T2W Trading Community

Despite the threat of increasing competition, and new technologies, the large telecom companies remain massive cash generators. Vodafone generated free cash flow of £6.4 billion last year while BT delivered £1.6 billion. Both as a result are engaging in capital enhancing initiatives such as share repurchases and increased dividends.

From a balance sheet perspective both telcos in the Fat Prophets Portfolio are solid. Vodafone's gearing is under 20 percent while at BT net debt is now £7.7 billion, and some way from the £29 billion amassed during the dotcom boom.

The fundamental story of robust cash flows, increasing dividend payouts, and improving balance sheet strength is prevalent amongst other telcos. Indeed these attributes at O2 contributed to a takeover by Spain's Telefonica last year.

Corporate activity has been particularly rife amongst the mid-tier telecom operators. Cable & Wireless took over Energis last year while Virgin Mobile was recently bought by US cable company NTL. Increasing competitive pressures combined with attractive valuations suggest that further industry rationalisation should not be discounted.

Sensing value, outsiders are also getting in on the act. Bid vehicle Holmar has tabled an offer for Telent, formerly Marconi. Irish telcoms company Eircom, meanwhile is being stalked by Australian based, Babcock and Brown.

Corporate activity in the UK has to some extent taken the lead from that across the Atlantic. In March AT&T, the largest telco in the US, announced the takeover of BellSouth. It was only last year that AT&T itself was bought by SBC Communications for $16 billion. That deal pre-empted competitor Verizon's acquisition of long distance carrier MCI Communications. The latest move could now force Verizon to make a play for Qwest Communications, the fourth surviving 'Baby Bell'.

Rapid consolidation amongst the phone carriers is also spilling over to the companies supplying their infrastructure. Last month Nokia and Siemens agreed to create the world's third-largest network equipment supplier through a joint venture. As a result Alcatel-Lucent, Ericsson-Marconi and Nokia Siemens Networks will all have more than double the revenues of their nearest competitors. Nortel, Motorola and Huawei may now come under pressure to seek deals themselves.

We believe that increasing competitive pressures combined with attractive valuations will ensure that industry rationalisation in the UK, and globally gathers pace. The benefits to participants therein lie in efficiencies of scale, increased pricing power, and wider product offerings. However merged companies will also have the financial muscle to respond to ongoing advances on the technological front.

Overall the telecommunications sector has undergone something of a transformation over the past decade. The trend over the next decade is likely to involve many companies broadening their horizons. Indeed some have already outlined the desire to present a converged offering of mobile and fixed-line telephony, broadband internet access and pay-TV.

In any case, in the here and now we find a sector where growth projections are more realistic and valuation fundamentals more conservative than they were six years ago. While a return to the heady levels reached during the dot com boom is unlikely, the sector offers much merit as an investment destination.