Time to Telco

The internet boom of the late 1990s was not restricted to just Information Technology companies. Rather, investors flocked to "TMT" stocks - where TMT stood for "Tech, Media, Telecoms" – in the expectation that all three of these sectors would benefit from the growth on the internet.

With the benefit of hindsight, investors' expectations were only close to the mark for one of these three sectors, Information Technology. For the period from the end of 1999 through to the end of 2021, returns from the Information Technology sector, at 4.7% per annum (in NZ dollars), came reasonably close to returns from the broader global share market, which returned 5.0% per annum over the same period.

With hindsight, the Media and Entertainment companies which were swept up the 1990s internet boom have proven to be poor investments, with many traditional media companies in particular having gone bust or having seen their market capitalisations shrink to a tiny fraction of what they once were, as advertising dollars have been redirected from print and TV to online advertising.

The poor returns to traditional media companies would not be immediately apparent if you looked at the performance of the MSCI World Media & Entertainment index, which has only slightly lagged the performance of the Information Technology sector over the past 21 years. However, it is important to appreciate that all of the returns from that index has come from 3 companies that were not even listed in 1999 – Alphabet (Google), Meta (Facebook), and Netflix. These 3 companies represented two thirds of the capitalisation of the MSCI World Media & Entertainment index at the end of 2021, and their large weighting in this index obscures the fact that the media companies that were listed at the turn of the millennium have generally produced very poor returns.

However, in this column I want to focus on the other sector that investors got so badly wrong in the 1990s, telecommunication services companies ("telcos"). From the end of 1999 through to the end of 2021, investors in telecommunication services companies lost money, at a rate of -1.6% per annum.

In the late 1990s, telecommunication revenues were growing rapidly, as mobile phones became more ubiquitous, and people and businesses increasingly subscribed to internet services and installed second lines to support dial-up internet access.

Investors invariably prefer the easy option of extrapolating current trends over identifying the next one, and in the late 1990s they were doing this in spades with telecommunication companies. At the turn of the millennium, telecommunication service companies represented over 10% of global market capitalisation. In New Zealand, Telecom New Zealand (now Spark) represented more than 30% of the free-float capitalisation of the New Zealand equity market.

At the end of the 1990s, the profitability of the telcos was very high (for example, Telecom NZ earned EBITDA margins of 58%) and earnings multiples were even higher, reflecting the expectations of many investors that growth in the demand for telecommunication services (and data in particular) meant that telco profitability would continue to rise.

Investors were right to expect that the demand for data would continue to grow, but wrong to assume that this would translate to greater profitability. Over the past two decades, a number of factors have caused a significant erosion in telco revenues and profitability:

• On a per-megabyte basis, the price of sending and receiving data has fallen as rapidly as volume has increased. The biggest & fastest broadband packages today cost less per month than dial-up internet on a dedicated line used to cost in the 1990s.
• Tolls on long distance calling used to be a major source of telco revenue, but the ability of telcos to charge for long distance calling has all but disappeared, due to increased competition, regulation, and the threat of people using internet-based services like Skype and Facetime to avoid calling charges. When Telecom NZ (now Spark) first dropped the cost of its dial-up internet service to $2.50 per hour, I remember asking Rod Deane (then-CEO of Telecom) how long it could continue to charge 99 cents per minute for calls to Australia, in light of the fact that technically-savvy people could now talk to each over the internet for about 4 cents per minute. He seemed surprised by the idea but didn’t seem to think it would pose much of a threat!
• Regulators have put caps on what dominant telcos can charge competitors for accessing their networks, which limits their ability to make excess profits even in those remaining corners of their networks where they continue to hold a monopoly position.
• Line charges on copper-line phone connections also used to be a major source of telco revenue. The ubiquity of mobile phones and VoIP has meant that traditional copper-line phone connections have all but disappeared.
• All-you-can-eat mobile phone plans mean that average revenues from mobile phone users have fallen significantly.

