Mobile’s moment Mobile’s moment

It is good to talk again. If there is one sign that the telecom sector is bouncing back from the excesses of the late 1990s and the costly pursuit of 3G licences, it is the “will it or won’t it?” guessing game surrounding Vodafone’s possible multi-million pound bid for AT&T Wireless. After much speculation, Vodafone finally admitted on February 9 that it is exploring a bid. The merits of a possible bid by Vodafone, and whether it is being forced into a deal, may have divided shareholders and analysts but it is its most ambitious move since the £100bn takeover of Mannesmann in 1999. There are clear signs that consumers are keen to talk and text as well. In the UK, there are 48 million users of mobile phones and the net figure is increasing every day. An estimated 58 million text messages a day are sent. To paraphrase an advertisement for a telephone operator, these numbers suggest the future is bright for telecoms. But telecoms is not a homogeneous sector. The main subsectors are incumbents such as BT, mobile operators like Vodafone, alternatives such as Colt Telecom and equipment companies such as Nokia and Ericsson. Most analysts and fund managers argue that the fastest rate of growth will come from the mobile subsector, with the greatest uncertainty surrounding the alternatives, while the incumbents face a future of utility-like returns. Therefore, it may be more accurate to paraphrase the advert as “the future is bright, the future is mobile”. As the third leg of the TMT triumvirate, telecom stocks were driven higher in price during the technology bubble as commentators predicted a new “paradigm” partly based on a revolution in communications. The sector obviously suffered, along with technology, after the bubble burst. This was compounded by the high levels of debt accumulated by many telecom companies in buying 3G licences and shareholdings in other telecom businesses around the world. Telenor in Norway, for example, even gained a presence in the Bangladesh market, which is currently a strong growth area. The recovery in telecom share prices since late 2002 (it was the first part of TMT to recover) has renewed confidence among some investors that the sector is set to fulfil the growth predictions of the late 1990s. But while greater optimism about telecoms is warranted, like all sectors, the key to success is stock selection. Over one year to January 31, the FTSE UK All-Share Telecommunications Services index has delivered a return of 22.5% compared with 16.6% from the FTSE All-Share index. But fortunes are reversed over three and five years. Over these time periods, the telecoms index returned -52.2% and -48.9% respectively, compared with -26% and 17.4% from the All-Share. The picture is worse for global telecoms. The FTSE All World Telecommunications Services index has delivered a return of 15.3% over one year, -40.6% over three years and 42.2% over five. In contrast, the FTSE All World index has returned 23.5%, 20.4% and -8.3% respectively. These performance figures mask the fact that telecommunications services includes fixed-line incumbents and mobile operators. The market for these companies has changed over the past few years. John Hatherly, head of global analysis at M&G, says telecom companies overspent on 3G licences in 1999 and 2000. “They paid ridiculous amounts of money for these licences. Telecom companies also sought to fund global expansion. But they then discovered that telecom companies were still susceptible to economic cycles. After the bubble burst in 2000, telecoms were derated. As a result, they had to de-emphasise acquisitions, pay back debt and strengthen balance sheets over the next two years.” The telecom sector reached the bottom in October 2002. Hatherly adds: “Since then, the sector has been partly rehabilitated and has returned to favour. This reflects increasing demand for mobiles, improved balance sheets and credit ratings and changes in management at many companies.” It has now entered a third phase of a recovery in demand and investment. “There has been a pick-up in demand, particularly on the mobile side, over the past year. This growth has exceeded market expectations.” Artemis New Enterprises fund manager Lindsay Whitelaw believes data on the mobile subsector is looking good: “mmO2 recently announced results which revealed growth in subscribers ahead of most people’s expectations. Vodafone has also reported a good flow of business. The underlying business at Vodafone is looking good but the outlook depends on its overseas expansion strategy and whether it acquires AT&T Wireless. “My own view is that a takeover of AT&T by Vodafone is less likely rather than more likely. When we last had a meeting with Vodafone, they said the day of the mega-merger was over. “We are keen on the mobiles sector given the numbers coming through and the momentum behind the companies. They are at realistic valuations and are delivering good numbers. We are slightly cautious because of the short-term impact of Hutchison Telecom’s pledge to come out with a relaunched 3G offering. Although this is known, when the offering is launched, the press coverage might affect share prices in the short term. But on a 12-month view we like mobiles, particularly Vodafone and mmO2.” Whitelaw is less optimistic about prospects for BT, however: “BT is in transition mode and under pressure. About 40% of its sales are from its legacy business, which its competitors are slowing chipping away at.” BT now has 30 million lines in service. “BT is doing the right things in trying to diversify, such as by offering broadband services,” adds Whitelaw. “It is facing a difficult few quarters as it tries to demonstrate to the market that it can grow the business. Its price needs to fall further for it to become attractive.” BT is