Telecommunication Services Sector Rating: Underperform

Telecommunication Services Sector

Telecommunication services sector overview

Rising interest rates could hurt the telecom sector, whose relatively high dividends often attract investors in a low-interest-rate environment. Although demand for wireless services is rising, competition in the sector is rising, as well. Company debt loads could also be a problem if rates rise.

Market outlook for the telecommunication services sector

The telecom sector is certainly not what it was a couple of decades ago and has now shrunk to the point that it will be joining with the media group later this year to form a new communications sector. As we get closer to that date, we will of course evaluate our rating and issue a new rating for the new sector.

For now, we remain underperform on the existing sector as the days of near-monopolistic control of landlines are long gone. These days the sector is driven by fierce competition, with new ways of communicating continually entering the market, and consistent—and expensive—upgrade cycles. To us, this reduces the traditional defensive appeal of the telecom sector.

The group had performed somewhat better recently, as investors appeared to be buoyed by the earnings reports of some companies in the group that showed increased subscriber numbers, as well as the potential for increased merger activity. We believed this was an overreaction and that competition, as mentioned above, will continue to pressure profits and cause churning within the group. Additionally, we believe that an improving U.S. economy and increasing inflation will push interest rates at least modestly higher, leading to a continued reversal of some of the yield chasing that helped to fuel gains in the sector in the past. And we have seen the group return to underperformance over the past few months.

That doesn't mean that there aren't some attractive qualities in the group, especially with the advances and changes occurring in the communications realm. The amount of information being transmitted across channels controlled by this group is staggering, and it doesn't seem to be slowing, meaning the sector is one that is seeing steady increases in demand.

As mentioned, we have seen that periods of outperformance have been short-lived, however, as the downside of that increase in demand is the onslaught of competition. As telecom businesses compete for increasingly budget-conscious consumers, pricing power has declined. In addition, companies in the wireless space are shifting their pricing structure away from long-term contracts and free equipment toward more flexible terms—potentially beneficial and more transparent for consumers, but likely squeezing profits in the sector to an even greater degree.

And while increasing consumer demand for wireless services is potentially positive for revenues, the flip side is that it can greatly increase costs for providers, due to the need for large equipment upgrades. As a result of this need to spend, the debt ratio on telecom companies has risen over the past several years, which could mean a double whammy should interest rates rise—debt service costs would rise as the companies roll over their loans, and the yield trade would likely reverse.

Factors that may affect the telecommunication services sector

Positive factors for the telecommunications sector include:

  • Increasing wireless demand: Demand is rising as more communication and media devices move to the wireless arena, providing the potential for revenues to rise.
  • Relatively high dividends: The dividends typically paid by telecom companies have attracted investors tired of paltry fixed income yields.

Negative factors for the telecommunications sector include:

  • Falling profits: Net profit margins are declining for the telecom sector as competition squeezes margins.
  • Rising expenses: Capital expenditures in the telecom space are increasing as companies look to improve and expand their networks. This could be a burden on profitability.
  • Heavy debt loads: The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector.

Clients can see our top-rated stocks in the telecommunications sector.

Want to learn more about a specific sector?  Click on a link below for more information or visit Schwab Sector Views to see how they compare.

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