Telecom: Investing Essentials

Beginning with the invention of the telephone, communication has evolved and never been faster or easier than it is today. Many companies have risen over the decades to facilitate these communications.

Few industries connect people like the telecom industry -- particularly in this day and age -- as the mobile revolution has firmly gripped the world while Internet connectivity is nearly ubiquitous in mature and developed markets.

Because of their defensive nature, many investors like telecom stocks since cash flows are less dependent on economic cycles. That reliable cash flow yields reliable dividend streams for shareholders. Here's an industry primer for anyone currently invested, or looking to invest, in telecom.

What is the telecom industry?

The telecom industry consists of companies that deliver network connectivity to consumers, which includes wired and wireless connections. That would include traditional cable companies offering bundled phone, Internet, and TV service alongside wireless carriers that deliver cellular data to mobile devices.

As in many utility sectors, the telecom industry structurally favors oligopolies. That stems from the fact that telecom companies have very high capital expenditure requirements for networking infrastructure, which becomes a natural barrier to entry. That also means scale is important so companies can better utilize all that expensive equipment.

This is also why the telecom industry is prone to consolidation. Companies seeking to minimize expenses through cost-saving synergies frequently merge or acquire other companies, reducing administrative overhead and other shared costs while consolidating market power.

How big is the telecom industry?

The telecom industry has a deep and expansive value chain. Equipment vendors must stay on the cutting edge of technology as innovation drives new advances in connectivity and performance. Network operators then choose how frequently to upgrade their networks to remain competitive. Consumer demand for high-speed data continues to drive accelerated network upgrades.

Within the U.S. in 2013, there were over 335 million wireless subscriber connections. On the wired side, there are approximately 28 million voice customers, 54 million cable video subscribers, and 54 million wired Internet subscribers. The 9 largest telecommunications companies (including wired and wireless) generated a combined $428 billion in revenue in 2013.

Indirectly related are semiconductor companies that must also make chips within the devices that will connect to the networks. That includes cellular baseband modems for long-distance communication as well as Wi-Fi chips for short-range communication.

It's difficult to quantify how big this industry is on a global scale, especially when considering all of the aspects of the value chain.

How does the telecom industry work?

Telecom companies deploy large networks that deliver service to consumers. Meanwhile, the companies ensure connectivity with each other's networks as well as content providers.

One challenge telecom companies face is service commoditization. Even though the industry is characterized by oligopoly and high capital requirements, most markets usually have alternative providers customers can choose from. Since each service is a comparable substitute, telecom companies have weak pricing power. However, in markets that lack competition, without alternatives, telecom companies have strong pricing power.

Wireless companies must also acquire radio spectrum rights to broadcast service. Within the U.S., this is done through an auction process that the Federal Communications Commission conducts. That generally gives larger companies with deeper pockets some inherent advantages, although auction rules are sometimes set up to favor smaller companies for the sake of competition.

Wired providers have historically used old-fashioned copper wire to connect homes, but fiber optic cables are superior for various reasons. Fiber is less expensive to deploy across long distances, experiences less signal degradation, and use less power, to name a few. However, since competition in this industry is not intense, many companies are not incentivized to spend on upgrading to fiber unless rivals are doing so. Many wired providers use hybrid networks that use both copper and fiber as a middle-ground solution.

What drives the telecom industry

The biggest driving factor of the industry is connectivity adoption. In many emerging markets, Internet penetration remains quite low. That's especially true for markets where monetization is difficult, or where geography makes network deployment challenging. The number of global Internet users is expected to reach nearly 3 billion by the end of 2014, which is less than half of Earth's total population of over 7 billion.

Increased data usage will also be an important driver of the telecom industry, particularly on the wireless side. Most mobile operators have been shifting to tiered pricing structures for years as a way to recoup significant infrastructure investments. Not all data types are equal, and video easily consumes the most data. Mobile data traffic grew 81% last year, while mobile usage is now 25% of all web usage.

The broader Internet of Things trend is also on the rise. With it, connected devices of all forms will continue creating data that will then be transmitted over networks. By 2020, there could be as many as 26 billion connected devices with embedded technology. The Internet of Things will likely also drive data usage for the benefit of the telecom industry.

Rising Internet adoption, increased usage, and the Internet of Things are the three most important trends driving the telecom industry today.

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