The expected start of 5G telecom services in multiple U.S. markets by the end of this year can be seen as a major opportunity for operators in the communication infrastructure industry. However, the industry's near-term growth prospects remain vulnerable to a number of factors, including the risks of disruption from extreme weather and the growing menace of cyber attacks. Operators in this space braved a number of devastating hurricanes for a modest recovery in 2017,
The success of 5G technology also hinges on substantial investments to upgrade infrastructure in the core fiber backhaul network to support anticipated growth in data services. Although these investments will eventually help minimize service delivery costs to adequately support broadband competition, rural coverage and wireless densification, short-term profitability is likely to get eroded leading to earnings dilution.
Efforts to build resilient infrastructure facilities to withstand natural catastrophes further increase operating costs. Moreover, simmering tensions between the United States and China related to trade restrictions imposed on the sale of communication equipment to Chinese firms have dented the industry's credibility and led to loss of businesses. Unless the two countries amicably resolve their trade differences, growth prospects of the sector are likely to remain chequered.
Industry Lags on Shareholder Returns
Looking at shareholder returns over the past year, it appears that solid 5G push amid healthy economic fundamentals wasn’t enough for enhancing investors’ confidence in the industry’s prospects. In addition, geopolitical tensions and consequent fallouts on grounds of national security have hurt the stability of the market and put the sector in a spot of bother.
The Zacks Communication – Infrastructure Industry within the broader Zacks Computer and Technology Sector has underperformed both the S&P 500 and its own sector over the past year.
While the stocks in this industry have collectively declined 2.8%, the Zacks S&P 500 Composite and Zacks Technology Sector have rallied 13.7% and 20%, respectively.
The major drop in industry stocks this Spring likely reflects the market's bearish outlook in the wake of the Sprint - T Mobile deal. The deal may or may not reach fruition, but points it to the industry's weakening competitive dynamics in the face of consolidating customers.
One-Year Price Performance
Sector Stocks Trading Cheap
Due to a highly volatile geopolitical scenario and underperformance of the industry on average over the past year, the industry's valuation picture looks attractive. One might get a good sense of the industry’s relative valuation by looking at its enterprise value-to EBITDA ratio (EV/EBITDA), which is the most appropriate multiple for valuing telecom stocks.
Telecom is a capital-intensive industry with high fixed costs, bulk of which is funded through debt. Moreover, the companies have high depreciation expenses due to a large fixed asset base. The EV/EBITDA ratio essentially measures the value of a telecom company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses.
The industry currently has a trailing 12-month EV/EBITDA ratio of 11X, which is below the 12-month median of 11.5X. Over the past year, the industry has traded as high as 12X and as low as 10.4X.
The S&P 500 index is currently trading at 11.6X trailing 12-month EBITDA, with a high, low and median over the past year of 12.7X, 10.7X, and 11.3X, respectively.
Enterprise Value/EBITDA Ratio (TTM)
Comparing the group’s EV/EBITDA ratio with that of its border sector also shows that the group is trading at a discount. The Zacks Computer and Technology Sector’s trailing 12-month EV/EBITDA ratio of 11.2X is above the Zacks Communication Infrastructure Industry’s ratio.
Enterprise Value/EBITDA Ratio (TTM)
Underperformance May Continue Due to Bleak Earnings Outlook
The industry's seemingly attractive valuation picture is likely reflective of a 'value trap' than real 'value' given the group's weak earnings outlook, with aggregate estimates for this year steadily coming down.
The light blue line in the chart below shows the evolution of aggregate 2018 earnings estimates for operators in this space (the red line represents 2019 expectations).
Price and Consensus: Zacks Communication Infrastructure industry
Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.
The consensus EPS estimates for the current fiscal year have been revised 14.4% downward since Mar 31, 2018.
Current Fiscal Year EPS Estimate Revisions
Zacks Industry Rank Indicates Cloudy Prospects
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
Currently, with a Zacks Industry Rank #234, the Zacks Communication Infrastructure industry is at the bottom 9% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
Our proprietary Heat Map shows that the industry’s rank has continually deteriorated over the past five weeks.
Industry Portrays Lackluster Long-Term Growth
While the near-term prospects look unwelcoming for investors, the long-term (3-5 years) EPS growth estimates for the Zacks Communication Infrastructure industry appears unconvincing as well. Although the group’s mean estimate of long-term EPS growth rate has increased since February 2018 to reach the current level of 7.9%, it compares unfavorably to 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of a tempered long-term EPS growth could be the recovery in EBITDA that telecom firms have been showing since the beginning of 2016.
Another important indication of improving long-term prospects is the uptrend in the group’s free cash flow, which is a key metric for evaluating telecom stocks.
While the industry has evolved from predominantly a provider of voice services into a diverse, competitive and interconnected industry using terrestrial, satellite and wireless transmission systems, fragility of telecommunication networks remains a potent challenge due to natural calamities and cyber threats. Furthermore, a highly volatile geopolitical scenario has put pressure on the stability of the business and has adversely affected the operating model.
The industry might not be able to tide over the broader challenges in the near term. So, it may not be a good idea to bet on this space right now. Investors could be better off if they avoid a few communication infrastructure stocks that have a soft earnings outlook despite cheap valuation metrics.
Below are three stocks within the communication infrastructure universe that have been witnessing negative earnings estimate revisions and carry a Zacks Rank #4 (Sell). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
ADTRAN, Inc. (ADTN): Shares of this Huntsville, AL-based communication infrastructure stock have declined 24% in the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 147.3% downward over the last 90 days.
Price and Consensus: ADTN
CommScope Holding Company, Inc. (COMM): The consensus EPS estimate for this Hickory, NC-based communication infrastructure stock has moved 8% lower for the current fiscal year, in the last 90 days. The stock has fallen 21.6% over the past year.
Price and Consensus: COMM
Superconductor Technologies Inc. (SCON): The stock of this Austin, TX-based communication infrastructure stock has declined 39.5% in the past year. The consensus EPS estimate for the current year has been revised 160.9% downward over the last 90 days.
Price and Consensus: SCON
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