Telecom companies calling for a closer look

The gangbuster launch of the new iPhone X and booming demand for the flagship device has boosted not just  Apple (AAPL), but also many other companies across industries. One industry to directly benefit is telecommunications. Both in the United States and Canada, leading wireless carriers stand to gain as more subscribers change plans and upgrade their devices.

A trend like this is particularly beneficial to companies south of the border, where there has been a significant disconnect between the rapidly surging S&P 500 Index and the telecommunications sector, one of the worst performing sectors so far this year. While the S&P 500 is up more than 17%, the S&P 500 Telecommunication Services Index has cratered more than 14% on a year-to-date basis, as of Nov. 10, 2017. By contrast, the S&P/TSX Capped Telecommunication Services Index has rocketed almost 20% for the same period.

Despite the divergence in their market performances, telecom companies on both sides of the border are pushing hard to diversify while keeping pace with rapid technological evolution and changing consumer trends. In the process, they are becoming increasingly reliant on smartphones and the internet for revenue.

Investors may want to take a closer look at leading U.S. and Canadian telecom service providers that are either trading at a discount to their fair value or are fully valued but have strong growth prospects. These businesses have solid business models, are quick to adopt newer technologies, and have the wherewithal to withstand competitive and regulatory pressures, while paying handsome dividend yields, according to Morningstar equity research.

The largest wireless carrier in the U.S.,  Verizon (VZ) provides communications services to 114 million wireless subscribers. The company also caters to businesses and governmental agencies via its wireless and wireline segments.

Despite increasing competitive pressures from smaller rivals  T-Mobile (TMUS) and  Sprint (S), Verizon remains the leader in the duopolistic U.S. wireless market along with AT&T. The two hold nearly 70% of market share. Despite disruptive actions by smaller rivals, such as offering unlimited data plans, Verizon's position in the industry remains solid for now, says a Morningstar equity report. "The company remains focused on defending its high-value postpaid subscriber base by keeping churn low," says the report, adding that the carrier "also remains committed to wireless network investments and is diligently pursuing the development of 5G."

Verizon's competitive superiority stems from the cost advantage and efficient scale inherent in its wireless business, which should enable the firm to generate excess returns on capital over the next decade, says Morningstar equity analyst Allan Nichols. "Verizon not only has relatively low fixed costs per connection than most of its rivals, but its network quality has enabled the company to maintain premium pricing (20%-25% price premium) and higher customer loyalty (industry leading churn) in the face of intense competition for customers," says Nichols, who pegs the stock's fair value at US$50, indicating some upside potential.

Verizon, the larger of the duopoly, claims 36% more postpaid phone subscribers than AT&T, a figure that Nichols says has been increasing recently as AT&T has chosen not to compete as aggressively in the postpaid market.

The company has also been beefing up its media business by making acquisitions such as Huffington Post and Yahoo in an attempt to retain and regain consumers switching from traditional cable packages to more online content.

The second-largest U.S. wireless carrier,  AT&T (T) serves more than 100 million consumers, including about 65 million postpaid phone subscribers. The firm also provides fixed-line services, including voice, data and television services, to consumers and small businesses in 21 states, and to larger enterprises nationwide.

AT&T has pursued large acquisitions in order to grow and diversify revenue as the growth in the U.S. wireless market stagnates. "First, with the DirecTV acquisition, AT&T aims to cross-sell video offerings with its wireless service in the hopes of reducing churn and extracting increased value out of its subscriber base," says a Morningstar equity report. "Second, with the pending Time Warner acquisition, AT&T hopes that vertical integration will provide both revenue synergies and cost efficiencies in content right negotiations."

AT&T, like Verizon, has lately been under pressure from smaller competitors, but its robust cost advantage will allow it to continue spending far more aggressively on networks, marketing and additional wireless spectrum than anyone else in the industry, says Nichols. "We see several aspects of the wireless business where AT&T is able to spread its massive fixed costs over a larger customer base," he adds. "The strongest evidence of AT&T's moat in the wireless business is its ability to invest heavily in its network while generally improving wireless margins and generating solid cash flow."

