Telecom/Tech: Margin Compression Be A'Coming
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2012-04-18 10:49 by Karl Denninger
in Technology Ignore this thread
Telecom/Tech: Margin Compression Be A'Coming

One word: Duh.

The U.S. wireless market, long the fastest-growing sector in the telecommunications industry, looks like it’s headed for a wall.

Sales of wireless contracts, the most lucrative segment of the business because it locks in monthly payments over long periods, may have shrunk for the first time ever in the first quarter. One big reason for the sharp reversal: Soaring iPhone sales in late 2011 may have satiated consumers’ appetites for wireless plans.

You have several problems here that will ultimately resolve in lower multiples, negative growth (that is, a saturated industry that feeds on each other rather than growing the base) and the flattening of the subsidy model.

Let's go down the list, in order:

  • Penetration has effectively reached 100%.  Seriously folks; in the US in terms of active devices the total count is claimed to be some 300 million.  That's more than one for every man, woman and child over the age of 10.  Growth?  Where?  Are you seriously going to suggest that we'll sell cellphones to dogs and cats -- or roaches?

  • Subsidy models have grossly distorted the market.  The iPhone is the worst in this regard but not the only sinner.  Apple devices cost carriers about $650 each, you allegedly "pay" $199 (or less.)  The truth is that your difference in price for the plan you're on totals more than $700 annually for the two years you're on contract, which means you pay an effective $1800+ for that phone.  This is how the carriers can afford to "eat" your upgrades. 

  • Trading on your customer's stupidity only works until your customer becomes smart.  And the subsidy model is grossly stupid.  You'd be way, way ahead to finance that phone even at 30% interest on your credit card instead, but the carriers don't want you to know that.  Eventually, however, the truth of what's going on will sink in, and when it does both the carriers and suppliers have got a serious problem with their customer base.

  • Consumer real disposable income has dropped while cost of living has risen -- for the last decade.  This hole was filled in with "home equity extraction" and to some degree the falling cost of technology.  But that cost of technology decrease has been "extracted" back out through skyrocketing telecommunications expense.  $100+ cellphone bills are exorbitant folks; that's comparable to most people's electric bill. 

  • The early signs of saturation and margin foldback have been hidden through the Fed's QE games and government handouts.  But those signs of softening are present.  Sandisk anyone?  Flash memory is at the core of most modern devices and demand is softening.  How you square this with continued multiple expansion and "profits everywhere" is more than a bit of a stretch.

  • We just came into a cyclical profit peak last quarter.  I've warned of this for a year, roughly, and it's a bad time for it.  To hit a cyclical profit peak while the "cheap money" games are being played at the highest level ever is asking for trouble by the Titanic-load.  Shrinking profit margins hit P/Es and then if liquidity also comes out at the same time....

  • The story is not just US-centric.  China is slowing and Europe is a train-wreck.

Where's the growth going to come from when the US market is saturated, Europe is on the edge of a monstrous contraction in their economic picture led by Spain, Portugal and Italy and China is putting up weak (and overstated, as they always are) GDP numbers?

Who wins?  The low-cost supplier wins on a comparative basis.

But this may be deceptive too so I argue one must evaluate after re-basing operating results accounting for sustainable hardware margins.

Assuming you're looking for things to buy (as opposed to short) look at the companies in this space that have hardware margins at or under 10% but are putting up good numbers and have a reasonable P/E -- 10 or even less -- on that predicate.  So if you have some firm with a 30% hardware margin, for example, refigure their cash flow with their hardware market segment having a 10% operating margin and then look at what the P/E is with that adjustment.  If you can still stomach paying at that operating margin then it might be worth getting involved.

As for carriers Verizon is insanely expensive.  They are being supported by their yield but at 44 times earnings my answer to anyone advocating buying the stock is "you have to be kidding me!"  AT&T is no better at 46(!) times earnings, albeit with a 5.7% dividend yield.  If you think either of these firms is going to sit back and let Apple (and others) suck off their gross margins on a permanent basis and their stock is going to remain at levels of 40+ times earnings you're out of your mind.  Either share prices crash by a literal 50% or more or the firms force the end of that subsidy model and the handset suppliers' operating margins get destroyed.

If you remember my previous article on this point I argued that the claim that we've got carriers playing regulatory arbitrage and "stealing" 80% of your cell bill was utter crap.  The numbers say I'm right on this with Verizon and AT&T both trading well north of 40 times earnings. 

The entities stealing your money as a customer are the handset suppliers, specifically (but not exclusively) Apple.

Remember that Netflix had stellar "growth" numbers and impressive forward projections right up until their growth trajectory rolled over and operating margins collapsed.  Then the stock price got cut to a literal quarter of what it was previously before "rebounding" to "only" less than 1/3rd of its previous value.

This story is going to repeat in a lot of high-fliers in the coming months.  Insane valuations and cost-shifting models have created another 1999-style valuation bubble in many of these firms and rationalization will occur -- it is simply a matter of time.