Debt and the Telecom Giants: Why Spreading Risk May Matter in Times of Economic Decline

Summary:

• VZ appears to be the most fundamentally stable of the peers, but it’s hard to tell if the stock is undervalued.
• Investors hoping for a T recovery should keep an eye on the level of leverage, which seems to have a big impact on market value.
• Investors in TMUS may experience the most significant earnings growth, but much of it is already priced in to stock prices and capital returns need to improve.

AT&T Inc. (NYSE:T), T-Mobile United States (NASDAQ: TMUS), and Verizon (NYSE: VZ) are the three major telecommunications operators in the United States. Stocks have performed poorly, with TMUS registering 6.8% over the past 12 months, T suffering a steep decline of 38.4% and VZ losing some 23.3%. In this article, we’ll discuss the effects of debt, 5G and consumer spending on the valuations of these stocks and see how their fundamentals compare.

Keep in mind that dividends are a big reason some of these stocks are attractive, and investors can find an analysis of the quality of dividends in each of the individual stock reports.

Overview of the telecommunications industry

Going from top to bottom, the telecommunications industry has a median PE of 16.2x, well below the historical median of 20.9x, indicating that some stocks may be undervalued. The chart below shows the evolution of market sentiment for this sector:

Looking at forward estimates, we see that analysts are the most bullish on the wireless industry, expecting 38% annual earnings growth over the next 5 years – T-Mobile US is part of this industry. On the other hand, the integrated telecommunications services sector is expected to see its profits increase by 3.5% per year over the next few years, which includes AT&T and Verizon.

Compare fundamentals

Analysts appear to be relatively neutral on revenue and estimate slow growth for Verizon and T-Mobile US, while AT&T is expected to drop to $125 billion in 2023 and then stabilize after the fallout.

The table below shows the key metrics for the three telecom stocks. In billions of USD, unless otherwise indicated:

The average EV to sell for telecom stocks is 2.8x, which means that only AT&T is a significant outlier, however, if we evaluate the expected revenue after the spin-off (2024 estimates), we get a EV figure to sales of 2, indicating the stock is closer to average than it first appears.

We can see that debt is a big part of the risk in telecom stocks. This is exacerbated by rising interest rates which can make refinancing debt more expensive and erode investors’ bottom line. It is therefore not surprising that the equity value of these stocks has declined. This could continue to deteriorate if inflation does not stabilize, as interest rates are sensitive to rising prices.

5G may have been rushed

Telecom stocks tend to have stable revenues and earnings, so the key issue they have to manage are expenses such as CapEx and interest on debt. These companies have committed to expanding their 5G infrastructure in an effort to improve the quality of their service. However, investors should ask themselves, “What is the marginal benefit of 5G adoption?” Businesses may quickly find that they struggle to increase the price of the additional service package, which can lead to a lower return on capital from their 5G spend.

The case for implementing 5G is certainly clear – if they don’t, competitors will use it and acquire more users for the same price. However, the case for rushing with 5G infrastructure is not so obvious. The first wave of deployment was costly and best practices have yet to be developed to ensure a cost effective approach. This can result in overspending of investor-owned cash.

Returns on capital employed are tied to this and are an important metric to track. If the ROCE is equal to or less than the cost of capital, companies are not efficient in their decision making. For our three telecommunications companies, we note the following ROCE:

• AT&T: 8.7%, down from 6% three years ago.
• T-Mobile US: 5.7%, compared to 8.3% three years ago.
• Verizon: 8.3%, down from 12.8% three years ago.

Management can argue that these projects have yet to bear fruit and that investors should be patient with investments. That may be true, but it’s always good to know the current baseline for individual businesses.

From the list above, we can see that AT&T and Verizon have the highest ROCE values, which are likely above their cost of capital. T-Mobile US noted a decline to 5.7%, which could still be around its cost of capital, as telecom stocks tend to be less risky and have an average cost of capital of around 6%. .

It appears that Verizon and AT&T are currently managing their businesses for stability, while T-Mobile US may have outgrown plans for growth.

Debt puts pressure on valuations

Telecommunications companies are notorious for financing their projects through debt. This is great in a low interest rate environment. However, things get more complicated in the long run rates increase to 3+%. Comparing the table shows that these companies are heavily reliant on debt financing, with AT&T at 115% to market capitalization, while T-Mobile has a much more manageable 41%.

Clearly, deleveraging is a high priority for AT&T, or the company’s equity could continue to suffer. AT&T has reduced its total debt by $72.8 billion since last quarter, but the remaining balance will take some time to stabilize, especially as higher interest payments leave less room for the company to repay his debt. Verizon is somewhere in the middle, and we can expect inflation news to have less of an impact on the stock.

There are many indicators available to analyze when assessing debt risk. In our case, we opted for “debt at market value of equity” because it is a current, actual measure of the value of a company’s equity. Tradition and inertia sometimes encourage investors to use debt for (book value of) equity, but companies cannot sell assets or issue stock at book value and are therefore not helpful to investors.

Negative consumer sentiment is also at play

It is also important to keep in mind that we are in a downward economic trend, where changes in consumer spending can influence the revenues of these companies. At times like these, we can expect consumers to keep basic services, but reduce discretionary spending and ancillary services. The Current (July) personal savings rate 5% may delay this effect, but investors should be aware that consumers have less money to spend and may be incentivized to reallocate their spending.

Conclusion: grouping together can help

Verizon appears to be the most stable stock among its larger peers, while AT&T appears to be the cheapest.

Investors considering AT&T are betting management can revitalize the company and bring it to financial stability — something that doesn’t necessarily have a good track record. On the other hand, if management is steering the company in the right direction, AT&T shareholders have the most to gain based on the company’s current bargain prices.

T-Mobile US is well managed, but may currently be costly to shareholders and must justify its growth plans with increased profits.

Investors in telecommunications stocks are betting on the future performance of these stocks, which may not hold up as well as expected. That’s part of the reason why some of them seem to be so cheap right now. Another way to mitigate some of the risks is to look at all of these companies as a whole, rather than placing high hopes on individual choices.

Investors who want more telecom alternatives can also check out our list of the biggest telecom stocks.

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Simply Wall St analyst Goran Damchevski and Simply Wall St have no position at any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials.