Stocks: The Trouble with Telecom

After a traumatic beginning, the year 2009 has turned out to be a great year for U.S. stocks generally. But one sector of the market, telecom, wasn't allowed into the party. In a year when many stocks have doubled on hopes of an economic recovery, telecom has been wounded by its reputation for slow, steady growth. While the Standard & Poor's 500-stock index is up 21% this year, the S&P 500 telecommunication service sector was down 1.6% year-to-date as of Nov. 27. That's the only one of the broad index's sectors in negative territory. The tech sector has gained 50%, while consumer discretionary stocks have risen 35%. Telecom's troubles are well-known on Wall Street. First, there is uncertainty about the effect of new regulations, particularly from the Obama Administration's Federal Communications Commission, or FCC. Second, the recession has accelerated the trend away from traditional landline phone service, as more companies and residences cut lines or decide to switch to wireless, Internet, or cable phone service. Third, competition among telecom players is fierce, both in offering new services—such as wireless smartphones—and in lowering prices. Defensive PlaysBut the biggest strike against telecom may have more to do with trends in the broader stock market, says Ron Altman Sr., portfolio manager of the Aston/M.D. Sass Enhanced Equity Fund (AMBEX). "Part of it has absolutely nothing to do with the fundamental outlook for these companies," he says. AT&T (T) and Verizon Communications (VZ) dominate the telecom sector. Each firm has a market value greater than the other S&P 500 telecom stocks combined. Telecom's problem is that both AT&T and Verizon are known as boring, slow-growing, defensive plays. But since March, the stock market has rewarded volatile, risky stocks. AT&T is down 4% this year, while Verizon has dropped 3.7%. It might seem unfair: Telecom was hit hard by the start of the recession and the financial crisis, but it isn't benefiting from hopes of a recovery. The sector fell 34% in 2008. "They led the way into the recession," says Collins Stewart analyst Greg Miller. But "these are largely defensive names, so they rarely lead the way out of recessions." Steady RevenuesSome telecom businesses continue to grow, including wireless, data, and video. That's enough to partly offset the loss of landline customers and tough competitive pressures. For example, Verizon's revenues are up 9% in the past year, while AT&T's sales were basically flat. That's pretty good considering the median S&P 500 firm saw sales drop 6.5% in the last 12 months. (Both AT&T and Verizon saw earnings-per-share slip about 11% in the past 12 months, as competition for customers narrowed profit margins. Earnings for the full telecom sector dropped 7.1% last quarter, while the profits for the entire S&P 500 fell 13.7%.) "Their revenues have held up beautifully," says Charlie Smith, chief investment officer at Fort Pitt Capital Group, which has owned AT&T and Verizon shares for seven years. Even optimistic telecom shareholders like Smith don't expect explosive revenue and profit growth in the future. But, Smith says, firms can save money as the cost of technology falls and capital expenditures decrease. "Their costs are growing more slowly than their revenues are growing," he says. These telecom firms "have a long history of driving costs out of the business," says Altman, who also owns AT&T and Verizon. But Collins Stewart's Miller warns that telecom firms are still "highly deflationary businesses." In other words, falling customer prices are expected to cause the sector to grow more slowly than inflation over the long term. Dividend AppealWhat still makes telecom attractive to some investors are the sector's dividends. Dan Genter, president of RNC Genter, is only holding telecom stocks in his firm's "high dividend strategy." He doubts 2010 will be a "stratospheric year" for stocks, so with telecom, he says, "you get a good dividend while you wait." Telecom firms currently have the four highest dividend yields in the S&P 500: Frontier Communications (FTR), with a yield of 12.5%; Windstream (WIN), with a yield of 9.9%; Qwest Communications (Q), with a yield of 8.3%; and Centurytel (CTL), with a yield of 7.8%. The high yields of those smaller players may reflect their higher risk profile. But Verizon has a dividend yield of 5.9% and AT&T has a dividend yield of 6%, and most observers say those dividends look quite safe. The yield on the S&P 500 is 1.96%. In fact, both firms have consistently raised their dividends. After meeting with Verizon management, JPMorgan (JPM) analyst Mike McCormack told investors Dec. 1: "The company remains committed to return free cash via dividends with a hope for continued annual increases." In an environment where rates on money-market funds and short-term Treasuries are near zero, telecom stocks offer rare chances to get yield. What they don't offer investors is a clear path to major price appreciation. It's possible that expectations are so low that telecom can surprise Wall Street with major profit or sales growth in 2010. But unless that happens, the sector may only return to fashion when investors again choose stability and consistency over the potential for major upside.

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