Time to Put Telecom on Hold?

After the strong run for wireline operators, the stocks are starting to look look pricey, according to S&P's Todd Rosenbluth

by Sam Stovall From Standard & Poor's Equity Research

Could wireline-telecommunications stocks be ready for a breather, as indicated by the recent double top in its relative strength chart? From both a fundamental and technical perspective, it appears to us as if the wireline-telecom group may become market performer, or even an underperformer, in the months ahead.

The S&P 1500 Integrated Telecommunications (wireline) sub-industry began its forced march in October, 2005, and posted a 16-month price appreciation of 52% to the S&P 1500's climb of 21%, spurred on by the digestion of earlier acquisitions and improved cash flows. But now the S&P Telecom Services sector—in which the Integrated Telecom sub-industry index carries an 83% weighting—is trading at a 16% premium trailing price-earnings (p-e) ratio to the overall market, vs. its normal 1% premium.

What's more, while earnings are expected to lead the pack in 2007, rising 22% compared with the market's projected 8% advance, the sector's p-e-to-growth ratio (p-e on 2007 estimated earnings divided by the projected five-year consensus earnings growth rate) of 2.1 is well above the market's 1.3, and is the highest of all 10 sectors.

Landscape Shift

Todd Rosenbluth, S&P's equity analyst for this industry, recently wrote: "Our fundamental outlook for the Integrated Telecommunications Services (wireline) subindustry for 2007 is neutral, as we believe that the large integrated services providers will generate adequate free cash flow in the near term, even after making large acquisitions and battling newer competitors."

Rosenbluth says the telecom landscape has been significantly altered with the formation of the new AT&T (T; ranked 3 STARS, hold), its subsequent addition of BellSouth in late December, 2006, and the combination of Verizon Communications (VZ; ranked 3 STARS, hold) and MCI in January, 2006. He sees AT&T and Verizon causing imbalance in 2007 as they compete for share of consumer spending, and exercise power over their suppliers.

Furthermore, he believes we will see some of the synergies of these deals adding to free cash flow. The number of midsize telecom carriers has grown with the formation of Embarq (EQ; ranked 3 STARS, hold) and Windstream (WIN; ranked 4 STARS, buy).

Fiber Roll-Out

Rosenbluth says the fourth quarter 2006 results that have been reported by this group reflect improved operating efficiencies, even as total access lines and revenues for the wireline companies were restricted by competition from cable companies and wireless substitution. For the remaining carriers, DSL (digital subscriber line) customer growth should remain strong, due in part to pricing relative to competitors.

He expects the telecom providers to roll out more fiber-based broadband and video services in 2007, and to expand the service bundle to include wireless in order to combat spreading cable telephony competition. He believes the smaller telecom providers, including some that recently announced mergers, will wait until equipment pricing for such services declines before rolling out faster speeds of broadband. However, even with an increased focus on capital spending for fiber initiatives, he believes the telecom providers will generate sufficient cash flow to support share buybacks and modest dividend increases.

Year-to-date through Feb. 16, the subindustry index was up 4.4%, vs. a 3% increase in the S&P 1500 index. "We don't expect this outperformance to continue throughout 2007 as we believe that some of the stocks are fully valued or overvalued," Rosenbluth says.