Outperformance likely unsustainable despite improved backdrop
Telecom operating conditions improving
* Bid activity in the telecom/cable sector has heated up markedly. The hope is that consolidation in the sector will continue, reducing competition and supports pricing power.
* Regulation-related headwinds are abating.
* 4G adoption is driving data volume growth higher.
Deflation in the telecom service sector has become ‘less bad’
This improved backdrop has buoyed performance and boosted sector earnings expectations relative to the overall market.
Notwithstanding the above, it is not a good time to add to positions
We recommend underweight positions in telecom services in European equity portfolios, for four key reasons:
1) Richly valued
The telecom service sector trades at a 26% premium to the market on expected 12-month forward EPS, a post-TMT-bubble high. The dividend yield premium over the broad market has declined sharply, and free cash flow
dividend coverage has dropped to a post-TMT-bubble low.
2) Hunt for yield to remain – but not intensify
Although the sector still provides a bigger dividend yield than the overall market, we doubt that investors will seek to chase this yield further in the absence of a new move lower in bond yields.
3) Uncertainty around return on investment
A key question for the sector is whether investment in services such as 4G and fibre broadband will provide an adequate return. Crucial will be the ability for the wave of consolidation in the sector to continue, which sees price
competition ease. We think this is an open question.
4) An underperformer in an improving growth backdrop
Economic momentum in Europe has picked up. Telecom service stocks have relatively low leverage to this improvement.