SPECIALS
Are Telecoms Shares Cheap?

By Alan Oscroft
May 23, 2001

With the hullabaloo surrounding that rights issue from BT (LSE: BT.A) dominating telecommunications news these days, we could perhaps be forgiven for thinking that not much else is going on in the sector. We might also assume that, after the much-publicised collapse of share prices, telecommunications shares are going for rock bottom prices these days. We'd be wrong on both counts.

Here's a quick roundup of the current prices surrounding the UK's biggest players:

Company       Mkt Cap   Share Price  Historic  Historic
              (£m)          (p)       P/E       PSR

Vodafone      135,769       204.0     42.1      17.2
BT             39,251       457.0     25.0       1.9
C&W            13,616       490.0     30.7       1.6
Colt            5,873       861.0     n/a        8.5
Energis         5,178       305.5     n/a        6.2
NTL             4,559     1,647.0     n/a        1.8
Telewest        3,584       128.0     n/a        3.2
Kingston          437       120.0     n/a        1.9
Thus              437        64.0     n/a        1.9
Atlantic           59        29.0     n/a        2.8
Redstone           47        40.5     n/a        1.4

What can we say about these valuations? With the average long term FTSE P/E of around 25, the P/Es of the companies in the above list that are mature enough for such figures to be meaningful have valuations that are not too far in excess of that average. Vodafone (LSE: VOD) stands out a bit, but it's not that long since its P/E was around the 70 mark.

Of the companies that are not yet profitable, most are trading on a "sensible" Price to Sales Ratio (PSR). Here, the long-term sustainable average is about 2. Again, Vodafone stands out with a rather high PSR. Both sales and profits at Vodafone have some achievements in front of them of they are to justify today's price.

So, at today's share prices, which are not outrageously high when compared with the market averages, are these hot telecommunications share underpriced?

After spending such a huge pile of money on 3G licences, the mobile phone operators need to get their new networks up and running, and that's just what they've been doing. Both Vodafone and British Telecommunications have successfully made their first 3G calls, and BT was planning to roll out its first 3G service this month on the Isle of Man. Unfortunately, the plan was delayed by software problems, denying BT the chance to beat Japan's NTT DoCoMo in the race to launch the world's first 3G service. But then, BT's plans for the tiny Isle of Man pale into modesty compared to NTT DoCoMo's plans for the slightly larger island of Honshu.

ADSL has been heralded as the saviour of the fixed line telecommunications suppliers, though at the same time as offering new opportunities to owners of local copper connections (like BT), it has been thrown open to competition by OFTEL's ruling that competitors must be allowed access to BT's equipment to run rival services. (The local loop must be "unbundled", as the techies like to describe it.)

But ADSL is running late too. Tales of people who have been on BT's waiting list for what seems like years abound, and even the smaller competitors, like Kingston Communications (LSE: KCOM), have had difficulties achieving their implementation targets.

If it is hard for the big suppliers to retain, let alone grow, profits, the pressure for smaller contenders like Atlantic Telecom (LSE: ATN) and Redstone Telecom (LSE: RED) to turn profitable long term must be that much higher, and the risk that much greater. The economics of the industry favours the big players, and the smaller fish must achieve unique market niches.

The telecommunications industry is in for a fair bit of growth over the next couple of decades, of that there's little doubt. But it's growth in the amount of the stuff being consumed: Internet, 3G mobile, cable TV, ADSL, interactive shopping, video on demand, mobile Internet. There are plenty of demands for more and more bandwidth already, and those demands are growing.

But that growth isn't going to come as fast or as easily as many expected. Acquisition of a 3G licence is not sufficient to generate 3G profits -- a network must be built and installed first. And successful ADSL trials don't mean that everyone will be enjoying broadband Internet access tomorrow -- it takes a lot of time and money to bring ADSL services into people's homes.

On top of the time lag in getting fancy new services out to market, prices of telecommunications services have been tumbling. It's difficult to see how the growth in demand for services is going to turn into increased profits, particularly as consumers are getting used to enjoying more and more telecommunications services for less and less outlay.

The problem for investors is that many of us have seen telecommunications as a growing industry, one that has seen a rejuvenation through recent technological advances, and growing industries are supposed to generate growing profits. But, at the same time, telecommunications can perhaps be seen as a mature industry in profit terms, and individuals and companies are not going to spend more and more of their money on telecommunications (as they do with other new technologies and new industries).

With that in mind, it is perhaps fair to see telecommunications companies on valuations that are broadly in line with the long term market average, and there could be some sensible (if not stellar) long term investments amongst them. The big companies probably deserve today's valuations as their profits are unlikely to grow at a rate faster than the pie itself, and the smaller newcomers (who have a chance at growing their profits by taking a bigger piece of the pie) face considerable risk.

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