aiming to extend broadband internet coverage to 90% of the population by the summer and to 100% by 2005. There are concerns among analysts, however, that attempts by BT to grow revenue from broadband internet and mobile phones with network services from T-Mobile are being offset by losses in revenue from its traditional fixed-line consumer operation. Indeed, there are fears the new-wave revenue is failing to keep pace with losses from the core business. The alternatives sector, however, has bounced back, says Whitelaw. Thus had positive cashflow generation in the last three months of 2003. It is now expected to post positive profits by the second half of 2005. Whitelaw says Thus is a well managed company primarily focusing on the UK. “The newsflow is likely to be positive, so it comes down to a question of valuation.” John Clarke, telecoms analyst at Brewin Dolphin, adds that local loop unbundling – whereby customers’ BT phone lines can be transferred to other networks – may enable alternatives operators to compete more seriously. “Alternatives have been competing for 20 years but the local loop unbundling will enable these operators to go the last mile and gain access to the home without digging up the street. “BT is being made to provide access to other operators. Until now, alternatives have had to bill customers through BT but in future they will be able to bill them directly. The alternatives market has been fragmented but this will enable them to provide genuine competition.” Despite general optimism about mobile operators, Legg Mason TMT fund manager Jeremy Knight has halved his stake in Vodafone from 8.73% to 4% in recent months and has sold his entire 4.39% holding in mmO2. This is because he is concerned about the effect of greater competition from Hutchison in 3G. Knight is also unconvinced by the merits of Vodafone selling its 45% stake in Verizon Wireless to buy AT&T. But even though Knight, like other fund managers, is unconvinced about the prospects for growth at BT, he has invested in the company because of what he calls its attractive valuation: “It is the only fixed-line company in Europe without a mobile presence. The fixed-line business is obviously under pressure in Europe, particularly in the UK, but the valuation is attractive. BT, however, is trying to grow its broadband business and is looking to return money to shareholders, Dividends are becoming more important for investors so I expect an increase in BT’s share price because of these factors.” The telecom incumbents in Continental Europe are in a stronger position than BT in the UK. This is because deregulation on the Continent was started later than in the UK and has not been as extensive. Europe may also feature initial public offerings of two telecom companies in the next few months (see box on page 26). Knight likes a number of European telecom stocks. He has a 4.18% holding in Telecom Italia because it is well managed, has strong cashflow and a good yield, even though it is not a growth story. He says Portugal Telecom is undervalued because of the domestic pressure it is facing. But Knight likes the fact that it is cutting costs and, along with Telefonica, has a strong presence in Latin America. He has also added France Telecom and Deutsche Telekom to his portfolio in recent months. “France Telecom is attractive because it has great potential for cost-cutting. Compared with BT, its costs are ludicrous so there is great potential for strong growth at France Telecom. Deutsche Telekom is a slow growth story. It has improving numbers, is cost-cutting and has managed a difficult regulatory environment well.” Rod Marsden, manager of the JO Hambro Capital Management European and Continental European funds, says an attraction of France Telecom and Deutsche Telekom is that they have both significantly reduced their levels of debt over the past couple of years. The debt at France Telecom, for example, has fallen below E46bn (£31.65bn), which is now less than 100% of its capitalisation. He adds that cashflow has improved because European telecom companies have reduced spending on research and development as well as reducing their debt. Furthermore, says Marsden, they have made attempts to become more shareholder-friendly. “They have surprised the market on the upside. There has been a slowdown in use of fixed-line phones, but it has not been too bad.” Investors have been attracted to European telecom stocks that have diversified into high-growth foreign markets. Marsden highlights the Norwegian company Telenor, which has interests in Eastern Europe and Russia as well as South Asia. Deutsche Telekom also has interests in Eastern Europe, and owns T-Mobile USA, while Spain’s Telefonica has holdings in operations across Latin America. This partly explains why, over the past 12 months, Telefonica’s share price has risen by 50% and Deutsche Telekom has increased by about 35%, in contrast to BT’s rise of 10%. The improved cashflow is also likely to lead to European telecom stocks paying dividends again. Marsden says Deutsche Telekom will probably pay a dividend of 2.2% or 2.3% in 2004, whereas it did not pay a dividend in 2002 or 2003. The dividend may rise to 2.5-2.75% in 2005, says Marsden. He adds that France Telecom is also likely to pay an increasing dividend. The mobile subsector of telecoms appears to have returned to growth, having paid down debt and strengthened its balance sheet. There is also optimism that those alternatives that have survived until now are likely to be able to remain in business. But while recent business figures are encouraging, telecoms is a maturing business. There may be a couple of years of strong growth left for mobile operators, but do not expect this from incumbents or equipment companies. In five years’ time, the whole sector may be a yield play.