line. That’s what it costs to roll out a fleet of satellites. Ouch.

But here’s why we think the stock is getting interesting.

Here’s our 5-year forecast model. It’s based on the company’s 2019 guidance, plus their investor day presentation (which you can find here) and our interpretation of the commentary given to us by IRDM management (remember – they can and do only give us information already in the public domain).

You can read the model at your leisure. The key line items are – capex plunging and staying low; low debt repayments; and low cash taxes. This results in rapid deleverage, falling from an EV/TTM EBITDA of 6.5x at the end of 2018 to 2.8x at the end of 2022. That is quick indeed.

Not featured in the above model is any dividend payments. But look what IRDM said during their investor day: that they plan to “maintain target debt ratios at 2.5x – 3.5x OEBITDA and use excess cash for dividends, share buybacks, and strategic investments if compelling”. Note that’s an OEBITDA multiple, ie. before share based comp. So from about mid 2021, if our model is correct, the company will be in a position to commence paying dividends. When it does, we would expect an uplift in the stock, because more funds will be able to own the company and will buy into the stock in anticipation of the coming dividends.

Here’s our back-of-the-envelope calculation of the near term dividend potential. We think the yield on the current stock price could be somewhere between 4-8% by 2022, and between 7-15% by 2023. So you may have to wait a little while, but those yields are attractive from such a predictable business. In addition, you’re likely to tuck in some capital gains too. (We’ll take you through our returns model and show the blended IRR of the potential cap gain and dividend yield in our next note on IRDM, which will incorporate our Q2 earnings review and management call).

Moving to Buy – Long Term Hold on IRDM.

We think IRDM is now a compelling investment opportunity. But it’s quite time consuming to work out why – because the headline multiples are far too high at first glance. Stick with us whilst we walk you through it.

First up, the simple valuation.

Now clearly 9x trailing twelve month revenues is a lot for a company growing total revenues at a couple of points per year. That’s what the headlines tell you. But work with us as we look deeper.

Let’s look at the current valuation as a function of cashflow (rather than revenue or EBITDA or OEBITDA). In the table below we keep the share price constant at last night’s closing value and we project that forward based on the reducing net debt and a modest growth in shares outstanding (a result of stock-based compensation going forward).

Our color coding tells you the story. The revenue multiple is very high – this is an arithmetic function of the company having very high EBITDA margins. The EBITDA multiple is OK; the post-capex, pre-tax “unlevered FCF” multiple is good – and the post-tax version thereof is very good for the simple reason that there is very little tax to pay. We can all understand that if post-tax cashflow is similar to pretax cashflow then that’s a good thing.

Now, we want to go on a little creative detour. Indulge us whilst we do so. We want to look at – let’s imagine IRDM does achieve its plans for 2019 ie. not much capex, not much tax, but solid cashflow growth and solid core revenue growth. And let’s compare this to other companies – we’re going to use other telcos – AT&T and VZ – and also some mature tech companies, Microsoft, Apple and Google. Indulgence here is required because rather than invent some TTM pro forma for IRDM to 30 June (stripping out capex etc) we’re just using IRDM 2019 numbers at the midpoint of their OEBITDA guidance – we make assumptions based on history as to how OEBITDA translates to EBITDA. What we’re trying to do is show a steady-state IRDM as it is now, vs. the other steady-state comparables. The fundamental assumption here is that IRDM can more or less hit its 2019 guidance. We believe they believe they can do it – and for now that’s good enough for us.

Here’s how it all compares. We highlight two lines below. Market cap divided by post-tax free cashflow. That tells us – what do equity owners get at the end of the year after the company has paid the lenders and the IRS. Warren Buffett might call this “owner earnings”. And “core service revenue growth”. Now we’ve had to guess this for AT&T because they don’t publish the pro forma excluding the recent Time Warner acquisition. AT&T states in its SEC filings that substantially its revenue growth comes from the acquisition. So we’ve used +1.5% as core growth for A&T. Could be high or low – we suspect not far off reality.

Now let’s look at the above table in visual form.

If our analysis is right, and we’re aware there’s a couple of leaps in it, then it means IRDM is achieving core revenue growth which is faster than it “should” do for its post-tax FCF yield. And that means it is very efficient with cash. And that is because it’s set to ride the capex holiday. And that means we think the time is right to invest.

We’re backing our judgment. We’ve seen a couple telcos like this before and it’s worked out well for us. So we’re going with it. We’re moving to Buy – Long Term Hold.

In our next note on IRDM, which will be out soon, we’ll review their Q2 in detail and set some price targets for you to consider. For now we’d highlight a couple final points.

Firstly, positive catalysts for the stock. We think there are three. S&P just upgraded their credit outlook from ‘stable’ to ‘positive’ – that will ripple through the market. The company is due to sign a contract with the US federal government which will be very material in size. And finally, we expect a refinancing soon, taking out the French government-backed lender and bringing on board typical US leveraged loan players. That ought to result in the release of the restricted cash and the freeing of the IRDM management team to take more shareholder-friendly actions, such as dividends.

Secondly, downsides. This company has some volatility in the stock – this is likely due to the leverage, which can be good on the way up and bad on the way down. If you want to hold for the long term you will likely have to ride out some volatility. We don’t comment on allocation sizes but we ourselves intend to take a small long-only position on a personal account basis – we won’t buy for at least 24hrs after this article is published – and we will be starting with a small position so that we can add through any dips that present themselves. Also – as you can see above, this investment idea only works if the company succeeds in delevering. If that delevering is not happening – and revenue growth isn’t faster in order to compensate - then we will move to Sell and you might think about doing the same.

Cestrian Capital Research, Inc – 31 July 2019

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IRDM over 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.

Additional disclosure: We intend to add a small long equity position on a personal account basis. We won't take the position for at least 24 hours after publication of this article.

We are long MSFT on a personal account basis.

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