10-Point Checklist for Investing in Telecom Companies (Part 2)

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In Part 1 of this article series on honing your abilities to analyze telecom stocks, we discussed the first five points investors need to understand as part of their research process. To recap, investors should understand important industry metrics such as churn and ARPU, examine the network quality of the company and its relevant competitors, research the dividend policy, and review its capital structure -- all before buying a telecom stock. Now let's consider five additional items for investors to consider.

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6. Evaluate its spectrum holdings

Spectrum rights are the lifeblood of modern mobile networks. Similar to how radio stations own the rights to broadcast over a certain frequency and geography, telecom companies own the rights to similar frequencies of radio waves that we simply refer to as spectrum. So it only makes sense that a telecom investor should have a basic understanding of a wireless provider's spectrum holdings. The good news is, that's fairly easy to do.

Telecom operators provide information about their spectrum holdings and lease arrangements in their annual reports. If you're interested in a certain geographic area, the Federal Communications Commission maintains a website detailing which wireless companies own the rights to various spectrum frequencies.

7. Calculate free cash flow

Telecom companies throw off gobs of cash, thanks to their relatively stable, subscription-based business models. As discussed in this article's companion piece, building and maintaining a competitive wireless network requires substantial capital expenditures, which can erode those free cash flows. The differences between providers on these matters can be eye-opening. For example, AT&T (T -1.72%) and Verizon (VZ -1.23%) enjoy subscriber bases roughly twice the size of Sprint (S) and T-Mobile (TMUS -0.24%), and the tremendous difference shines through in terms their cash flow generation.

Data source: Bank of America Merrill Lynch; FY 2015 data. *Denotes 12 months ending March 31, 2016.

Though much has been made of T-Mobile's and Sprint's recent challenges to AT&T and Verizon, this chart reveals the extent of the financial differences among U.S. wireless providers. This sizable difference in cash flow generation gives AT&T and Verizon far more flexibility to invest in future growth drivers (see below). They can more easily spend more on marketing, promotional pricing, and other measures to fend off their resurgent competitors. In fact, I maintain that this chart provides one of most useful ways to frame the competitive landscape in the U.S. telecom market. Any investor looking at this market needs to examine the stock in question in a similar manner before buying.

8. Compare revenue growth strategies

As many smartphone markets in developed countries mature, revenue growth strategies are evolving at most telecoms in ways investors need to understand. For example, T-Mobile and Sprint remain the underdogs in the U.S. wireless market. To try to close that cash flow generation gap, both parties remain focused on growing their 4G wireless subscribers through a mix of marketing and price competition; T-Mobile's "Un-carrier" campaign is perhaps the best example.

Image source: T-Mobile.

However, in terms of their free cash flow advantages, AT&T and Verizon have instead pursued M&A strategies that should allow them to grow ARPU, albeit in different ways. Verizon has made a bet on building out its mobile advertising business by spending roughly $9 billion to acquire content and ad-tech powers AOL and Yahoo! over the past two years. AT&T, on the other hand, is moving to fashion itself into a one-stop shop for mobile connectivity and video programming through its purchase of DIRECTV and its proposed Time Warner buyout.

9. Study capex plans

Since it takes money to make money, investors need to understand a company's upcoming investment plans before buying. As was the case with their spectrum holdings, wireless providers typically offer some information on their near-term investment plans in their SEC filings.

For example, AT&T's annual report states, "We expect our 2016 capital investment, which includes our capital expenditures plus vendor financing payments related to our Mexico network, for our existing businesses to be in the $22,000 range, and we expect our capital investment to be in the 15 percent range of service revenues or lower from 2016 through 2018." Finding this information doesn't have to take a lot of time -- I found it from a quick search.

10. Review the management team

As with all good investing, it's critical to understand the cast of characters at the helm of a company. In fact, finding companies run by strong managers is one of the bedrocks of the Fool's primer on how to buy stocks. Among U.S. wireless providers, this is a fairly easy process, as the four largest wireless providers in the country are run by a well-known set of executives: Randall Stephenson at AT&T, Lowell McAdam at Verizon, John Legere at T-Mobile, and Marcelo Claure at Sprint.

A quick search can reveal the background information for the executive team and board of directors of a company that interests you. Furthermore, companies are required to publish their executive compensation plans in their annual proxy filings, which you can find on the investor-relations page of a company's website.

Foolish bottom line

Successfully buying telecom stocks requires quite a bit of analysis and familiarity with industry-specific metrics. However, with a little practice, anyone can get the hang of it. Equally important, using this checklist can help reveal some important risk factors that might not leap out at first glance. Getting to that point might require some additional upfront effort on your part, but the rewards will be worth it.