The Zacks Diversified Communication Services industry appears to be mired in demand volatility as consumers prefer to switch to low-priced alternatives to tide over the coronavirus-induced adversities and surge in Omicron infections. Moreover, high capital expenditures for 5G infrastructure upgrades, unpredictable raw material prices, chip shortage-led supply-chain disruptions and margin erosion due to price wars have dented the industry’s profitability.
Deutsche Telekom AG DTEGY, BCE Inc. BCE and Swisscom AG SCMWY should benefit in the long run from higher demand for scalable infrastructure for seamless connectivity amid the wide proliferation of IoT, driven by a faster pace of 5G deployment.
The Zacks Diversified Communication Services industry comprises firms that provide a wide array of communication services, including wireless, wireline and Internet to business enterprises and consumers. These companies offer mobile and wireline telephone services along with high-speed Internet, direct-to-home satellite television and other value-added services. In addition to providing integrated information and communications technology services to businesses and governments, some of these companies operate as local exchange carriers or full-service providers of data center colocation and related managed services in state-of-the-art data center facilities. Some industry participants also provide IP networks, private lines, network management and hosting services along with the sale, installation and maintenance of major branded IT and telephony equipment.
What's Shaping the Future of the Diversified Communication Services Industry?
Low-Priced Alternatives Resulting in Demand Erosion: Efforts to offset substantial capital expenditure for upgrading network infrastructure by raising fees have led to reduced demand, as customers prefer to switch to lower-priced alternatives. Moreover, the local-line access for traditional telephony services continues to decline among large customers due to higher wireless substitution and migration to IP-based services. This is reflected in the persistent erosion in overall network access services on a year-over-year basis, hurting revenues of local and long-distance operations. With Digital Subscriber Line and cable modems gaining widespread acceptance, customers are deactivating extra phone lines that were earlier used to access the Internet via dial-up modem. In addition, a shift toward wireless services and the aggressive rollout of VoIP and long-distance services by Tier-1 competitors have resulted in access line erosion. These negative impacts have become more pronounced as the coronavirus pandemic has hurt global economic growth, triggering large-scale unemployment.
Chip Shortage Persists: The industry continues to face an acute shortage of chips, which are the building blocks for various equipment used by the telecom carriers. Although the Biden administration is trying to address the global shortage of semiconductor chips and devise ways to increase domestic production, the demand-supply imbalance has crippled operations and largely affected profitability due to inflated equipment prices. The passage of the $1.2 trillion infrastructure bill in the House has instilled some sector confidence as it includes a $65 billion provision to significantly expand broadband access to Americans to thwart the technological dominance of countries like China. The plan envisions reaching the underserved areas of the country and prioritizing support for broadband networks affiliated with local governments, nonprofit organizations and cooperatives to encourage strong competition with privately-owned companies. The government has also pledged bipartisan support for funds of $50 billion to ramp up production capacity and reduce supply bottlenecks. However, unless the policy guidelines assume a tangible effect, the industry firms are likely to face short-term challenges, affecting their cash flow.
Evolution From Legacy Networks to Cater to Data Upsurge: Video and other bandwidth-intensive applications have witnessed exponential growth owing to the wide proliferation of smartphones and increased deployment of the superfast 5G technology. This has forced the industry participants to invest considerably in LTE, broadband and fiber to provide additional capacity and ramp up the Internet and wireless networks. These companies are rapidly transforming themselves from legacy copper-based telecommunications firms to technology powerhouses, with capabilities to meet the growing demand for flexible data, video, voice and IP solutions. At the same time, the industry participants continue to focus on leveraging wireline momentum, expanding media coverage, improving customer service and achieving a competitive cost structure to generate higher average revenue per user while attracting new customers. Also, these firms are offering the flexibility to better manage data traffic by leveraging indigenous software-defined networks to enable low-latency, high-bandwidth applications for faster access to data processing. Utilizing machine learning techniques and artificial intelligence capabilities, these networks are likely to transform the way data-intensive images and videos are transferred across the industry on a real-time basis. All these efforts have particularly helped firms in the industry to cater to the upsurge in data demand, with digital sustainability becoming the norm of the day as the majority of the population is forced to work from home.
