Thursday, January 31, 2013

The Best Stocks in the Telco Sector for 2013

With AT&T (NYSE: T) and Verizon (NYSE: VZ) having reported results it’s time to take a look at what they said about spending and the trends within their businesses. Tier 1 carriers make up the bulk of telco spending, and investors can garner a lot of insight from what they say. In summary I would argue that there has been an acceleration of the trend towards smartphones and corporations spending on mobility based solution in the last quarter, and this will continue in 2013. The overall trend is positive, but the macro-environment is causing the carriers to be cautious on spending.

AT&T Just Loves Efficiency

I previously wrote about this theme in an article linked here, and AT&T managed to repeat the trick it did in the last quarter! Then it talked about capital spending for 2012 hitting the lower part of the $19-20 billion range it had previously given. In the end CapEx came in stronger at $19.7 billion. Granted some of this was due to Sandy, but it also demonstrates the variability in spending plans. Indeed it is this uncertainty that makes telco such a volatile market.

Turning to the guidance for 2013 given in November (at their analyst day meeting) the company discussed spending up to $22 billion this year, and the market got excited by the potential for a ramp up in telco spending. Unfortunately with these earnings AT&T nudged the market lower with forecasts for $21 billion. The reasons given for this were:
  • LTE roll out was ahead of plans so AT&T didn’t feel the need to ramp up spending as aggressively as it had intimated earlier.
  • It found efficiencies with overlaps in wireless and wireline projects.
Frankly this just sounds a bit like the usual story of corporations holding back on spending while they wait for the economy to get better.

The areas where we do know AT& T will be spending are in its LTE network with its ‘Project VIP,’ a scheme to ensure LTE coverage for 300 million people by the end of 2014. In addition its key growth drivers are wireless, wireline data and the expansion of smartphone penetration. Indeed as smartphones expand (89% of postpaid sales in the quarter) the increase in bandwidth demand will expand significantly placing more stress on the network.

The other big driver is corporate spending on mobility solutions and this did very well in the quarter.

Verizon Holds its Cards Close

In recent times Verizon has made a virtue of keeping its spending in check after having been the first major US carrier to aggressively roll out LTE. Its general plan seems to be to continue to reduce CapEx as a share of revenues by keeping spending flat for this year while increasing utilization of its existing LTE network.

Verizon’s capital spending came in slightly higher than forecast this year but that was mainly due to some Sandy related spending and buying some spectrum. Its management declared itself ‘very confident’ that CapEx would be flat in 2013.

My take on what is going on here is that Verizon is seeing its customer spending trends working in its favor. In other words adoption of smartphones and its 4G LTE network is gathering apace and feels that in an uncertain macro environment the correct thing to do is to try to expand margins from its existing LTE network. It has clearlyy stated that it is not adding capacity to its 3G network.
Indeed, its smartphone sales accelerated nicely in Q4 with 65% of smartphones activated in Q4 being on 4G LTE. Overall penetration increased to 58% from 44% last year.

Key Conclusions and Three Ideas

While both companies downplayed or reduced capital spending expectations I think the results and commentary were a net positive. Telco spending isn’t just about Tier 1 spending, and with the acceleration in smartphone adoption and 4G LTE becoming commonplace there will be significant pressure on other carriers to increase spending.

I want to discuss a few ideas that focus on the trends ascertained here. On the theme of corporate mobility I think Bring Your Own Device (BYOD) is a key idea. I last discussed Aruba Networks (NASDAQ: ARUN) in an article linked here, and looking at the mix of Android and iPhone sales in these results as well as the trend towards corporate mobility it is a clear sign that Aruba is doing well. Earnings estimates have been trending higher accordingly. The question with Aruba is when will BYOD growth start to plateau? I’m not sure of the answer but it is certainly not in the next few quarters.

Another idea I like is F5 Networks (NASDAQ: FFIV), which reported results recently and saw a pick-up in its telco related spending revenues. Its application delivery controllers help ensure applications get moved around the Internet efficiently and with both carriers reporting strong growth in smartphone adoption I think this means bandwidth rich application demand is going to concomitantly increase, and F5 should be a key beneficiary. In addition both networks spoke of strong cloud adoption so data center spending should increase as well.

My last idea is Acme Packet (NASDAQ: APKT). I’ve discussed it more in an article linked here. It is a play on the adoption of Voice over LTE (VoLTE) spending by carriers, and the indicators are that this will kick in by the end of 2013 or early 2014. If this idea is correct then APKT should start to see the benefits by mid year. It’s not the cheapest stock out there but it has a strong balance sheet with $370 million in net cash and liquid assets. In addition it generates cash and if and when VoLTE spending ramps up you can bet that the market will bid it higher with the earnings momentum. Well worth a look

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