Don't hang up yet on those telecom stocks

For most of the 1990s the majority of quoted telecom companies were viewed as worthy if somewhat dull investments. Companies such as BT traded on relatively low price-earnings ratios and offered a dividend yield that was above the market average.

During the 1990s more and more state-owned telecom companies were privatised and quoted on their respective national exchanges. The majority of these companies were faced with similar problems of a bloated cost base and an overly bureaucratic management. The rigours of a public listing has acted to force major changes so that by the later 1990s telecom companies had made substantial progress in reducing their cost bases. Furthermore, senior management had become more nimble and alive to the potential offered by new technology.

Therefore, in the late 1990s, when the craze for high-tech and growth investment took off, Telecom stocks enjoyed a major re-rating. Unlike start-ups, the incumbent telcos seemed to offer investors the best of all possible worlds.

First, the privatised telcos had a huge and captive customer base generating enviable cashflows. Progress made on efficiency improvements meant that the underlying profitability of basic telephony services had increased. Secondly, telecom companies seemed to be well-placed to exploit the opportunities offered by new technologies and the Internet.

This was evidenced by the relatively strong position achieved by the majority of the privatised operators in the rapidly growing mobile sector.

The twin attributes of large and potentially rapidly growing cashflows led to a stampede for these companies' shares and consequently their share prices rose dramatically. At the peak of the market earlier this year the Dutch operator, KPN, was trading on a price-earnings (P/E) ratio in excess of 60, while the slower growing BT was on an above market average P/E of over 30. Since that peak in March/April telecom share prices have fallen to earth with a bump. For example, KPN and Deutsche Telekom have seen their shares decline by close to 50 per cent from their peaks.

Of course, part of this share price weakness can be accounted for by the general weakness in global stock markets. However, telecom stocks have fallen more sharply than the overall market suggesting that investors have reassessed their expectations regarding the financial prospects of the sector.

The threat posed by new entrants has certainly become more apparent. Telcos, including Eircom, have been losing market share in their traditional fixed line business at a more rapid rate than previously expected.

Volume growth from the more rapidly growing areas of mobile and data transmission has been buoyant but competitive pressures have acted to squeeze profit margins. The result of these pressures has been a general revision downwards in profit forecasts across the whole sector. Unfortunately for the army of private investors here, Eircom had been no exception in this regard.

A further negative for telecom stocks has been the realisation that the investment cost of developing new technologies is going to be enormous. The auction process for UK third generation mobile licences that generated a staggering £22.5 billion sterling served to highlight the scale of investment required.

The recent weakness in telecom share prices clearly reflects some of these negative factors and must be raising doubts regarding the long-term growth prospects of the global telecom sector. However, despite the recent volatility in share prices and the flow of poor financial news, demand for the products and services offered by telecom companies seems set to grow rapidly for a prolonged period.

Therefore, investors would probably be wise to stick with their telecom investments through the current phase of uncertainty.