Dominance in telecom is steadily shifting away from traditional wireline companies to wireless -- a trend that's affecting the market for telecom equipment as well, says Standard & Poor's analyst Kenneth Leon, who covers the wireless-services and -equipment companies. Growth in wireline is definitely slowing, he says, and many customers are using their wireless phones for long-distance calls while retaining a wireline connection for local service. Between 10% and 15% of the total market is now using wireless exclusively, Leon says.
The leaders in wireless service, he adds, include Verizon Communications (VZ ), Sprint (FON ), and Cingular, a joint venture of BellSouth (BLS ) and SBC Communications (SBC ), and for international markets Vodafone (VOD ). On the equipment side Leon's top recommendation is Qualcomm (QCOM ), the leader in CDMA technology.
These were some of the points Leon made in an investing chat presented Mar. 1 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. AOL subscribers can find a complete transcript at keyword: BW Talk.
Note: Kenneth Leon is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."
Q: Ken, what's the state of the telecom stocks generally in this volatile market?
A:I cover both wireless-services and wireless-equipment stocks, and we currently have a neutral viewpoint on telecom wireless services, expecting increased competition over the next 12 months. Consolidation both in the U.S. and overseas may also have a negative impact on capital spending for wireless equipment.
Q: What wireless-service companies look strongest now?
A:There are five nationwide carriers in the U.S. market that control over 90% of total subscribers. We see Verizon Communications (VZ ); Cingular, owned by BellSouth (BLS ) and SBC, and Sprint (FON ), with its proposed merger with Nextel Communications (NXTL ), as best positioned in the U.S. market. We also like Vodafone (VOD ) for playing the international market.
Q: Who looks best in wireless equipment these days?
A:Our top recommendation is Qualcomm (QCOM ), which is the market leader for CDMA technology. This is the only company that enjoys pricing power in the industry. The company is well positioned with its intellectual property on CDMA, for which it gets paid royalties on chipsets and handsets that are shipped around the world. Because of the company's unique position, we see Qualcomm as similar to the position that Microsoft (MSFT ) enjoyed in the 1990s.
We expect revenue growth greater than 20% with net margins near 35% in 2005. We also see strong free cash flow and cash at the end of the year approaching $9 billion with no debt. We see Qualcomm as a core position in a technology portfolio. With the recent weakness in equipment stocks, including Qualcomm, we would buy Qualcomm shares.
Q: So does S&P rate QCOM a strong buy or a buy?
A:We have it rated as a strong buy. It is also in S&P's Equity Research Top 10 Portfolio recommendations.
Q: What other strong buys or buys do you have in your coverage area, Ken? Beyond QCOM.
A:In the last few months we have pared down several names. QCOM is the only strong buy we have in our universe for equipment. We also have a strong buy on Cisco (CSCO ), which is covered by Ari Bensinger. In wireless services, we don't have any strong buys, but we do have buy recommendations on Sprint, Nextel Communications, and Nextel Partners (NXTP ).
Q: Do you see any impact on your area from voice-over-Internet protocol (VoIP)?
A:Again, from a wireless perspective, we're beginning to see wireless take on IP-based services -- for example, the network upgrades to third-generation platforms will allow wireless subscribers to be able to navigate the Web and send and receive e-mails and files. The services and features that you can get on a broadband wireline network are expected to be available on wireless networks in the next two years.
Q: How are valuations now among the stocks you cover?
A:Most of the wireless equipment group have corrected 15% this year, and we are seeing more reasonable valuations relative to their growth rate, but most of the stocks are still trading at a premium to the market. In the case of wireless services, we are seeing valuations either below or at the market level
Q: So is this a good time to get into wireless services?
A:We think one should be selective in the group and play a mix of domestic and international stocks. In the U.S., because there has been so much consolidation with mergers and acquisitions, we think the names we mentioned before are attractive. And outside the U.S., we think Vodafone has attractive valuation and a strong competitive position.
Q: Do you see wireless becoming the dominant player, vs. wireline?
A:It's already happening, and I was one of the first ones to cover wireless back in the '80s. As evidence of that statement, we're seeing acquisitions in wireless being sold at premiums, while we're seeing long-distance acquisitions coming at discounts.
