The earnings recession is worse than it looks on the surface. Based on footnotes adjustments (featured by HBS & MIT Sloan), we show that earnings distortion reached levels not seen since the tech bubble and the financial crisis. While GAAP earnings are down 1% over the trailing twelve months (TTM), core earnings are down 6%.

The core fundamentals of businesses are declining in nearly every sector. 10 out of 11 sectors have declining returns on invested capital (ROIC).

Only one sector, the Telecom sector, has a rising ROIC. Unsurprisingly, Telecom is also the top-rated sector according to our sector rating methodology and earns our Very Attractive rating. The Telecom sector – and specifically BCE Inc. (BCE: $48/share) – is this week’s Long Idea.

Improving Returns in Telecoms

Not only does the Telecom sector have a rising ROIC over the TTM period, its ROIC has risen every year since 2015, as shown in Figure 1. The sector also generates consistently positive economic earnings due to the fact that its ROIC is higher than its weighted average cost of capital (WACC).

Figure 1: Telecom ROIC vs. WACC: 2015-TTM[1]

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Improving margins are driving the rising ROIC for this sector. The aggregate NOPAT margin for the sector rose from 10.2% in 2015 to 12.6% TTM. Invested capital turns have fallen from 0.46 to 0.42 over the same times. Firms in this industry have become less efficient at turning capital into revenue, but they’ve become much more efficient at cutting costs and turning more revenue into profit.

Appendix II shows NOPAT margin and invested capital turns for all 11 sectors going back to 1998.

While the Telecom sector is profitable overall, profitability is highly concentrated. Just four companies – Verizon (VZ), Nippon Telegraph and Telephone (NTTYY), BCE Inc. (BCE), and America Movil (AMX) – earned $19 billion in economic earnings over the TTM period. The remaining 33 companies we cover in the sector combined for $14 billion in economic losses.

This high level of concentration proves diligence remains important. The Telecom sector may be Very Attractive overall, but there are still plenty of risky stocks in the sector that investors should avoid.

One Stock to Buy in the Telecom Sector

Investors looking to find value in the Telecom sector should start by looking at the four most profitable companies in the industry per above. We already made the case for why investors should buy VZ in our article “Earn Double the 30-Year Treasury Yield with This Pick”.

BCE is another one of our top picks in the sector. The Canadian telecom giant shares many of the same traits that make us bullish on Verizon, including:

  • The fastest network in its market, which allows it to grow its market share while also increasing its average revenue per user
  • Growth potential over the next several years due to the upcoming deployment of 5G technology
  • A cheap valuation and high dividend yield, which is supported by ample free cash flow

From 2015-2018, BCE grew its after-tax operating profit (NOPAT) by 4% compounded annually while maintaining a consistent ROIC of ~8%. Over the TTM period, NOPAT is up 3% year-over-year while ROIC remains steady.

Meanwhile, BCE’s stock has been almost flat, up just 2% over the past five years. It appears that the market does not recognize the value of this company’s cash flows.

At its current valuation of $48/share, BCE has a price to economic book value (PEBV) of 0.8. This ratio means the market expects BCE’s NOPAT to permanently decline by 20%. For a company with BCE’s track record of consistent profit growth, this expectation seems overly pessimistic.

If BCE can maintain its 2018 NOPAT margin of 18% and grow NOPAT by 2% compounded annually for the next decade, the stock is worth $70/share today, a 46% upside to the current stock price. See the math behind this dynamic DCF scenario.

BCE also offers a 5% dividend yield, which is well supported by the cumulative $9 billion (22% of market cap) in free cash flow it earned from 2015-2018. Investors in BCE get both a steady income and the opportunity for capital appreciation.

The Rest of the Market

While Telecom is the only sector with a rising ROIC over the TTM period, looking at the recent trends in ROIC for the rest of the market provides important insights. Figures 2-11 show the aggregate ROIC and WACC for every other sector from 2015-TTM.

Investors who want to see a longer-term view can find charts of ROIC vs. WACC going back to 1998 for every sector in Appendix I.

Investors who are curious about the drivers of ROIC can find NOPAT margin and invested capital turns for each sector going back to 1998 in Appendix II.