Together, these factors mean that despite huge increases in the volume of data transmitted over telecommunication networks, most developed country telcos around the world have seen virtually no growth in revenues over the past 20 years. Further, profit margins have declined, meaning that most telcos are making lower profits now than they were at the end of the TMT boom.

Should we extrapolate this trend, and project that telecommunication revenues will continue to lag the broader growth in the economy?

In the same way that it was a mistake for investors in the late 1990s to extrapolate a recent history of strong telecommunications revenue growth and assume it would continue forever, I believe that many investors could be making a mistake today in looking at the more recent track record of flat telecommunications revenues and assuming that the sector will never grow.

Unlike many other sectors where there has been moribund spending growth over the past decade (for example, pay TV subscriptions), the flat revenues experienced by the telecommunication services sector do not indicate a lack of underlying demand growth. Rather, people are more reliant on telecommunication services than ever before. Revenues have only been flat because consumers and businesses have been able to access the telecommunication services they need at cheaper and cheaper prices. The fact that demand for telecommunications has continued to grow while pricing has declined to a point where it is no longer a significant consideration for most consumers would suggest that there is at least some prospect that telecommunication revenues may begin to keep pace with the broader economy.

Most of the factors that have eaten away at telco revenues over the past two decades have largely played out for many telcos. Revenues from copper lines and distance calling charges have fallen to just a tiny percentage of overall revenues, such that further declines would not have meaningful impact on telcos’ overall financial performance. The main revenue streams are now from mobile and broadband, where churn rates are reasonably low, and where providers compete mainly on the quality of their service rather than on price. There is a prospect that relatively new revenue streams like IoT and edge computing could grow to become significant revenue streams for telcos.

However, in a departure from the excess optimism that they apply to most other sectors, sell side analysts continue to be heavily influenced by their rear-view mirrors, and model growth rates of only 1% to 2% for most telecommunications companies. As a result they typically publish tepid recommendations on telcos that are trading on modest multiples of tax paid earnings. In aggregate, the telecommunications services sector now represents just 1.8% of the capitalisation of the MSCI World index, down from a peak of over 10% in the late 1990s.  

For example, consider Verizon, the most highly valued telco in the world, with market capitalisation of US$220 billion. Verizon reported profits of $22.1 billion last year, so is being valued on a trailing price/earnings multiple of 10 times. It is currently distributing about half of profits to shareholders, resulting in a dividend yield of 4.8%.

Verizon has the largest share of the US mobile communications market, and this accounts for the majority of its revenues and profits. Further, its 5G fixed wireless solution creates an opportunity to win fixed broadband market share from cable TV companies and other telecommunications companies.  Verizon appears to have got through the hump of 5G-related capital spending, and we anticipate that the free cashflow that Verizon generates over the next decade will amount to about 75% of reported profits. While Verizon will likely pay down debt over the next 2 to 3 years, we would hope that its strong cashflows will ultimately lead to a higher dividend payout or share buybacks. Based on our modelling of Verizon, we believe that revenue growth of slightly over 2% per annum should be sufficient to see Verizon delivering buy-and-hold returns to investors of over 8% over annum over the next two decades.

While the share market is full of optimists who like to think that their favourite growth stock will deliver double-digit returns, there is a high risk that the assumptions underlying their optimism will be found wanting. In my view, investors will generally get a better reward for risk by looking for lower risk companies where share market pricing does not extrapolate recent growth trends too far into the future.  Many telcos like Verizon fit this bill. Over the past year, Verizon has been the least volatile stock in the MSCI United States index, and when the broader share market falls it typically falls by less than half as much as the average stock. Further, the low expectations that investors and sell side analysts have for Verizon’s future growth suggests that there is a prospect that it could be significantly re-rated if its revenues begin to grow in line with the broader economy.

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that hold shares in Verizon and other telecommunication services companies. The potential returns for Verizon discussed in this article are just a central forecast, and actual returns could well be significantly different from the numbers discussed in the article.