Telecom ought to be cyclical, but lately, it hasn’t been. Other asset intensive, low marginal cost industries have seen capex turn upward over the past few years, driven by recovery, low interest rates and tax incentives, while capex by telecom leaders VZ and T continues to set new historical lows despite their complaints about overcrowded networks and pleas for new spectrum. The best explanation is a lack of competition, spurred by the business shift to wireless where asymmetrical spectrum holdings exacerbate a tepid rivalry. The result is wireless prices that are second only to Canada, and strong and stable cash flows for the market leaders. Recent actions, such as the blocked T/TMobile merger and the proposed VZ/Cable tie up suggest both an intention by industry leaders to thwart rivalry, and the intent of the current FCC to promote it. We are concerned that the strong recent returns for the top carriers are vulnerable to government policy and renewed rivalry, and prefer secondary carriers, tower companies and equipment suppliers.
Telecom carrier capital spending and cash flows no longer seem to follow the cyclical pattern typical of asset intensive, low marginal cost businesses. High fixed cost businesses – e.g. airlines, railroads, heavy manufacturing, and chemicals, et al. – ordinarily follow a well-worn path of rising cash flows to rising investment to plummeting returns to sharp capex cuts. Telecom, despite one of the most asset heavy profiles in the economy, no longer seems to follow this path. While the rest of the economy sees rising capex, spurred by recovery, interest rates and tax incentives, VZ and T are taking network spending lower and raising prices – pleasing investors and vexing regulators.
The reduction in capital intensity has coincided with the ascension of wireless, despite the apparent wireless data crisis. Wireless has risen from 24% of telco revenues to 66% over the past decade, while capex/sales has fallen sharply. On face value, this is curious, as US carriers have been vocal about looming capacity shortages in the face of explosive demand for mobile data. Wireless capacity can be added in two ways – spectrum or capex – and while both AT&T and Verizon have chased the former via aggressive deals, neither has been willing to invest in new cell sites.
Verizon and AT&T’s superior spectrum holdings already give them enormous competitive advantage, evident in market share, profitability, and pricing. T and VZ operate primarily in the 850MHz and 700MHz bands, allowing cells with nearly 50% better range and more than twice the coverage area than in the 1.9GHz band used by Sprint, T-Mobile and others. This means much better coverage with many fewer cells and thus, less investment. Verizon and AT&T’s coverage advantage has allowed them to build leading share while blunting price competition from their less fortunate rivals. Over many years, share advantage has translated to significant scale advantage, but has not translated into price cuts for customers.
International markets show the same pattern of spectrum inequality, market concentration, and muted investment. Typically, the first carriers in a market operate on more attractive frequencies, giving them cost and coverage advantages over later entrants in higher bands. The extent of the benefit is tied to the population density of each country. In countries where spectrum allocations are skewed, market share is concentrated and population is sparse, prices tend to be high. This is clearly the case in the Canada and the U.S., where monthly wireless bills are the highest in the developed world.
We are concerned that the currently strong telecom industry cash flows are unstable and could be severely affected by regulation or changing rivalry. Historically strong cash flows, from high prices and low capex, have allowed T and VZ to sustain nearly 6% dividend yields and strong share price appreciation. This Pax Telco-mana is vulnerable to regulatory and judicial actions by the government to promote competition, threats by non-traditional competitors and/or an aggressive competitive move by either of the leaders.
U.S. regulators may act to promote competition, which could yield increased spending and renewed price rivalry. The FCC and DOJ blocked T’s T-Mobile acquisition, and may do the same to VZ’s spectrum deal with cable MSOs. Congress has authorized the FCC to auction as much as 120MHz of highly desirable spectrum, with leeway to set rules to promote competitive balance. A Republican FCC could yield rules more favorable to the market leaders, so we expect the current commission to push to set the auction conditions as quickly as possible.
Cash rich Internet companies have strong incentive to promote a competitive wireless data market. Web leaders, like Google, Apple, Microsoft, and Amazon, are focusing on their mobile products for much of their anticipated growth, and to various degrees, have been aggressive investors in infrastructure. These companies could inject capital to support second tier carriers, or even bid on spectrum directly, looking to promote lower prices and higher caps for mobile data.
We see significant risk to the top telecom carriers. We prefer secondary carriers, equipment vendors and tower companies. T and VZ have delivered extraordinary returns over the past two years, and still support nearly 6% dividend yields. We are concerned that the cash flows underlying these earnings and pay-outs are at risk to future competition. We prefer secondary carriers (which could benefit from new spectrum), telecommunications equipment vendors (which have suffered a multiyear slump,) and to a lesser extent, tower companies (which are already richly valued).
For the full research note, please visit our published research site.