Investor's Checklist: Telecom Sector

The telecommunication sector is filled with the kinds of companies we love to hate:

• They earn mediocre (and declining) returns on capital, 
• economic moats are nonexistent or deteriorating, 
• their future depends on the whims of regulators, and 
• they constantly spend boatloads of money just to stay in place.  

Even companies that once boasted wide moats, such as those that control the local phone network, face increasing competition from newer players, such as cable and wireless networks.  Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

Telecom Economics

Building and maintaining a telecom network, whether fixed line or wireless, is an extremely expensive endeavor that requires truckloads of upfront capital.  This requirement provides a substantial barrier to entry and usually protects the established players.  To raise capital, a new entrant must have a great story to tell investors.  The emergence of the Internet, the opening of local networks to competition, and rapid wireless growth during the 1990s gave numerous new players the yarns they needed, which is why the usual barrier provided by huge capital requirements came crumbling down as investors lined up to grab a piece of the action.

While the effects of this massive infusion of capital are still being felt in the industry, ongoing capital needs have sunk many new entrants.  Even a mature telecom firm will need to invest significant capital to maintain its network, meet changing customer demands, and respond to competitive pressures.

Because of the enormous cost to build a network, carriers typically have very low ratios of sales to assets (asset turnover ratios).  Even a mature carrier typically generates only around $1 per year in sales for each $1 of assets invested.  But building a business of ample size to support interest payments and ongoing capital needs is very important.  Because fixed costs are so high, it's imperative for carriers to have enough customers over which to spread the costs.

Squeezing as much profit from the sale as possible is also crucial.  While size again plays a role here, a telecom company must be able to send bills, provide customer service, maintain the network, and market services efficiently.  A mature company, either fixed line or wireless, should expect to earn operating margins between 20 percent and 30 percent.  Short of this level, it is extremely difficult to earn an attractive return on invested capital, given the slow pace at which assets turn over.

With so many companies raising money and building networks in the late 1990s, the volume of business needed to support all these huge investments never materialised.

Conclusion:

The telecom sector of tomorrow will look nothing like the sector of the past.  Competition is far greater throughout the industry and economic moats exceedingly difficult to come by.  The future of the industry will be shaped by regulatory and technological changes, which means that financial strength and flexibility are likely to be what separate successful firms from unsuccessful ones over the next few years.

Investor's Checklist:  Telecom

• Shifting regulations and new technologies have made the telecom industry far more competitive.  Though some areas are more stable than others, look for a wide margin of safety to any estimate of value before investing.
• Telecom is a capital-intensive business.  Having the resources to maintain and improve the network is critical to success.
• Telecom is high fixed-cost business.  Keeping an eye on margins is very important.
• Watching debt is also important.  Firms can easily overextend themselves as they build networks.
• The price of wireless airtime is plummeting. Carriers continue to compete primarily on price.

The Five Rules for Successful Stock Investing
by Pat Dorsey