We are worried about a recession. We have no economists at New Street (at least, not practicing ones), and we claim no special insights, but many of our clients are worried, and press reports are filled with worry, and after a ten-year growth stretch and a trade war and a government shutdown, it seems sensible to worry.
With that in mind, we set about quantifying the risk of a recession to our stocks in a report we published last weekend (Recession Special: LINK). We explored four different factors that could impact telecom and cable stocks in a recession. We summed these up, doing our best to account for areas where the four factors overlapped, to arrive at a rough view of potential exposure.
The first thing that jumped out at us was that there are no absolute winners (see Slide 4). The least exposed companies on our list face 20-25% risk to their stock prices (Verizon and the towers). That may seem grim, but it is a lot better than the 65-70% risk faced by the most exposed (Sprint and DISH). The magnitude of risk we arrived at seemed implausible at first, but these same companies declined more in the last two recessions (see Slide 15).
The first factor is business risk. We built a framework for each of the six main products that our companies sell to determine revenue at risk from subscriber losses and pricing pressure (advertising and pay-tv are most at risk; wireless and broadband are least at risk). When combined with business mix, this gives us revenue at risk by company. The range is tight; all companies face revenue pressure of 3-5% (see Slide 8). The range of EBITDA at risk is much greater because different products have different incremental margins and different companies have very different starting margins (slide 10).
The second factor is refinancing risk, and there are two components to this: the risk posed to earnings and FCF from refinancing maturing debt at higher rates, and the risk to a company’s solvency if they can’t refinance maturing debt. Most companies face some risk to FCF from refinancing at higher rates; it’s modest for most, but quite significant for Sprint, DISH and Altice (slide 42). Only Sprint faces material risk of not being able to pay down maturing debt if credit markets seize up (Slide 41).
The third factor is multiple compression. Separate from the decline in EBITDA, all the companies and sectors we cover have experienced multiple compression in prior recessions. Multiples for our companies have fallen less than for the broader market, but they have fallen. The impact on equities depends on the magnitude of multiple compression, the starting multiple, and leverage. Towers face the most risk to their multiples, but with high starting multiples, the equity at risk from this factor is not much higher than most others, even with high leverage. Verizon and T-Mobile are least exposed to this factor, given modest risk to multiples and low leverage (slide 49).
Finally, we accounted for dividends since these offset some of the equity risk for the companies that pay them. Verizon and AT&T pay the largest dividends, but CCI, AMT and Comcast also benefit. Combining the impacts from the four factors gets us to the total exposure (slide 54). Verizon, the towers and T-Mobile are the best positioned, while Sprint and DISH face the greatest risk.
We followed up the Recession Special with a short report looking at the impact of a recession on wireless capex and 5G deployment (see follow up report here: LINK). We show that AT&T and Sprint may indeed need to cut capex and push out 5G investment. In Sprint’s case, they face a funding shortfall of $8BN; something must go. In AT&T’s, they could have a hard time staying within their leverage target of 2.5x; they already need to sell $8BN in assets to get there without a recession.
We have more questions from clients that we are still working on answers to. Please keep the questions coming.
Shifting focus from the US to Asia, the Chinese telcos look most exposed to recession risk in our view. However, this is not to do with top line pressure, which we see as defensive. Rather as we wrote (HERE) we see risk that the need to support Huawei/ZTE and stimulate the slowing economy might cause the Chinese government to push the telcos into an accelerated 5G deployment. When the government did this post the crisis in 2008, telco capex rose by 69% over a three-year period.
Despite this risk, consensus capex expectations have fallen by 10% in China in the last 9 months, with analysts influenced by the telcos who continue to argue for a steady state approach to 5G. Given capex is the key driver of the Chinese telco share prices, this explains why the space has been strong in recent months. Our fear is that we may well be at one of those times when the needs of China Inc. outweigh the needs of the telcos, suggesting that the next move in capex expectations is likely higher.
In the note we increased our medium term capex forecasts for the telcos by 10% and downgraded China Mobile and China Telecom to Neutral. The obvious way to play rising capex expectations in China is of course through China Tower which we see as the best stock in the space. We have written on China Tower on multiple occasions recently, firstly upgrading to Buy (HERE), explaining why it is our top pick in our China 2019 outlook (HERE), then further upgrading on rising revenue expectations (HERE).
And then in Europe, as a starting point the whole sector should be relatively defensive (and even more so than the last major recession 10 years ago). Within the group, we would rank our preferences as follows:
Similar to the US and China, the towers should be the most defensive among our companies, especially if a recession prompts policy makers to reduce interest rates. Cellnex and Inwit would be our picks here.
The challengers are also well positioned. Although we don’t think consumers would drop telecoms services, they might shop around for cheaper services. Iliad, TalkTalk, and United Internet stand to benefit from increased share gains.
Pay-tv companies may also be insulated. This might be controversial, but in the last recession, we saw a pick-up in demand for pay-tv services as some consumers spend more time at home. This is different from the trend we see in the US where there are much cheaper substitutes to traditional pay-tv packages (Comcast’s Sky assets could benefit).
The telcos that are likely to do the worst would be those that are leveraged and exposed to higher retail prices, like the leveraged incumbents – TI, Telefonica, Liberty Global and Vodafone. They would likely face pressure due both to operational underperformance and additional investor concern about balance sheet stress.
We are not banking on a recession. Our ratings and targets assume continued economic expansion. But if the worries prove founded, we know where to hide, and we have our shopping list for what to buy at the bottom.
For the full weekly review and updated comp sheets, see HERE.