Serious Money: Technological change and regulation are key to understanding the investment case for phone companies, writes Chris Johns
Share prices of European telecommunications stocks are up, on average, around 3 per cent year to date, a pretty woeful performance compared to the market as a whole. As ever, averages conceal wide variations in individual share price performance.
One or two stocks have done very well, particularly those at the centre of takeover rumours. Denmark's TDC is up nearly 50 per cent as a number of private equity groups look to be competing to buy the company. Similarly, Eircom has enjoyed a stellar few weeks, with the latest rumour focusing on a potential bid from Swisscom.
At the bottom end of the performance league table are the big national carriers: Portugal Telecom; Telecom Italia; Belgacom; Deutsche Telekom; Swisscom, and France Telecom have all seen their share prices fall so far this year.
The performance pattern is clear. Some stocks have risen for specific reasons. 02 is another good performer, partly because of bid rumours. Another "special situation" driving Eircom's performance is the perception that putting money to work in telco stocks in countries with ineffective telephony regulation is usually a profitable idea.
So, the first, not terribly insightful, moral of this story is to buy stocks (not just telcos) that could be bid for. But why has the sector, excluding bid stories, been such a poor performer? By most measures, telephone company shares are not expensive and these businesses are now hugely cash generative.
The answer lies mostly with competitive threats and partly with regulation. Investors are concerned that most of the cashflows generated by these businesses will probably be competed away and where competition doesn't have this effect, the regulators - with the possible exception of Ireland - will step in.
Anyone interested in why some investors love the regulatory environment in which Eircom operates should look at the websites www.irelandoffline.org and www.comwreck.com. Serious Money is, of course, not responsible for the content of these external websites.
The most obvious competitive threat is from so-called disruptive technology, more specifically, the fundamental challenge posed by the promise of free calls with voice over internet protocol (VoIP).
Ebay's purchase of the most well-known internet telephony company, Skype, is just one of a number of industry moves whereby different companies are seeking to offer telephony over the internet, for free in the case of Skype to Skype users at any rate and for very low cost in the case of many other operators.
Nobody really knows whether internet telephony will really blow up the business models of incumbent telcos, but many of us suspect it will.
The dinosaurs are fighting back of course, and a typical counter-argument came the other day from the chairman of Telecom Italia, who pointed out that to use Skype, or virtually any other VoIP service, you need broadband internet access. And, of course, who charges customers through the nose for broadband?
Additionally, he argued, consumers will only want Skype for long-distance calls - in Europe, most calls are local and low-cost already, or are made to mobile phones which always incur a "termination" charge (industry jargon for high cost), which Skype cannot get around.
When offered something for free or low cost, I wouldn't be so sure that consumers will happily ignore the free option. Also, if you are going to rely on super-high mobile phone tariffs forever, this is where I suspect regulators will - or should - step in.
But the real killer comes with that access argument. There are all sorts of possibilities opening up whereby consumers could break the link with companies like Eircom, Telecom Italia and even Vodafone.
The successor to Wi-Fi technology, which still requires broadband access, Wi-Max (which doesn't), is now being rolled out, mostly in the US, but it is spreading to Europe.
This technology allows companies to provide ultra high-speed internet access over wide areas. With a laptop or an appropriately enabled mobile phone and Skype, anyone will be able to phone anyone for free, without recourse to broadband or wireless companies' mobile phone charges.
The Wi-Max or other disruptive technology operator will, of course, presumably charge something, but some municipalities in the US are already experimenting with publicly provided wireless access. Wi-Fi-enabled handsets are already available to buy, so Wi-Max phones can't be too far behind. In the US and parts of Europe, it is already possible to use existing mobile handsets in conjunction with Skype.
Much of this is now standard fare: most of us are familiar with the underlying concepts and why they have been holding back the performance of most telephone companies. What is less familiar is the argument raging amongst industry experts about VoIP as merely a symptom of the underlying telco malaise, not even a major one. Here, the debate becomes very technical and, at times, philosophical. And too difficult for some regulators.
Telcos, goes the argument, are wedded to the idea of the "intelligent network". This is where a company takes data or calls into its network, controls and/or manipulates those inputs and eventually delivers them in neatly packaged form to the final user. The trouble is, they are not very good at this: picture messaging has been a commercial flop, SMS texting an accident and anything other than voice traffic has so far failed to live up to hopes. The internet is an obvious example of everything that a telco hates: the stupid network, see www.rageboy.com/stupidnet.html.
There are many critics of the industry favourite model, the "triple play fallacy" is the faith telcos have in the moneymaking ability of delivery of voice, internet and video down an intelligent network. Instead, these critics champion the stupid network: this is a very big pipe that channels as much as possible as quickly as possible to anybody who wants it.
The stupid network, is, by its nature, uncontrollable: the end user takes and does what he wants.
Critically, the provider of the stupid network can make very little money out of it. People who create cool applications to handle the outputs can potentially do well, think Skype, eBay and Google. Corporates control the intelligent network, but consumers shape the outcomes of the stupid network. Regulators, if they understand that change is occurring at an astonishing rate, should be on the side of the consumer and the stupid network.
BT seems to have recognised some of this with its attempt to embrace rather than fight disruptive technology. But even here there is a paradox: by migrating its entire business platform to the internet the company might be embracing the stupid network. How it is going to make money from this is uncertain.
Who can predict any of that? I'd rather buy Google - huge implied option value on any number of speculative technologies panning out - than a phone business. Google - which has doubled since Serious Money first tipped it a year ago - is one company that understands the stupid network.
Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.