Integrated Customized Offering to Mitigate Risks: In order to improve profitability, the companies are increasingly focusing on providing support services to various small and mid-sized businesses (SMBs) with an integrated portfolio of voice, data and technology services. The firms are tailoring their services to suit individual business needs and are facilitating SMBs to better adapt themselves to necessary technology advancements. At the same time, the industry is battling hard-to-mitigate operating risks stemming from volatility in demand, an unpredictable business environment led by the virus outbreak and challenging geopolitical scenarios by offering free services to low-income families and seamless wireless connectivity to the masses.
Zacks Industry Rank Indicates Bearish Trends
The Zacks Diversified Communication Services industry is housed within the broader Zacks Utilities sector. It carries a Zacks Industry Rank #229, which places it at the bottom 10% of more than 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.
The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings growth potential. Before we present a few diversified communication stocks that are well-positioned to outperform the market based on a relatively modest earnings outlook, let’s take a look at the industry’s recent stock market performance and valuation picture.
Industry Lags S&P 500, Sector
The Zacks Diversified Communication Services industry lagged the S&P 500 Index and the broader Zacks Utilities sector over the past year largely due to COVID-19 woes.
The industry has rallied 3.2% over this period compared with the S&P 500’s growth of 23.7% and the sector’s rally of 7.7%.
One Year Price Performance
Industry's Current Valuation
On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA), which is the most appropriate multiple for valuing telecom stocks, the industry is currently trading at 13.1X compared with the S&P 500’s 15.73X. It is also below the sector’s trailing-12-month EV/EBITDA of 17.17X.
Over the past five years, the industry has traded as high as 14.16X and as low as 7.28X and at the median of 11.72X, as the chart below shows.
Trailing 12-Month enterprise value-to EBITDA (EV/EBITDA) Ratio
3 Diversified Communication Services Stocks Likely to Move Ahead of the Pack
Deutsche Telekom AG: Headquartered in Bonn, Germany, Deutsche Telecom is one of the largest telecommunications service providers in Europe. In addition to its strong position in the domestic market, the company is likely to benefit from the accretive post-merger integration of T-Mobile US Inc. and Sprite in the United States, in which it owns about 43%. The removal of forced cable TV access in multiple dwelling units in Germany through telecom legislation is likely to help the company expand its broadband market. Moreover, an aggressive fiber rollout strategy across the country is expected to augment its domestic market hold. The Zacks Consensus Estimate for current-year earnings has been revised 7% upward over the past year. The stock sports a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here. It has a VGM Score of B and long-term earnings growth expectations of 9.9%.
Price and Consensus: DTEGY
BCE Inc.: BCE is Canada’s largest communications service provider and serves as the holding company for Bell Canada. The company provides local and long-distance phone service to approximately 70% of Canada’s population, primarily in Ontario and Quebec. BCE's wireless segment is expected to benefit from postpaid business as it continues to enjoy solid subscriber additions as well as higher revenue contributions from prepaid services. Significant investments in network coverage, customer retention, lucrative data plans and the launch of new handsets are likely to drive subscriber base expansion. It is witnessing operating profitability growth across its wireless, wireline and media segments. As part of its fiber-to-the-premises expansion into the populous regions surrounding Toronto, Bell is bringing direct fiber links to more than 200,000 residential and business locations in the City of Hamilton. The stock carries a Zacks Rank #3 (Hold) and has gained 20.2% in the past year. It has a long-term earnings growth expectation of 4.3% and delivered an earnings surprise of 4.5%, on average, in the trailing four quarters.
Price and Consensus: BCE
Swisscom AG: Headquartered in Bern, Switzerland, Swisscom offers mobile and fixed-network telecommunications services across the country and Italy. A wealthy domestic market with stable economic conditions, a relatively lax regulatory environment compared to the EU, its dominant market position and a strong leadership team are some of the key growth drivers of the company. With a complete spectrum of state-of-the-art data services, from leased lines to integrated solutions for corporate and residential customers, Swisscom’s healthy growth momentum is likely to continue. The Zacks Consensus Estimate for current-year and next-year earnings has been revised upward by 29.7% and 9.9%, respectively, over the past year. The stock carries a Zacks Rank #3 and has gained 4.5% in the past year.
Price and Consensus: SCMWY
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