Telecom Stocks: Back on the Rise

Though the group has proved to be less defensive recently, telecom service stocks have begun to recover. S&P thinks some look undervalued

By Sam Stovall From Standard & Poor's Equity Research

The trailing 12-month relative strength ranking for the S&P 1500 integrated telecommunications services subindustry index improved in the past week and now lies in the middle 40% of all subindustries in the S&P Composite 1500 Index (consisting of the S&P 500, MidCap 400, and SmallCap 600 indices). According to Todd Rosenbluth, S&P Equity Research's telecom services group head, the improvement in relative performance was likely due to the reporting of strong third-quarter cash flows last week that would likely continue to support the group's hefty dividend payments. For the year through Nov. 7, the subindustry, which yields 6.3%, fell 34.4% vs. a 36.5% decline for the S&P 1500 index.

There are 10 large, midcap, and small-cap companies in the S&P 1500 integrated telecom services subindustry index, six of which carry 5- or 4-STARS rankings: AT&T (T; 27; 5 STARS, or strong buy), Century Telephone (CTL; 26; 4 STARS, or buy), Embarq (EQ; 32; 4 STARS), Frontier Communications (FTR; 9; 5 STARS), Verizon Communications (VZ; 30; 4 STARS) , and Windstream (WIN; 9; 4 STARS).

Effect of Consolidation

Rosenbluth maintains a positive 12-month fundamental outlook for the integrated telecommunication services (wireline) subindustry, on the view that large integrated service providers will generate free cash flow from broadband growth and cost savings to support dividends and share repurchases even as the U.S. economy slows.

Due to consolidation, the two dominant carriers in the subindustry are AT&T and Verizon Communications. Rosenbluth expects their revenues to grow modestly in 2008 and 2009 and expects some of the synergies of their acquisitions to add to free cash flow. Midsize telecom carriers include Qwest Communications (Q; 3; 3 STARS, or hold) and Windstream. Merger activity at midsize carriers, which picked up in 2007, now includes a deal, subject to approvals, between CenturyTel and Embarq.

"We expect telecom carriers to face some challenges as the economy slows and fewer new home sales lead to a further loss of access line customers and limits broadband growth, which at some carriers was recently down 40% from a year earlier," notes Rosenbluth. "Third-quarter 2008 results reflected strong gains in wireless for large carriers and more stability in wireline operations at the midsize firms, even as access line losses persisted. In our view, growth in wireless units and cost-saving measures, such as back office integration, will prove key result drivers in 2009 for the major telecom providers, as wireline voice services remain under pressure. We view positively that there have been limited regulatory changes to universal service and intercarrier compensation thus far in 2008 that could have put pressure on the cash flow prospects for the rural carriers."