Betting on Telecom? See DCF - Analyst Blog

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In a technology driven world, it has become a prerequisite for the telecom companies to constantly upgrade themselves lest they fall behind. But remaining up-to-date involves technological changes and innovations that raise the capital spending needs of the telecom carriers and in turn put pressure on the companies' bottom lines. The recent smartphone frenzy has also prompted huge investments in spectrum purchases to boost video content and other data services.

Developments notwithstanding, investments in telecom stocks seem risky as the global market faces the threat of yet another recession. While we await a political resolution to Euro-zone sovereign debt crisis, the contagion is spreading globally, weighing down on economic growth. The problems in Europe are spilling over to the rest of the world and might even put a halt to the slowly moving U.S. economy.

We believe any economic meltdown could delay the ongoing developments in the telecom industry leading to negative implications on financials, pulling down the stock prices. Considering the risks, if an investor still wants to bet on telecom stocks, our discounted cash flow (DCF ) analysis can be counted on for solid returns.

Our 50-yearDCF valuation model discounts free cash flow (i.e. cash flow from operating activities minus capital expenditure) using an appropriate discount rate (i.e. expected or required return on a company's stock) to derive the company's Fair Value. The ratio of Share Price ( P ) to Fair Value per share (DFCF ) gives us an idea whether the stock is undervalued (P/DFCF is less than 100%) or overvalued (P/DFCF is more than 100%).

We are providing some insight to the U.S. companies that provide both wireless andwireline services. Wireless services are the major contributors to the future growth of telecom companies as subscribers are discontinuinglandlines and moving quickly to wireless connections.

Given below is a detailed analysis of valuation for the top three U.S. mobile operators-- Verizon Communications ( VZ">VZ ), AT&T Inc. ( T ) and Sprint Nextel Corp. ( S ), which look attractive at present.

Taking share prices of the first trading day of the New Year (i.e. January 3, 2012), ourDCF model yields a Fair Value of $39.74 and $94.81 for AT&T and Verizon, respectively. This implies that the stocks are trading at respective discounts of 23.5% and 58.1% for AT&T and Verizon. P/DCF for the stocks are less than 100%, showing both AT&T (P/DFCF : 76.5%) and Verizon (P/DFCF : 41.9%) are undervalued at current levels.

Coming to Sprint, the Fair Value derived from ourDCF model represents a negative number of $7.86, sending P/DCF (-29.8%) to a negative territory indicating that the company's shares are undervalued. Notably, Sprint is a loss making entity and as a result giving a negative Fair Value.

Despite the negative Fair Value, Sprint is showing the largest consolidated revenue and earnings per share growth, each more than 4% over the next 50 years. Wireless revenue should grow at aCAGR (2011-2062) of 4.4%. Verizon should also grow at the same rate as Sprint with regard to revenue and earnings per share. Wireless revenue will be the strongest at Verizon, increasing at a rate of 4.8% over the next 50 years.

Revenue growth is the least for AT&T, the second largest U.S. mobile operator, showing only 2.4% growth for the next 50 years with declining earnings per share growth of 0.4%.

Over the next 10 years (2012-2022), revenue for Sprint and Verizon would grow about 4% but the AT&T growth rate would be almost half in contrast to its peers. Further, earnings per share look highly attractive for Sprint with substantial growth of 8.9% followed by 3.8% growth for Verizon. Notably, AT&T is expected to generate negative earnings per share growth of approximately 13%.

Conclusion

Based on our analysis, we find Sprint much superior to the other two although it has been incurring losses over the past several quarters. Its outlook looks promising on plans to start deploying its own4G Long-Term Evolution (LTE ) based networks in mid 2012. The developments made by the company would help it emerge as a strong winner in the years ahead.

Further, Sprint is slowly turning around its business and is expected to register new highs in the upcoming years backed by reducing churn (customer switch), improving average revenue per user, increasing adoption ofsmartphones and the strong sales of Apple Inc. 's ( AAPL">AAPL ) iPhone.

Furthermore, we see a good chance of Sprint's share price moving up faster than Verizon and AT&T, as it is trading 60% below the year-ago price. Hence, Sprint would be our favorite bet for the long term.

But if investors do not want to bet on Sprint given the associated risks and its present performance, picking the stock of the largest U.S. mobile operator Verizon would be the next best option.

We believe Verizon is on track to meet its revenue and earnings targets based on the introduction ofsmartphones , tablets and data devices in the wireless segment as well as continued strongFiOS fiber-optic network and strategic services in thewireline business. Additionally, the iPhone and the entry into the cloud computing business makes Verizon attractive for investment as it would boost the company's growth going forward.

AT&T, which was the hot pick last year, lags Sprint and Verizon, going by ourDCF model. The unsuccessful ending to the T-Mobile merger story shattered AT&T hopes of becoming the largest U.S. wireless carrier by dethroning Verizon. The company is in now in need of additional airwaves to expand its high-speed4G services.

Already criticized for dropped calls and poor network coverage, AT&T will face more constraints in its capacity deployment than Verizon, hurting subscriber growth. Nevertheless, AT&T is expected to generate strong growth primarily driven by iPhone and smartphone sales coupled with growth in tablets and connected devices that will accelerate subscriber gains while reducing churn.

The company's recent launch of4G LTE networks, expanding U-verse services, and entry into cloud computing and hotel WiFi businesses would boost its profitability. In addition, AT&T was the first wireless carrier to provide mobile social gaming options on itssmartphones and tablets, which differentiates it from other operators. Hence, we will be carefully watching the movements of AT&T for acquiring additional airwaves to increase its capacity networks.


 
APPLE INC ( AAPL ): Free Stock Analysis Report
 
SPRINT NEXTEL ( S ): Free Stock Analysis Report
 
AT&T INC ( T ): Free Stock Analysis Report
 
VERIZON COMM ( VZ ): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Stocks

Referenced Stocks: AAPL , P , S , T , VZ

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