In a connected world, we can often overlook the complexity of the communication web around us. We automatically assume that we will have cell coverage even deep in the forest and that download speeds are good enough for streaming movies whenever we feel like it.
The visible part of the telecom industry is well known to consumers: think of Netflix, Facebook, etc.
We often don’t think of the infrastructure that makes all of this possible. In this Industry Primer, we will look at how the telecom industry works and how you can evaluate investments in it.
An efficient telecommunications network is the foundation upon which an information society is built.
Industry Structure
The telecom industry has seen a great deal of evolution from the old phone companies to the satellite communication and Internet providers of today. The industry has split into several groups.
Telecom Equipment Manufacturers
Before any company can sell communication services, the infrastructure needs to be there, which requires equipment like phone lines, servers, optical fiber, antennas, and much more. This is a sector with very specialized manufacturers, with usually just a handful of companies controlling each technical niche.
Some companies worth mentioning in this sector are:
- Motorola: a former mobile phone manufacturer, the Finnish company is still a vital telecom equipment provider today.
- Ericsson: This Swedish company is one of the leading global equipment providers for advanced telecommunication, including 5G.
- Cisco: The leading provider of routers and switches.
- Qualcomm: The leading US supplier of connectivity for IoT (Internet of Things) and 5G equipment.
There are many other companies in this sector, most focused on a fairly narrow range of equipment.
Services and Infrastructure Operators
In the last two decades, a new type of telecom company has emerged. They are not manufacturers but also do not provide direct internet or phone to consumers. Instead, they operate infrastructure for the Internet provider.
A perfect example is the cell phone tower business. A service provider operates the towers and rents access to them to 3-4 different mobile operators. This spreads the costs of one tower between multiple clients and makes the mobile providers more efficient.
In that sense, the mobile tower company acts like a very specialized industrial real estate landlord. That’s why they are often organized as a REIT.
American Tower is a good example of such a company in the US. More adventurous investors might be interested in foreign operators with more growth opportunities, like Africa-based Helios Tower.
Network Operators & Providers
These are the companies the final consumers usually interact with. They provide their users the actual mobile or Internet coverage or maybe cable TV.
They are usually very large companies, with valuations in the hundreds of billions of dollars. They often operate as monopolies or oligopolies, with no more than 2-3 providers usually dominating a country. Good examples of this sector are companies like AT&T, Verizon, Comcast, and Vodaphone. Foreign markets can also be attractive to investors, like Deutsche Telekom (Germany), Orange (France/EU), or Nippon Telegraph & Telephone Corp (Japan).
SaaS
A new type of telecom company has emerged in the last ten years: SaaS (Software as a Service). They replace some of the older options with Internet-based systems and blur the line between the telecom and tech sectors.
The pandemic made them a lot more popular and sped up the adoption of these solutions. A good example is Zoom, but there are also older solutions like Skype (part of Microsoft). Streaming device maker Roku is another one.
New segments like telemedicine software or remote education solutions are also possible opportunities in this sector.
Specialized Communication
The last sector is the telecommunication segment which responds to niche demand. This sector has two components.
The first part is satellite communication for remote regions. We covered this sector in our “Gilat Satellite Network” investing report of November 2021.
This is an interesting sector, but intense competition is expected to come from billionaire-owned space companies like the Starlink network from Elon Musk’s SpaceX or the project Kuiper by Amazon/Blue Origin from Jeff Bezos.
Overall, the older technology based on geosynchronous satellites might need to adapt against broadband provided by low-Eart orbit satellite constellations.
The second part is secure military communication. The defense communications equipment market is expected to grow at 10% annually from 2019 to 2029.
The increasing usage of drones, network-centric armies, and electronic warfare will all boost the need for robust and secure military communication. Some of the most active companies in this sector are large defense contractors like BAE, Thales, or Raytheon, but smaller companies might be able to provide unique services for specific applications.
This can overlap with the first sector, as the intensive usage of the Starlink system by the Ukrainian army illustrated. SpaceX is also active with the recently revealed Starshield constellation.
Assessing Telecom Companies
Income investing: Large Operators & Manufacturers
The largest telecom companies are mostly defensive, income-focused investments. They are already dominant and have little room to grow their market share. They will mostly grow with the overall sector and the country’s economy. This is also true for mature, large mobile tower companies.
These companies make good investments if they are priced relatively cheaply. A not-too-high level of debt and good service quality will be the selection criteria as well.
Manufacturers of equipment are a little riskier than companies like AT&T. Their technology might slowly become outdated, and they must keep reinvesting in R&D to stay ahead.
In addition, telecom is a politically sensitive topic, and some companies might be unable to access some markets in case of trade wars, as the ban on Huawei equipment in most of the West has shown.
Growth Investing: Foreign Operators & Innovators
Not all of the world is perfectly connected. Operators in emerging markets or outright under-developed regions like Africa can display strong growth profiles, similar to the one Western telecom companies had in the 1990s.
The difference is that, in this case, investors have the advantage of insight of knowing the path forward from past experience in the West. Especially interesting are companies focusing on mobile networks, as most of the developing world has gone directly went to smartphones without passing through the landline or cable network stage.
These markets also profit from a young population eager to communicate and bypass inefficient and outdated local institutions like banks, taxi monopolies, universities, etc.
The other sector of growth is companies with unique technological advantages. This might be very hard to quantify for investors without a technical background. Nevertheless, if a company holds unique patents or technology, it could experience explosive growth and capture market share for the incumbent manufacturers.
Specialized Providers
Suppliers to the military are likely to have a stable source of income from military contracts and are more like defense companies than pure telecom companies.
Satellite companies should be analyzed with caution to estimate if their specific business model and client base are threatened by the rise of Low-Earth orbit constellations. A fair level of understanding of the sector will be needed to avoid buying into value traps.
SaaS
SaaS companies have been treated by investors as tech companies more than telecom companies. This led to very pricey valuations during the pandemic, which has dramatically cooled off. That was predictable: a P/E of 235 for Zoom in 2020 never made any sense from a risk/reward perspective.
For SaaS solutions, the strength of the competitive moat is of prime importance. Before Zoom, there was Skype (which is still widely used for that matter), and after Zoom, something else might come.
The risk of tech giants launching their own competing products should also be remembered. When a company is already operating on Microsoft-provided cloud and Microsoft-provided email, it might as well prefer to stick to a Microsoft-provided call and meeting system.
Conclusion
The telecom sector is as foundational for modern economies as the utility sector. In many countries, it has stopped being a strong growth sector and has become more akin to a stable, dividend-focused type of investment. So this can be a great sector for investors looking for income and relative safety.
For technically-minded investors, it is also a sector rich with obscure niches and specialized suppliers that might give them an occasion to leverage their knowledge into an investing advantage.
Lastly, growth investors can find more options if they’re willing to expand their horizons to more risky overseas jurisdictions. In emerging markets, connectivity is just beginning, with many networks still barely able to provide mobile internet out of the big cities, even less 4G or 5G.
These markets are also often semi-protected environments where foreign companies cannot really compete with local operators. Sticking to the largest local operators and geographical diversification will be essential to manage the risks inherent to developing markets.
Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process; they don’t replace it.
