ARRS Arris International Plc - Ordinary Shares

Unprecedented growth in high-speed mobile Internet traffic, in particular for wireless data and video, has transformed the telecommunications industry into the most evolving, inventive, and keenly contested space. In addition, the emergence of wireless broadband technology has created several new service areas, which offer huge growth potential.

According to a report by Infonetics Research, telecom operators globally generated approximately $2 trillion in revenues in 2013. This is a slight improvement from $1.9 trillion revenues recorded in 2012. Notably, the report also stated that telecom carriers are increasingly spending on capital expenditures in order to update their networks with the latest technologies. In 2013, carriers’ expenditures rose 6% year over year and are expected to rise at a CAGR of 2% from 2012 to 2017, most likely to reach a significant $355 billion by that time.

While the telecom growth momentum is expected to be maintained in the U.S. over the near term, the major impetus is likely to come from emerging markets of China, India, Brazil and Russia. Carrier expenditures have increased in Japan and even major telecom operators in Western Europe, the most vulnerable region economically, have raised their budget.

Major Attributes

Currently, the U.S. Telecommunications Industry is evolving around 5 broad factors. These include wireless gradually becoming the future of the telecom industry and the consequent popularity of spectrum. High-speed fiber-based network is projected to expand more aggressively, especially for video/TV offerings.

In addition, consolidation within the industry will continue mainly due to shortage of airwaves and attaining economies of scale. Innovative products will be launched in areas of m-Commerce, virtualization and cloud-based technology, high-speed metro Ethernet, to name a few. Apart from these, there still remains ample scope for expansion in the U.S.  According to the Federal Communications Commission (FCC), nearly a fifth of rural American households lack broadband access.    

Wireless is the Key

Despite the massive growth in fiber-to-the-home networks, we believe that wireless networks will boost growth in the telecom industry. Moreover, the sector is witnessing a fundamental change. The focus of the operators has shifted from voice calls to data and video. Any new network standard aims at faster data connectivity, quick video streaming with high resolution and rich multimedia applications.

The GSM Association’s research wing, GMSA Intelligence, recently revealed its estimation that there will be more than 1 billion LTE connections globally by 2017. Currently, there are approximately 176 million LTE connections worldwide. By 2017, the number is likely to reach around 465 LTE networks across 128 countries.

GSMA Intelligence further reported that LTE users consume an average of 1.5GB data per month, twofold of what is consumed by non-LTE users. In the developing countries, LTE users can generate 20 times higher average revenue per user (ARPU) to carriers than non-LTE users, whereas in the developed countries, ARPU can be 10-40% higher for LTE users instead of non-LTE users. Apart from the terrestrial wireless network, the U.S. has an advanced satellite broadband network, mobile satellite radio systems and extensive WiFi networks.

Mergers and Acquisitions to Continue

We believe that the U.S. telecom industry will witness more mergers and acquisitions in 2014. Owing to the rising popularity and demand for the scarce and valuable wireless spectrum, mergers and acquisitions have increased exponentially. While the strong established players need more spectrums to gain competitiveness, small players prefer to merge with strong rivals rather than trying to establish a nationwide foothold which is extremely capital intensive.   

Verizon Communications Inc. (VZ) bought spectrums from major cable MSOs including Comcast Corp. (CMCSA), Time Warner Cable Inc. (TWC) and Bright House Networks. Recently, Verizon announced the largest acquisition proposal of the wireless industry. The company has decided to acquire the remaining 45% stake of Verizon Wireless Network from Vodafone Group plc. (VOD). Verizon currently holds the majority 55% of this venture. Charter Communications Inc. (CHTR) has offerd a bid to acquire Time Warner Cable.

Pre-paid wireless operator MetroPCS has been acquired by T-Mobile US Inc. (TMUS) and another pre-paid operator Leap Wireless International Inc. (LEAP) is awaiting regulatory approval to be acquired by AT&T Inc. (T). Softbank of Japan recently acquired a 78% stake in Sprint Corp. (S) for $21.6 billion. Satellite TV operator DISH Network Corp. (DISH) currently has a lucrative portfolio of spectrums (an estimated value of $10 billion) and is looking for a suitable merger option to develop a nationwide wireless network.

Product Innovation

Severe spectrum crunch coupled with gradual smartphone adoption is forcing the wireless operators to look for other options to raise revenues. These include new pricing plans, a shift from unlimited data usage to tier-based data usage, and higher upgrade fees for smartphones and tablets in order to offset handset subsidies. In fact, the average revenue per user for most of the wireless carriers has been rising over the last two years. It is also expected to grow in the long term primarily due to massive growth in mobile data usage. Smartphone and tablet users are progressively uploading video content and are becoming broadcasters in their own right.

Another growth area for the telecom industry is the fiber-based video service. According to Infonetics, video service revenues, in the first half of 2013, were approximately $110 billion globally, up 2% from the corresponding period of the previous year. The global pay-TV market size may reach up to $270 billion by 2017. Similarly, for the cable TV operators, a new growth area is the small and medium sized business (SMB) segment. Currently, the market size of the U.S. Business Services segment is approximately $8 billion. Various industry researches estimate that the SMB segment is expected to offer a market opportunity worth $20 billion to $30 billion in the long term.

