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A telecom outlook from Wells Fargo Securities

Opinions expressed in this piece are solely those of the author and do not represent the views of SNL Kagan.

The telecom industry is poised for upside despite increasing capital intensity, according to senior analyst Davis Hebert of Wells Fargo High Yield.

His telecom sector overview is part of a newly published corporate credit outlook report on 31 industries in 10 broad sectors covered by Wells Fargo high-yield bond analysts. I profiled his cable TV outlook in this blog on Dec. 13.

I like the unique perspective that high-yield investors have about risk, especially in capital-heavy industries like telecom. Both wireless and wireline carriers are increasingly challenging broadband and cable TV providers for residential and enterprise customers but will likely have to invest considerable capital ahead to effectively compete.

Hebert upgraded his telecom rating to "overweight" because he thinks the sector will outperform the overall high-yield market's projected average 5.3% total return in 2017. However, there is a lot of wiggle room in that overall market projection, with a spread of negative 9.7% on a bearish outlook to a positive 7.3% total return for the bullish case.

Rising interest rate environments breed volatility. But in any scenario, Wells Fargo believes that telecom will outperform the market.

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Year-to-date (through Dec. 15), the Wells Fargo telecom index has outperformed the high-yield market in total return by 523 basis points while missing the market's overall yield by just 34 basis points. Telecom was the best performing total return industry among the 31 profiled in Wells Fargo's 2017 outlook report (through Nov. 30).

In contrast, telecom pretty much matched the market's negative 4.8% total return and overall 8.8% yield in 2015. Keep in mind that the telecom index is a tale of two subsectors: higher performing wireless and lower performing wireline (as noted in the summary table above.)

Here are some key take aways from Hebert's outlook for telecom:

Positives include next-generation mobile services, such as ultra-fast 5G wireless, robust wireline fiber capacity, and a full array of cloud services for higher-margin enterprise customers.

Negatives include increasing capital intensity to compete with cable TV and broadband providers, elevated capital expenditures, a secular decline in local voice and long distance, and increasing competition for video, data, cloud, and mobile services.

Market share gains are possible for wireless challengers T-Mobile US Inc. and Sprint Corp. against the twin titans Verizon Communications Inc. and AT&T Inc. Some investors remain skeptical that Sprint can continue to gain share if it spends less than its competitors on network enhancements. Most still believe that T-Mobile and Sprint are bound to merge in order to effectively compete as a viable third force.

M&A has been a primary driver of total returns this year, with the bonds of acquirers CenturyLink Inc., Windstream Holdings Inc., and Frontier Communications Corp. posting double-digit price appreciation.

The biggest laggard has been Level 3 Communications Inc. whose bonds initially slipped after the Oct. 31 news of its proposed $34 billion cash-and-stock acquisition by mid-market provider CenturyLink. Disappointed Level 3 investors had hoped the fiber backbone provider would be acquired by a large investment-grade player like AT&T or Verizon.

Financial expectations for the sector include EBITDA growth for the third- and fourth-largest wireless providers Sprint and T-Mobile but low single-digit declines for the wireline incumbents CenturyLink, Windstream and Frontier. If this occurs, we may see margin shift ahead as lower-margin wireless providers expand while higher-margin wireline companies contract. SNL Kagan's earnings database shows last-12-months EBITDA margins averaging 30% for wireless carriers and 34% for wireline providers.

Debt leverage has been about 3.5x EBITDA for telecom but could come under pressure via the ongoing government spectrum auction and acquisitions. In addition, installment and leasing plans tend to require large upfront investments. Significant CapEx spending and dividend payouts could also hamper attempts to improve balance sheets ahead. Wireline companies are already under more pressure than wireless carriers with last-12-months free cash flow margins at only about 2% for wireline versus 8% for wireless companies.