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3 stocks in Morningstar's most undervalued sector

Brian Colello  |  18 Apr 2018Text size  Decrease  Increase  |  
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Fibre, 4G and consumer migration to pay television from traditional bundles are creating investment opportunities in several markets--among other localised trends for Australian players.

The shifting macro-economic outlook for telecommunications is gradually changing the space for companies and their investors.

More localised but hugely significant changes are occurring within Australia's telecommunications sector, including the continuing roll-out of the National Broadband Network (NBN).

Global context

In Europe, the main telecom themes remain the move to convergence along with increased fibre and 4G buildouts. Spain has long been the leader in convergence, with around 80 per cent of broadband customers subscribing to a wireless service from the same company. France has also been pushing convergence but isn't as far along. Germany was slower but is increasingly pushing convergence.

Now even the United Kingdom and Italy, which have been big laggards, are starting to offer converged services. The movement to convergence is enhanced by the faster broadband speeds offered by fibre.

Historically, cable-TV operators have enjoyed an advantage with broadband speeds due to networks that were designed for video and include more fibre and coax rather than copper. However, to better compete, telecom operators are increasingly laying fibre that provides equivalent speeds to the cable operators.

Europe has been much slower at moving to 4G than the United States or Asia, but 4G has really taken off in the past year. Penetration rates are still behind the U.S. and parts of Asia, though. Thus, we expect the transition to 4G to continue as operators extend their 4G networks.

While the transition to 4G continues in Europe, the US, Japan, and South Korea are preparing for the jump to 5G. Several companies in these countries have discussed initial offerings by the end of this year.

For pay-TV distributors, we continue to see migration from traditional providers such as Comcast CMCSA and Dish Network DISH to the newer streaming content providers--known as over-the-top (OTT) providers such as Sling TV, DirecTV Now, and YouTube TV. Stan and Netflix are the two most notable OTTs in Australia--the former partly owned by Fairfax and Channel Nine .

We believe that more-concentrated bundles and lower price points will continue to attract cord-shavers and possibly even some cord-cutters. The major OTT providers now have over 4.5 million subscribers in the US, and we project that this number will increase. For traditional video providers with a broadband offering, we expect companies like Comcast to shift margins from the video piece of the bundle to the broadband side.

Aussie, NZ stocks to watch

Each of the following businesses hold Morningstar narrow economic moats. Telstra (ASX: TLS) is the clear leader in Australia's telecommunications services, with dominant market share in each service category and is the lowest-cost provider.

According to Morningstar analyst, Brian Han, "The NBN is reshaping Telstra and a slimmed-down operational base is now focused on mobiles, network applications and services, and digital media".

"Mobile market share of 48 per cent remains well ahead of rivals Optus and Vodafone at 33 per cent and 19 per cdent, respectively. Competitive advantage in coverage and speed of the Telstra mobile network attracts customers demanding reliable mobile connectivity," he says.

While Telstra's enjoys ongoing strength in the mobile space, its fixed line operations face "structural decline and increased competition".

"In line with global trends, revenue from traditional voice services provided by the public switched telephone network, or PSTN, or copper network, is in decline. The advent of the NBN will result in the gradual decommissioning and transfer of customers to the NBN, but Telstra will receive compensation," Han says.

How management plugs the $3 billion per year earnings hole the NBN roll-out creates over the longer-term is the critical issue for investors.

"On the other hand, TPG Telecom's planned entry into the mobile market is likely to raise the competitive intensity to another level and partly limit Telstra's ability to plug the NBN earnings hole," says Han.

He believes TPG Telecom (ASX: TPM) is well positioned for structural changes in the industry: "Rollout of the national broadband network, or NBN, and takeup of high-traffic products such as Internet protocol television, will increase the demand for broadband and backhaul capacity".

"TPG has materially increased its scale through the $1.5 billion merger with iiNet, in August 2015. We expect the merger to herald synergies largely through increasing utilisation of TPG's backhaul infrastructure.

"The planned entry into the highly competitive Australian and Singaporean mobile telephony market raises TPG's risk profile, given both countries' high mobile penetration with the market already well-served by three operators," Han says.

While the prior stocks hold four-star ratings from Morningstar, Spark New Zealand (ASX: SPK-NZ) holds three--though its fair value estimate of $3.70 means it currently tracks as moderately under-valued.

"Although competition has been aggressive in the New Zealand telecommunications market, we believe Spark's scale provides a competitive advantage. Construction of an ultrafast broadband network will lower barriers to entry in fixed-line and broadband and represents a risk to the business," Han says.

He sees considerable "breathing space" for Spark to consolidate its market position and build out new opportunities in the New Zealand IT services industry. This view is further supported by its strong balance sheet and adding "defensive appeal and dividend security".

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Brian Colello, CPA, is a senior equity analyst for Morningstar, based in the US.

Glenn Freeman is a senior editor with Morningstar, based in Sydney.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is a senior equity analyst with Morningstar, based in the US.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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