Is there value for investors in the telecom sector?

Key takeaways

• Competition in the industry is fierce, but some demand is all but guaranteed because of how essential the service is.

• Valuations are depressed, so there’s a case that current yields look attractive.

• Slow growth has added to poor sentiment, massive spending to rollout new technologies needs to deliver sooner rather than later.

The telecommunications sector provides phone, data, and internet services across the globe. It's a big, highly regulated, and evolving industry that plays an important role in modern lives – keeping us connected to friends, family, work, and entertainment.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them can rise and fall in value, so you could get back less than you invest. Ratios shouldn’t be looked at on their own and past performance isn’t a guide to the future.

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How has telecoms performed?

The telecoms industry has been underperforming the broader market for a while now, and 2023 wasn’t an exception.

The rollout of 5G and fibre has come at a massive cost, and at a time when consumers are feeling the pinch. That’s put a dark cloud over the sector and, in what’s a highly competitive arena, a lot of investors are wondering what demand will look like over the coming years.

What are the opportunities in telecoms?

The telecoms sector tends to benefit from an essential service premium.

Mobile and internet connectivity is crucial for work, education, entertainment and increasingly, social interaction. That means a base level of demand is relatively secure in any economic environment, making it an attractive sector in downturns – of course that’s not guaranteed though.

Pay-as-you-go options are still around, but a lot of products and services are now subscription-based. That doesn’t just make a nice steady stream of cashflow, but also helps lock customers in.

Even in the age of internet switching providers, making searching for the best deals easier than ever, there’s still a level of demand that’s sticky under the subscription model.

In the UK especially, prices linked to inflation can help revenue keep up in a high inflation world. But costs usually do the same, so it’s swings and roundabouts at times.

The telecoms sector might have some of the highest barriers to entry. There’s usually only a handful of big players in each market and it takes huge capital to build and maintain the infrastructure to provide internet or mobile services. For example, BT racked up a £5.3bn capital expenditure bill last year, over a quarter of its total revenue.

Take 5G. Providers don’t just need physical infrastructure, they also have to pay for access to the 5G spectrum.

Just like buying access to certain radio frequencies, companies can license parts of the 5G spectrum from the government. This lets them transmit their own data across their licenced bands. And it doesn’t come cheap, the most recent auction a couple of years ago raised around £1.4bn for the government.

Many of the big names in the sector would comfortably fall into a value investor’s bucket of potential investments right now. Valuations have been under pressure for years. Add in a highly cash-generative model and yields are high enough to tempt income investors too. 

But there are reasons for the low valuations that investors should know about.

What are the risks in telecoms?

Telecoms businesses tend to carry huge amounts of debt. That’s not always an issue, mature businesses in strong industries can stomach big debt piles. But when it does become an issue is in a higher rate environment, as the cost to service and issue new debt goes up.

With interest rates remaining high, investors should pay more attention to debt than they may have done in the past. To put some numbers on it, BT and Vodafone have a combined £80bn+ of debt.

While telecoms aren’t technically utilities, they do share a lot of similarities with the likes of water and power companies. Regulation for one means there’s always a risk that the business landscape can change.

Given the tight parameters set by the regulator, there’s not a whole lot to differentiate from service to service. That means price becomes the key attraction and companies often resort to bundling to pull consumers into multiple products and services. In a highly competitive industry, that means keeping margins up can be hard.

Lack of growth has been a bugbear for the sector. Huge investment in developing new technology and services from fibre to 5G means there’s mounting pressure for that to pull through into revenue and profit growth.

Our main concern, aside from consolidation within the sector (mergers or acquisitions), is growth is hard to come by. An argument can be made that new technology, like 5G, just replaces its predecessor instead of adding to growth.

What should investors make of telecoms?

We can see the appeal of yields at current valuations, and the utility-like demand profile is appealing, but we’d caution that sentiment is poor for a good reason. The sector’s underperformance comes from high investment costs and slow growth. As we approach the final stages of investment in fibre and 5G, there’s a lot of pressure on companies to start delivering growth and investors should be selective in the space.