Should you invest in smartphone stocks?

Allan Nichols, a telecommunications analyst, is quick to admit that he’s a dinosaur when it comes to mobile technology. He only recently purchased smartphones for his family. When he did, he also signed up for a more robust, and more expensive, data plan.

“Verizon was happy to see us upgrade,” said Nichols, senior international telecom analyst for Morningstar, the investment research firm. The more money he hands over each month, the better it is for the company’s bottom line.

There are millions of people around the world who are like Nichols — technological Luddites who are only now buying data-sucking smartphones.

Although they may seem ubiquitous, only 31 per cent of people around the world are using smartphones, according to a January 2013 study released by eMarketer, a US-based data analytics firm that tracks digital-focussed industries. That’s up from 10 per cent three years ago.

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In a mere four years, 50 per cent of the global population will be using smartphones, the firm predicted.

As more people embrace mobile technology, telecom sector revenues and profits are expected to rise, and with them returns for investors who hold shares in some of the world’s predominant telecom companies. However, growth prospects for these companies vary widely depending on the region’s laws, population and competitive landscape.

Since 10 March 2009, the S and P Global 1200 Telecommunication Services Index has climbed 50 per cent, compared to the S and P Global 1200 Index, which has risen 114 per cent.

That’s a sign that the sector has more room to grow, said Aditya Shivram, a portfolio manager with Fidelity Investments.

“No matter where you are in the world, the big-picture theme is smartphone, data and social networking over mobile devices,” Shivram said. “These all require huge data demand.”

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Telecoms in general can be solid investments because people consider their mobile phones as a necessary expense, even during tough economic times. These companies are also considered cash cows because they collect recurring monthly payments, makingrevenue prediction less speculative.

The global telecom sector can be appealing for many types of investors.

Those who seek growth can find fast-growing operations in emerging markets, Europe has opportunities for those who seek undervalued companies and yield-seekers can find stable, dividend-paying companies in North America. What to buy depends on your time horizon and risk tolerance.

Examining Europe
European telecoms took a beating during the recession. Many Eurozone companies actually saw revenue growth fall by between 2 per cent and 5 per cent in 2012 over 2011, said Nichols. That trend is continuing. First-quarter revenues for Deutsche Telekom have dropped 4.5 per cent year-on-year. Orange, Telecom Italia and KPN have seen similar revenue decreases.

In addition, several companies have slashed dividends, such as Spain’s Telefonica, which has seen its stock price plummet 53 per cent over the last five years.

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The competitive and regulatory environment is poor, said Shivram. Multiple telecoms vie for consumer dollars and regulators have historically frowned upon mergers in the sector.

While these developments may read as cautionary tales, some experts say it can’t get much worse. European telecom valuations are among the lowest out of any region. Many companies are trading on enterprise-value-to-EBITDA ratio — the valuation metric most analysts prefer using for this sector — of 4.5 times. The number has historically been between 6 and 7 times EV/EBITDA.

EBITDA, a measure of a company’s financial performance, stands for earnings before interest, taxes, depreciation and amortisation.

The sector is on the upswing, said Nichols. Investors just need to take a long-term approach. Europe’s economy will improve and people will start spending again. “We will see growth,” he said, likely in a couple of years.

Tina Sadler, a portfolio manager with Templeton Global Equity Group, said that regulators are expected to ease restrictions at some point. “The sector is crying out for consolidation,” she said. “That would really help things.”

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Emerging markets play
In general, revenues and earnings for emerging-market telecoms are growing at a double-digit rate, much faster than the mid-single-digit growth for companies in developed nations.

There are two main reasons for the speedier growth. Many companies in markets such as Thailand and Indonesia have less-developed landline businesses than operations in developed countries do. That means that if people want to talk on the phone, they have to buy a mobile device and that means more revenues for these telecoms.  

Also, Chinese smartphone manufacturers, such as Lenovo and Xiaomi, have developed cheap phones that sell for about 1,000 renminbi (US$160), said Christine Tan, a portfolio manager with Excel Funds Management. Now many more people can afford a smartphone. She points out that Chinese-made mobile devices account for 30% of global smartphone and tablet production.

However, investing in emerging-market telecoms is not all upside. Tan specifically cautioned investors to avoid  India, where there’s a lot of competition. While the country’s smartphone use is increasing, brutal price wars have depressed revenues.

The best investments are ones in “rational” markets, said Tan, such as Thailand, Morocco, Indonesia and Nigeria. These are places where there are only two or three main players and where data revenues are low, but growing.

China, for example — it is still considered an emerging market in the telecom sector — has a higher smartphone penetration than many other emerging markets, with nearly half the country using one, according to Goldman Sachs. The investment firm said it should catch up to US levels by 2015.

Nichols pointed out that valuations can vary wildly. There are companies trading at three times EV/EBITDA, while others trade at around seven times, if not higher.

Tan looks for businesses trading at more “reasonable” multiples of about five times.  

Navigating North America
Canada and the US have the most stable markets. Revenues are only expanding in the mid-single digits, but they are growing. According to eMarketer, smartphone penetration in both countries is between 51 per cent and 55 per cent, and is expected to hit nearly 80 per cent in four years.

Indeed, penetration will eventually reach 100 per cent or even more if people start owning more than one smartphone, according to eMarketer.

Most companies also pay attractive dividends that are, unlike in Europe, not at risk of a cut, says Shivram. AT&T, for example, has a 5 per cent yield, while Canada’s Rogers Communication pays 4.2 per cent.

“[North America) telcos are more of a bond proxy,” said Tan. “They have low growth, good free cash flow and they reward shareholders with bond buy backs and dividends.”

US and Canadian telecoms trade for higher multiples than those in other countries, which makes them somewhat less attractive, financial experts said. Companies have historically traded for around six to seven times EV/EBITDA and, said Nichols, they’re trading at the higher end of that range today.

That’s partly due to the reliable earnings — investors have snapped up the stocks since they know what they’re getting. At the same time, income-seeking investors have jumped into these stocks purely for the dividends.

What’s the best buy?
Every region has opportunities, but investors should first be clear about what they seek.

If you’re looking for undervalued operations and can be patient, then Europe has the best buys of any region, said Nichols. More risk-averse income investors, though, may want to own the large North American businesses.

For growth-oriented buyers, attractively valued emerging-market telecoms are a good bet, though Tan notes the long time horizon  required here.

No matter the region, consensus suggests that it’s hard to go wrong with a telecom in your portfolio. “There are good companies all over the place,” said Nichols.

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