Moreover, growing demand for technically superior products has been the silver lining for the telecommunication industry in an otherwise tough environment. Metro Ethernet, IPTV, cloud computing, managed IP services, m-commerce, m-banking, telematics services are some of the major innovations in recent times. These developments are also helping telecom equipment manufacturers, infrastructure solutions providers, and mobile phone makers to consolidate finances.

Zacks Industry Rank

Within the Zacks Industry classification, Telecommunications is broadly grouped in the Computer and Technology sector (one of the 16 Zacks sectors) and are further sub-divided into seven industries at the expanded level: Communications Infrastructure, Communications Components, Satellite Communications, Communications Semiconductor, Wireless Equipment Supplier, National Wireless Service Provider and Non-U.S. Wireless Operator.  The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank. As a guideline, the outlook for industries with a Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Communications Infrastructure is #34, Communications Component is #110, Satellite Communications is #110, Communications Semiconductor is #110, Wireless Equipment Supplier is #67, National Wireless Service providers is #165 and Non-U.S. Wireless Operators is #179. Looking at the Zacks Industry Rank of the seven telecommunications industries, we derive that the near-term outlook for the group is tending toward 'Neutral.'

Earnings Trend of the Sector

The broader Technology sector, of which the Telecommunications industry is part, remains weak with respect to earnings. So far, only 10.8% of the sector participants have reported fourth-quarter 2013 results, which have been strong in terms of beat ratios (percentage of companies coming out with positive surprises) and generated a positive growth.

Both earnings and revenues beat ratios were pretty robust at 71.4% and 85.7%, respectively. Additionally, total earnings for the reported companies have shown a significant 23.2% year-over-year increase on an 8.7% growth in revenues. This compares with a substantially lower earnings growth of 5.9% on a much lower 3.2% growth in revenues in the third quarter of 2013.

The consensus earnings expectations for full year 2014 also depict a fairly strong trend. Earnings growth is expected to grow at 1.8% in the first quarter and is expected to improve further to 11.2% in the second quarter. Overall, the sector is expected to register full-year earnings growth of 9.4%.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.

OPPORTUNITIES

The telecommunications industry as a whole offers a number of attributes that are difficult to ignore from the standpoint of investors.

• Telecommunications is a necessary utility: The need for telecom in both rural and urban areas, and its role in the infrastructure of both developed and developing markets, will continue to grow. In addition, economic stimulus plans in the U.S. and throughout the world should boost select service providers and equipment manufacturers.
• Barriers to Entry: The lack of public airwaves (spectrum) in the telecommunications industry creates a high barrier to entry. The U.S. telecom market is controlled by just four national players, as regional low-cost operators are not eligible to compete with large carriers. Furthermore, it is not easy to establish a new telecom carrier since it will require government approval to transmit voice, data, and video on public airwaves. Spectrum licenses are limited and therefore quite expensive. Moreover, the deployment of network infrastructure requires significant capital expenditure, which very few entities can afford.
• Strong Demand: A recovering economy speeds up the demand for real-time voice, data, and video manifold. The escalation in demand has encouraged telecom service providers to undertake large network extensions while upgrading plans. Moreover, the FCC projects mobile data demand to grow 25-50 fold over the next five years.

The companies that match well with the aforementioned considerations include Arris Enterprises Inc. (ARRS), China Unicom Ltd. (CHU), KT Corp. (KT), Comcast Corp. (CMCSA) and Liberty Global plc. (LBTYA).  Arris currently has a Zacks Rank #1 (Strong Buy) and the rest of these stocks currently have a Zacks Rank #2 (Buy).

WEAKNESSES

In general, the telecommunications companies that are under pressure have high debt levels and large financial leverage ratios or are unable to cope with the recent market trends. Other risks that remain are as follows:

• Potential Business Slowdown: Sales fluctuations of carriers are expected to continue to weigh on capital spending decisions -- a major problem faced by equipment vendors. The companies are expected to remain focused on improving their balance sheets, financial discipline and free cash-flow generation.
• Product Overlapping: We may see more product sharing deals between telecom, cable TV and satellite TV operators as each of these players are trying to gain a foothold in each other’s territory. Even pay-TV services, offerings to business enterprises, and mobile backhaul and metro-Ethernet segments may witness more convergence. Mobile phone makers are now gradually offering tablets (small laptops); chipset manufacturers who are offering chips for personal computers and mobile phones are frequently interchanging their areas of operations.
• Increased Competition: Technological upgrades and breakthroughs have resulted in cutthroat price competition. Product life-cycle and upgrade-cycle have been reduced drastically as several firms are introducing new products and services within a short span of time. Increasing competition is forcing every player to offer heterogeneous and bundled services.

Signs of the above-mentioned weaknesses can be seen in Rogers Communications Inc. (RCI), BCE Inc. (BCE), NII Holdings Inc. (NIHD) and Grupo Televisa S.A. (TV). All these stocks currently have a Zacks Rank #4 (Sell).

 
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