Why You Should Be Avoiding Telcos

Sometimes, it’s the things you don’t do that make all the difference.

Let me explain…

One of the most tempting things for a novice investor is to buy into a former high-flyer after a decent share price fall. The fact that it’s fallen means it’s cheap, right?

Occasionally, that is the case. If you’re lucky. But, mostly, it’s not.

Mostly, it can get you into a world of trouble.

Take Vocus Communications [ASX:VOC], the fast-growing telecommunications company. As you can see in the chart below, from a low of around $1.55 in November 2012, the stock reached a peak of $9.50 in May this year. That’s a return of more than 500%.

dr20161215_image1

Source: Optuma

It then started to correct lower. Which is nothing out of the ordinary after such a strong run. No doubt, some investors were tempted to ‘buy the dip’ here.

However, the first alarm bell sounded when VOC released its full-year results on 23 August.

The market’s response was not great, as you can see in the chart below. The selling continued in the following days. Something wasn’t quite right…

dr20161215_image2

Source: Optuma

A month later, the CFO resigned. Some board members then resigned, and there was a stoush over who should run the business.

Once again, it may have been tempting for ‘bargain hunters’ to step in and buy among the uncertainty.

But it would have been a bad move. Recently, VOC had its annual general meeting, which it used to downgrade FY17 profit expectations.

The share price plunged nearly 25% as a result. The chart below shows the damage.dr20161215_image3

Source: Optuma

The golden rule

One of the golden rules that I apply in my premium investment service, Crisis & Opportunity, is that we never buy into a stock that is in a downtrend. You simply don’t know when the downtrend will end.

Needless to say, even after such a fall, I still wouldn’t go anywhere near VOC. Since peaking at $9.50 earlier this year, the share price has halved. You could make money on it by betting on a bounce, but that is a low-probability play. You’re much better off letting the dust settle and waiting for the trend to stabilise and then turn back up.

By the look of the chart above, that moment is still some way off.

As I said at the start, the stocks you don’t buy in this game are just as important as the ones you do buy.

I used VOC because it’s a recent and reasonably well-known story. But the message is the same for a multitude of stocks: Don’t buy into downtrends, no matter what you think or ‘know’ about a stock.

Avoid telcos

VOC isn’t the only potential value trap in the telecommunications sector.

Firstly, here’s the list of stocks that are making new lows:

TPG Telecom [ASX:TPM] — Near two years lows

Vocus Communication [ASX:VOC] — At two and a half year lows

Telstra [ASX:TLS] — Recently bounced from three and a half year lows

MNF Group Limited [ASX:MNF] — Two and a half month lows

Speedcast International [ASX:SDA] — One and a half year low

Superloop [ASX:SLC] — Three month low

Next DC [ASX:NXT] — Eight month low

This tells you there is something wrong with the profit prospects for the sector.

That something is the NBN.

The NBN is a government built monopoly. It consists of telecommunications infrastructure made up of a number of different technologies.

The private sector’s role (Telstra, TPG etc) is to hook their customers up to the NBN when requested. They pay an access fee to do so, and pass this on to their customers, as well as a retail margin to make a profit.

It sounds simple. But it poses a problem for the sector’s future profitability.

Here’s the problem…

As the NBN rollout continues, more people are signing up to the network. The margins the telcos make on NBN services are much less than what they make on standard broadband services.

The problem is that access charges to use the NBN network are too high. And that’s because the cost of the NBN rollout has been massive. By the time it is finished (apparently around 2020, but don’t hold your breath) the capital cost will be in the vicinity of $60 billion.

The high access charges are an attempt to get a return on this expenditure.

But it won’t work, because high costs will impede the take-up of the NBN. In addition, the telcos will build their own infrastructure where they can to circumvent the NBN charges, and new wireless technology (5G) is not far away.

This means that there won’t be anywhere near the eight million households hooked up to the NBN that the government expects.

It’s an all-round debacle. Quite possibly the NBN will go down as the most expensive white elephant in Australia’s history.

In the short term this is creating a bunch of headwinds for telco stocks. Take-up of NBN services is still growing strongly, as it’s in its early stages. With each household that switches from an old broadband service to the NBN, the retail margin falls dramatically.

With the recent profit announcements by TPG and VOC, this headwind has become apparent. Hence the recent sell-off in the sector.

But it’s also created uncertainty around the regulatory environment moving forward.

The way that NBN pricing is structured right now is unsustainable. It’s also reducing competition, as smaller players are unable to compete.

The Australian Competition and Consumer Commission are due to release a report on the state of the market early next year, as they know the current structure, if left alone, won’t produce competition.

On top of all this, there have been calls for the government to write off a large part of the NBN investment. Doing this will enable it to lower its access charges and still earn a decent rate of return on the lowered capital value of the project.

This is the most sensible outcome. But given politicians are involved, I don’t expect it to happen anytime soon.

Putting all this together, the industry is in a state of flux. That’s why you’re seeing share prices of the major players hitting new lows. The growth premium is coming out of the sector, and increasing uncertainty is being priced in.

In the short term, this means you should avoid the sector.

But I expect, during 2017, that there will be some fantastic opportunities to take advantage of. I’ll be following those opportunities for readers of my premium service, Crisis & Opportunity.

There are some great companies in the sector. It’s just a matter of working out which ones are able to best take advantage of the tremendous growth opportunities, while avoiding the regulatory issues that come with the NBN.

Regards,

Greg Canavan
Editor, The Daily Reckoning

Greg Canavan
Greg Canavan is a contributing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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