And while AT&T's share in the valuable postpaid phone market slightly slipped from 33% in 2014 to 31% in 2016, during the same time its wireless EBITDA margin has expanded from the mid-30s to around 40%, says Nichols, who estimates the stock's fair value to be US$40 and stresses that "outside of Verizon, no one else in the industry comes close to AT&T's wireless profitability."

The largest wireless carrier in Canada,  Rogers Communications (RCI.B) boasts 10 million subscribers, about 8 million of which are postpaid. The company owns a vast cable network (4 million subscribers), internet, TV and phone services (5 million users), as well as the Sportsnet TV network, which holds exclusive broadcasting rights to NHL and Toronto Blue Jays games.

One of three players that dominate the Canadian wireless landscape, Rogers has seen tremendous growth in its wireless business, it's most profitable segment and where the firm controls one third of the Canadian market. Its third-quarter earnings report shows the firm added 129,000 postpaid net customers, the best quarterly gain in eight years. "Rogers continued to benefit from impressive growth in its wireless services in the third quarter, with its top line in line with our expectations while net customer additions exceeded our expectations," says a Morningstar equity report. "Rogers' total revenue grew 3% year over year, helped by robust wireless growth and flattish growth in cable."

Despite facing several competitive and regulatory challenges, Rogers "can leverage its established scale and network advantages to generate consistent excess returns on capital over time," says Morningstar equity analyst Alex Zhao, who recently upped the stock's fair value from $52 to $55, prompted by increased margin expectations for wireless operations.

Thanks to its strong cable foothold, Rogers' cable business accounts for about a fourth of its revenue and a third of its profit. The firm also dominates the internet market with nearly 50% penetration of homes, well ahead of BCE (about 34%), notes Zhao, who projects Rogers to increase revenue at a 4% compound annual growth rate (CGAR) and wireless segment to grow at 5% through 2021.

Canada's leading communications company with roughly 10 million customers,  BCE Inc. (BCE) offers fixed-line and wireless services across Canada and boasts over 7.4 million postpaid subscribers. Its media segment, Bell Media, owns an 80% stake in TSN, which covers numerous sporting events, and has exclusive licenses for a variety of entertainment content, such as HBO.

Like Rogers, BCE delivered a solid third-quarter performance with robust growth in its wireless, Internet and Internet Protocol TV services. The quarter saw a 5% year-over-year jump in revenue, boosted by strong customer gains in both its wireless and wireline segments. The wireless revenue for the quarter grew 11% from the year before, helped by both organic growth and the acquisition of Manitoba Telecom Services.

"We continue to believe that increasing wireless penetration in Canada is benefiting all players, while BCE's network strength helps it stand out in Eastern Canada, according to the latest network test by PC Magazine," says a Morningstar report. "We expect steady growth for BCE's wireless business as smartphone penetration and data demand provide a decent runway for growth."

The cheery outlook prompted Zhao to raise projections for postpaid customer gains in 2018 and 2019 for BCE and increasing his fair value estimate for the stock from $55 to $58.

"BCE's strengths in the Canadian wireless market are intact, [but] the firm's fixed-line business faces a challenging battle to capture share versus its cable rivals in Eastern Canada," cautions Zhao, noting that its fixed-line business still accounts for close to 60% of revenue and profits. Nonetheless, he is confident "in BCE's ability to earn adequate returns on invested capital over the next decade, thanks to efficient scale in both industries, as well as the company's solid record of execution and overall prudent capital allocation."

Morningstar projects total revenue to grow 5% in 2017 and then about 3% per year from 2018 through 2021, and wireless revenue to grow at a compound annual growth rate of 7% through 2020, supported by stronger growth in wireless and an uptick in average revenue per customer and modest expansion of the subscriber base.

The author owns a position in shares of Rogers Communications Inc.