After waiting in the shadows, the telco sector is looking good

Kathleen Brooks
SINCE the outbreak of the European debt crisis, analysts have sung the praises of the utilities sector. It had all the ingredients to be recession- busting: utility stocks tend to be anti-cyclical, they hold up well when other stocks tumble and they provide a reliable dividend. But as the global economy emerges from recession, some analysts are beginning to lose interest in the sector that provided them such hope at the peak of the financial crisis.

UBS recently downgraded utilities to neutral, adding that it has been “too bullish” on the utilities sector. Although its analysts acknowledge that there is still value to be had in the sector and, at this stage, it does not appear to be in over-bought territory, there are hurdles to further price appreciation.

Chief among the concerns for the utilities sector are slowing earnings momentum, tax increases and reduced dividends. It notes that governments across Europe have either announced or are considering a windfall tax for the sector. For example, the proposed nuclear fuel tax in Germany could imply a 67 per cent effective tax rate on nuclear fuel. This could cut energy provider E.on’s earnings-per-share for 2011-2012 by 17-19 per cent, according to calculations by UBS. Elsewhere, authorities in Spain and Finland have announced that they will also consider taxing nuclear energy and hydro power. Belgium, meanwhile, is pressing for a windfall tax to “repay” the value of free carbon emissions given to companies by the European Carbon Emissions Scheme. These proposed tax rises for the sector are bad news for investors since they threaten dividends and any potential share buy backs.

So if investors retreat from utilities, where should contract for difference (CFD) traders be looking for investment opportunities? Well, in the short-term, the telecoms sector. UBS recently upgraded it from underweight to overweight due to three factors: solid results in the second quarter, strong earnings momentum and, last but not least, it is the most over-sold sector in the market, as you can see in the chart below.

But it now looks ripe to outperform. Solid second quarter earnings and a positive short-term growth trajectory should boost the sector. Added to this, its dividend yield is at a 40-year high relative to the overall market. Telco stocks are now yielding 7 per cent – 1.75 times the average. And UBS argues that the dividend is pretty secure, at least in the near-term, due to continued demand for smart-phones and data services.

UBS’s preferred stock is Telefonica, the Spanish corporate that owns O2, the UK mobile phone operator. The investment bank is attracted to its valuation – the stock price remains 20 per cent below its January 2008 high – and its exposure to fast-growing markets in Latin America. In contrast, BT is one of its least-favoured stocks; the company has persistent problems with its pension deficit. Other stocks to look out for are Pace, which develops technology for cable television and Iliad, the French maker of electronic readers. Royal Bank of Scotland (RBS) has a buy rating on Pace. It was impressed by its interim results for the first half of 2010: revenue growth was an impressive 21 per cent higher than the same period in 2009. It also sees strong growth ahead in pay-for television, especially in emerging markets. Execution Noble recently upgraded Iliad to a buy, after its stock price fell below its fair value level.

So if CFD traders want to get some short-term profits in the last weeks of summer, then they should look beyond traditionally defensive utilities. After a long time in the shadows, it is time for the telecoms sector to shine.