For most of the major telecom providers, not only in the U.S. but around the world, a key strategy from management is to grow wireless as a percentage of their total revenues. This seems to be the most relevant benchmark that investors are tracking for the growth outlook and value of these companies.
Q: What about the wireless phones themselves? Who's the leader? And will we be seeing more and more bells and whistles?
A:First of all, wireless handsets grew 33% in 2004 over 2003, and we're projecting handsets in terms of unit shipments to grow 10% in 2005. What's driving growth is new market penetration in emerging countries such as China, Southeast Asia, India, Latin America, and Eastern Europe, as well as a high replacement cycle for handsets in developed markets like Japan, Korea, Western Europe, and North America. In terms of bells and whistles, what has become a standard in 2005 is color-display handsets, which shipped more than two-thirds with camera features. The next area of bells and whistles is going to be handsets that have Internet/Web capability for surfing the Web and for video streaming.
Q: Who are the leading manufacturers of these handsets?
A:The major handset manufacturers are Nokia (NOK ), Motorola (MOT ), Samsung (SSNKF ), Siemens (SI ), LG (LPL ), and the joint venture of Sony (SNE ) with Ericsson (ERICY ).
Q: How does S&P rank these stocks?
A:We have a buy on Nokia, a hold on Motorola, a hold on Ericsson.
Q: What about the suppliers of chips for the handsets? Who's ahead there?
A:For the CDMA market, Qualcomm is the market leader with more than a 95% share. For the GSM market and these technologies the leading suppliers are Texas Instruments (TXM ), STMicroelectronics (STM ), and Freescale Semiconductor (FSL ).
Q: How about Tellabs (TLAB )?
A:I cover Tellabs. We currently have a hold recommendation. While the stock has corrected somewhat, we think that its customers for broadband products are going to be slow in spending in 2005.
Q: Do you have any stocks in your area that you recommend selling?
A:We currently have sell recommendations on America Movil (AMX ), the largest wireless provider in Latin America, and on KT (KTC ), the largest wireline provider in Korea -- and it has a wireless business as well. And we have a sell on Triton PCS Holdings (TPC ). We also have a strong sell on China Unicom (CHU ).
Q: What's wrong with those companies?
A:In the case of America Movil, we see a potential slowdown in the Mexican economy, which may hurt subscriber and revenue growth for the company. We also see higher marketing costs to acquire new subscribers, which may narrow margins. We also see a less favorable foreign exchange position to the U.S. dollar than what they've enjoyed over the last 18 months.
In the case of KTC, they're faced with declining wireline revenues while trying to grow wireless revenues, but recent performance has been weak in comparison with SK Telecom (SKM ), the market leader, or the No. 3 provider, Freetel.
For Triton PCS, since they've lost affiliation with Cingular Wireless, we see a more difficult outlook as an independent service provider. Triton competes mostly in select markets in the southeast part of the U.S. For China Unicom, which is a strong sell, we see continuous high network costs in running two separate networks by technology, and we see weak net subscriber additions in recent quarters.
Q: What do you think will happen at wireline companies? Will they ever stop losing business to wireless?
A:We think they will continue to lose business, not only to wireless carriers but also cable operators.
Q: Will we eventually -- perhaps soon -- be able to carry one small device for all uses?
A:It's an aspiration for everyone, but it will take time. What has been recognized by many is that wireless devices are one of the largest and fastest-growing consumer-electronic products. The ability to communicate, be entertained, keep calendars, and send text messages will probably happen in a single device, including music capability -- many of the handsets today have MP3 features in them.
Q: Of course, meantime, more and more customers are using wireless exclusively -- any numbers on that? Has growth in wireline stopped or slowed?
A:It's somewhere between 10% and 15% of the total market. For the youth segment -- college students and twentysomethings -- it's significantly higher. The notion of wireless as a substitution for wireline is happening very significantly. Many households are using wireless for long-distance calls and still using local wireline. Growth in wireline is declining.
Another way to look at this is to say that the traditional telephone line access business is declining but the companies are seeing double-digit growth in broadband or DSL services for small businesses.
Edited by Jack Dierdorff