Selloff Leaves Strong Companies Looking Cheap in Communication Services

Alphabet GOOG and Meta META continue to weigh on the communication services sector, pulling the Morningstar US Communication Services Index down nearly 18% during the second quarter through June 27. The index has declined about 32% on a trailing 12-month basis versus an 11% drop for the broader market.

Communication Services Performance

- Company filings, Morningstar Equity Research. Data as of June 27, 2022.

We believe the increasingly negative sentiment around online advertising, and Meta in particular, remains unwarranted. The changes in Apple’s privacy policies have caused ad spending to slow, but we expect firms that can collect information about their customers’ interests will ultimately navigate this headwind and potential regulatory pressure to reignite growth. In any case, valuation multiples are now undemanding. Meta shares trade at only 14 times our 2022 earnings estimate. Alphabet trades at 23 times, which we still view as very reasonable, as we also think it is the stronger of the two businesses. Both stocks trade at large discounts to our fair value estimates.

Communication Services Star Rating Distribution by Industry

- Company filings, Morningstar Equity Research. Data as of June 27, 2022.

Cable stocks have also lagged the broader market over the past several months on fears of slowing broadband customer growth, especially given the strong fixed-wireless broadband customer additions Verizon VZ and T-Mobile TMUS have posted. We believe the threat from fixed-wireless is modest given the capacity limitations inherent in wireless networks and our view that the carriers will avoid any activity that threatens their lucrative smartphone businesses. We have also yet to see the fiber upgrade efforts at the phone companies have much impact, as recent customer additions have been modest. Cable valuation multiples have also retreated to attractive levels. Comcast’s CMCSA free cash flow yield now sits at nearly 9%, the highest level in nearly a decade. The firm plans to use cash flow to repurchase shares this year.

Quarterly Net Broadband Customer Additions (000s)

- Company filings, Morningstar Equity Research. Data as of June 27, 2022.

Media stocks have also seen a sharp shift in sentiment in the wake of disappointing customer growth at Netflix NFLX. Last quarter we said the growing pessimism around Netflix was warranted, as competition from older media firms has ratcheted higher. This view proved correct even more quickly than we expected, as the firm’s customer growth hit a wall during the first quarter. The firm lost 200,000 net customers globally during the quarter versus management’s expectation of 2.5 million net additions. Penetration in the U.S. has stagnated, while other services continue to gain ground.

Efforts to crack down on password sharing and add an ad-supported tier should provide some benefit, but we expect incremental revenue for Netflix will be small. For the broader media industry, we suspect that investors fear that streaming growth will fail to justify heavy content investments needed to attract customers. We believe this concern is valid given the huge sums legacy media firms have committed, but the distribution methods at these firms’ disposal should provide additional avenues to monetize these investments. We’ve also seen signs of growing discipline around content spending at Netflix, which could provide a respite from industry cost inflation.

U.S. Household Penetration

- Company filings, Morningstar Equity Research. Data as of June 27, 2022.

Top Picks

Walt Disney DIS Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $170 Fair Value Uncertainty: High

Disney remains the best-situated traditional media firm to navigate the transition to streaming, in our view. The firm's deep content library, teeming with major franchises, and its strong studios provide both the more family-friendly fare Disney is famous for and content suited to older audiences. We expect that fans will continue to flock to the firm's parks and resorts as pandemic restrictions lift globally. The cable networks, like ESPN, will likely continue to lose subscribers, but they generate cash flow to fund the firm's streaming ambitions, including platforms like Hulu and ESPN+ that will gradually displace traditional cable. The firm’s flagship streaming service Disney+ also continues to build momentum with audiences around the world, providing the platform that will likely become the primary touchpoint with consumers over the long term.

Comcast CMCSA Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $60 Fair Value Uncertainty: Medium

Comcast faces a double-whammy as concerns over slowing broadband customer growth have dogged the core cable business and fears surrounding increased content investments have hounded NBC Universal. We expect broadband customer growth will slow further as the market is maturing and the phone companies will likely gain share as their fiber upgrades progress. But we still expect Comcast will grow broadband revenue through the combination of modest customer additions and solid pricing power. NBC Universal will need to invest to increase interest around Peacock, but we still like the firm’s position overall thanks to its solid stable of content franchises, strong theme parks, and still highly profitable traditional television business. With a strong balance sheet, Comcast should be able to direct most of its free cash flow to shareholder returns, including a solid dividend and heavy share repurchases.

Meta Platforms META Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $384 Fair Value Uncertainty: High

Meta remains well positioned, as its core advertising business (via Facebook and Instagram) continues to perform well, producing nearly 50% operating margins. The impact of lower ad prices, mainly from short-form video ads as Meta monetizes its TikTok-like Reels feature, and Apple's iOS changes will pressure ad revenue growth, but we expect these pressures to be short-lived. Meta’s network effect remains intact, and user monetization continues to grow while other opportunities like commerce await. Meta's large user base should continue attracting advertisers as the firm uses more of its own user data to offset Apple’s privacy policy changes.