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Though it might seem simple and straightforward, investing in top telecom stocks is far more complex than it initially seems. As we learned in an earlier two-part blueprint for investing in telecom companies, providers of wireless and landline services operate in a multifaceted, highly regulated industry. If you really want to gain an in-depth sense of the industry, I suggest the above two articles as a great starting place. However, as a quick primer, we'll review three of the most important high-level takeaways that anyone considering buying telecom stocks absolutely must consider.
Size = strength
When it comes to winning in the telecom space, history shows time and again that size matters. The telecom industry's massive fixed costs -- and the voluminous cash flows they can eventually produce -- allow the companies with the financial resources to invest in their wireless or wireline infrastructure to maintain their competitive positions.
Moreover, closing the gap between market leaders and potential challengers requires massive capital expenditures on the insurgents' parts, which can strain companies' balance sheets along the way. Here's a quick example of how this dynamic plays out among U.S. wireless providers, where AT&T (T +2.12%) and Verizon (VZ +0.30%) are the entrenched incumbents, and T-Mobile (TMUS +2.16%) and Sprint (S +0.00%) desperately want to steal market share from the former.
|
AT&T |
Verizon |
Sprint* |
T-Mobile | |
|---|---|---|---|---|
|
Cash Flow from Operations |
$35.8 billion |
$38.9 billion |
$9.0 billion |
$5.4 billion |
|
Capital Expenditures |
-$19.2 billion |
-$17.7 billion |
-$7.0 billion |
-$4.7 billion) |
|
Free Cash Flow |
$16.6 billion |
$21.2 billion |
$2.0 billion |
$700 million |
Data source: Bank of America Merrill Lynch; FY 2015 data. *Denotes 12 months ending 3/31/16.
To me, this is one of the most important charts in explaining the current competitive stance of the U.S. wireless market. Verizon (143 million) and AT&T (133 million) enjoy a roughly 2-to-1 wireless subscriber advantage over T-Mobile (69 million) and Sprint (59 million). As you can see, this larger scale translates into AT&T and Verizon needing to invest a far smaller percentage of their cash from operations into their networks than Sprint or T-Mobile. All of that extra free cash flow gives Verizon and AT&T the ability to invest in opportunities like Verizon's acquisitions of AOL and Yahoo!, or AT&T's DIRECTV and Time Warner buyouts. When it comes to the telecom business, it pays to be one of the top dogs over the long term.
Not all yields are created equal
With well-known names like AT&T and Verizon sporting dividend yields more than double the market average, the telecom industry can be a paradise for income investors. However, chasing yield in this sector can be the siren song of a money-losing investment. Here, a company like rural wireline provider Windstream (WIN +0.00%) serves as a useful cautionary tale.
In case you've never heard of it, Windstream provides landline telephone, broadband, digital TV, and security services to 1.4 million subscribers across the rural areas of 18 states. Spun out from the now-defunct Alltel in 2006, Windstream's strategy has been to roll up as many rural fiber assets and subscribers as possible to essentially become the biggest fish in an area of the telecom industry that's in structural decline. This "growth via merger" model works well on a quarter-to-quarter basis, but it ultimately lies on the losing side of history. The company continues to push forward, recently announcing an all-stock merger with the similar EarthLink. However, with demand for its services declining as our digital world evolves, Windstream's core business strategy appears unsustainable over the long term.
What likely first pops out when looking at Windstream is its 8% dividend yield. However, as you saw in the above chart, Windstream's temptingly high dividend yield should more appropriately be viewed as a proxy for its risk. There's a long list to support this truism -- see Alaska Communications Systems or Frontier Communications -- but chasing yield in the telecom space is a quick way for investors to lose their shirts, which segues nicely into the final point on telecom investing.
Understand the business model
The final telecom investing tip might seem obvious, but given the industry's sneakily diverse mix of companies, investors must understand in detail the business model and strategy of a given company prior to buying. Are they in a growing segment of the industry? Wireless providers and the companies that supply their infrastructure are growing, while older technologies are fading. What does their competitive positioning in that market look like? As we saw with wireless providers, AT&T and Verizon remain far stronger than T-Mobile and Sprint. Despite the wireless space's overall favorable growth characteristics, the benefits of that growth are rarely distributed evenly.
At the end of the day, this harkens back to Warren Buffett's concept of a circle of competence. Investors make unintended mistakes when they don't take the time to fully understand any potential investment. The seeming simplicity and sleepiness of the telecom industry can mask the underlying complexity of the sector, much to an investors' detriment. Taking the time to dig into a company's competitive position, its dividend details (if applicable), and its business model and outlook are critical steps that can save investors from making costly missteps or, better still, help identify stocks that can earn investors thousands.
