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QUALIPORT
Top Quality Telecoms

By Maynard Paton (TMFMayn)
June 15, 2004

Telecom companies were last mentioned by the Qualiport five years ago. Back in 1999, the talk was of rapid growth phases and target buy prices based on 50 times earnings. But following a dramatic collapse in the sector's fortunes and share price valuations, it's time to pay a return visit.

Fundamentals

Here's a quick rundown of why telecom network companies could become quality investments.

Easy to understand: Almost everybody has a fixed-line phone in their home and/or place of work, the benefits of which have been known pretty much since Alexander Graham Bell called colleague Thomas Watson in 1876. Mobile phones have gained popularity of the past decade or two, buoyed by their obvious advantages.

Predictable, repeat business: Telephone calls -- voice or data -- are made each day, every day. The cost per individual call is generally small, so gloomy economic conditions should not herald a sudden drop-off in volumes or profits.

Industry forces: Significant capital requirements are substantial barriers to entry for newcomers. Tangible assets at the big network operators run into the billions and, given the collapse of, for example, Energis and Telewest (LSE: TWT) during recent years, potential start-ups will struggle to find generous backers.

Indeed, the failure of many businesses in the sector perhaps indicates those left standing have some sort of inherent operating strength. However, a costly network flop can become a high barrier to exit for an industry laggard, prompting desperate pricing strategies and stirring competitive rivalries further.

In terms of product substitution, the threat of the mobile replacing the traditional fixed-line phone is ever growing. However, the mobile at present has no real alternative. A big pro for fixed-line and mobile network owners alike is not having to rely on a handful of powerful customers for success. Suppliers to the telecom industry, however, generally have to deal with a handful of large network operators.

Finally, 3G licences provide a decent franchise for mobile groups. Governments usually limit the number of telecom permits and in the UK at least, there's no sign of a sixth 3G licence coming on to the market anytime soon.

Regulator: The main downside to the telecom industry is regulation. In the UK at least, hardly a week goes by it seems without some regulatory intervention, with BT (LSE: BT.A) in particular prone to OFCOM interference.

Mobile operators haven't escaped the authorities either, as directives to reduce call termination charges have sliced millions off revenues. Nevertheless, an active regulator is always a double-edged sword to shareholders, suggesting also the sector is not ultra-competitive and therefore attractive for buy and hold investors.

Three camps

The telecom sector can be divided up into three broad camps:

1. Profitable blue chips: Vodafone (LSE: VOD), BT (LSE: BT.A), mm02 (LSE: OOM) and Cable & Wireless (LSE: CW.)

2. Second-tier loss makers: Including Colt Telecom (LSE: CTM), Thus (LSE: THUS), Kingston Communications (LSE: KCOM) and PIPEX Communications (LSE: PXC).

3. Small-cap growth stories: For example, Telecom Plus (LSE: TEP) and Vanco (LSE: VAN).

Of the three camps, the blue chips appear the best starting point for long-term investors.

With the loss makers, accounting sleuths may be able to spot a hefty network depreciation charge masking great cash flow, but why bother trying to be clever when there are a handful of larger and obviously profitable alternatives around? Meanwhile, the sector's small-cap growth stars have short track records, which makes judging whether their competitive advantages are sustainable or not quite tricky.

Finances

Of the four blue chips, the financial records of BT, C&W and mm02 are not particularly impressive.

BT and C&W have suffered from various problems in the last few years, resulting in falling profits, cut dividends and boardroom clearouts. Only in the last year did the tide begin to turn, emphasised by sizeable dividend increases at both firms. Meanwhile, having been spun off from BT in 2001, mm02 recorded its maiden profit in 2003, though it has yet to declare a dividend. All in all, interpreting the underlying financial prowess of BT, C&W and mm02 could prove very difficult.

In contrast, Vodafone seems not to have missed a beat. Admittedly, there's been some corporate activity and the odd write-off, but the group's sales, underlying profits and dividend payments have grown progressively throughout the sector turmoil. Furthermore, Vodafone's latest full-year figures compare well to those of the three other contenders:

Company             Operating
margin (%)
Net interest
cover (x)
Underlying sales
growth (%)
BT 16 3.3 0
Cable & Wireless 7 net cash (8)
mm02 8 7.6 22
Vodafone 32 15.1 10

Vodafone's size gives it a strong competitive position, too. It's the world's leading mobile operator and has subsidiaries, associates and/or ventures operating in 26 different countries. It's fair to assume the resultant financial muscle gives Vodafone greater scope for long-term growth than mobile counterpart mm02, which at present is limited to the relatively mature mobile markets of the UK, Ireland, Germany and the Isle of Man. To put things into perspective, Vodafone generates operating profits of nearly 11b per annum; mm02 is worth less than 9b.

C&W, with its focus on corporate communications, loses out on its relative lack of business visibility and seems more of a turnaround story than long-term quality. BT has the threat of mobile substitutes and though you could argue that the fixed-line giant has broadband growth prospects, there's always 3G for Vodafone and mm02.

Of the four blue chip telecoms then, Vodafone is the obvious winner. It's (probably) got the least competitive worries, the best financial record, the largest financial firepower and the most favourable growth prospects. The company will be assessed for the portfolio's watch list in July.

Where now? The Ideal Qualiport Company