Basic Materials

Figure 2 shows the ROIC for the Basic Materials sector declined over the TTM period after rising steadily from 2015-2018. NOPAT margin fell from 10.8% in 2018 to 9.5% TTM, while capital turns fell from 0.62 to 0.57. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 2: Basic Materials ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Consumer Cyclicals

Figure 3 shows the ROIC for the Consumer Cyclicals sector declined from 8.7% in 2015 to 7.9% TTM. This decline is the result of invested capital turns falling from 1.26 in 2015 to 1.17 TTM. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 3: Consumer Cyclicals ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Consumer Non-Cyclicals

Figure 4 shows ROIC for the Consumer Non-Cyclicals sector has steadily declined since 2015. As we noted when we put Mondelez (MDLZ) in the Danger Zone, the rise of e-commerce and changing consumer tastes have diminished the competitive advantages that previously helped companies in this industry earn outsized returns. The declining advantage manifests in the sector’s falling NOPAT margins, down from 6.4% in 2015 to 5.8% TTM. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 4: Consumer Non-Cyclicals ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Energy

Figure 5 shows ROIC rebounded from 2016-2018 due to a combination of rising oil prices and tax cuts. NOPAT margins rose from 4.1% in 2015 to 8.2% in 2018. But, margins fell over TTM and brought ROIC down with them. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 5: Energy ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Financials

Figure 6 shows ROIC declined over the TTM for the Financials sector, as NOPAT margins fell from 15.2% to 13.2%. But, WACC declined by an even larger amount; so, the sector generated positive economic earnings. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 6: Financials ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Healthcare

Figure 7 shows ROIC for the Healthcare sector declined from 8.4% in 2015 to 7.5% TTM. This decline is driven by aggregate NOPAT margin for the sector declining from 10.4% to 8.9% over the same time. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 7: Healthcare ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Industrials

Figure 8 shows ROIC for the Industrials sector declined from 8% in 2015 to 7.6% TTM. This decline is driven by aggregate invested capital turns declining from 0.87 to 0.83 over the same time. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 8: Industrials ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Real Estate

Figure 9 shows ROIC for the REIT sector declined in 2018 and over the TTM period. Capital turns are up slightly, but NOPAT margins fell sharply over the last two years, from 24.9% in 2017 to 18.3% TTM. This sharp decline in ROIC explains why Real Estate is the worst rated sector according to our sector rating methodology. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 9: Real Estate ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Technology

Despite the decline over the TTM period, the Technology sector still has the highest ROIC of any sector by a wide margin. The decline is driven by a few mega-cap companies. Notably, Apple’s (AAPL) ROIC declined from 129% to 98% over the past year. Aggregate NOPAT margins are down from 15.7% in 2018 to 14.2% TTM, while aggregate capital turns are down from 1.05 to 0.99. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 10: Technology ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Utilities

The Utilities sector’s 3.4% ROIC is the lowest of any sector. As Figure 11 shows, it has also steadily declined since 2015. Margins are gradually increasing, but capital turns are down from 0.27 in 2015 to 0.23 TTM. See the Appendices for analysis of ROIC vs WACC, NOPAT margins and invested capital turns back to 1998.

Figure 11: Utilities ROIC vs. WACC: 2015-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

This article originally published on December 2, 2019.

Disclosure: David Trainer, Sam McBride, and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.

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Appendix I: ROIC and WACC Since 1998

The body of this report showed ROIC vs. WACC since 2015 so investors could more clearly see recent trends. This appendix shows the data going back to 1998 so that investors can better understand the long-term trajectory of each sector.

Figure 12: Basic Materials ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 13: Consumer Cyclicals ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 14: Consumer Non-Cyclicals ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 15: Energy ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 16: Financials ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 17: Healthcare ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 18: Industrials ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 19: Real Estate ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 20: Technology ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 21: Telecom ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 22: Utilities ROIC Vs. WACC: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Appendix II: NOPAT Margin and Invested Capital Turns Since 1998

This appendix shows the two drivers of ROIC – NOPAT margin and invested capital turns – for each sector going back to 1998. For more information on how we calculate these drivers of ROIC, see here.

Figure 23: Basic Materials NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 24: Consumer Cyclicals NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 25: Consumer Non-Cyclicals NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 26: Energy NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 27: Financials NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 28: Healthcare NOPAT Margin and IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 29: Industrials NOPAT Margin vs. IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 30: Real Estate NOPAT Margin Vs. IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 31: Technology NOPAT Margin Vs. IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 32: Telecom NOPAT Margin Vs. IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

Figure 33: Utilities NOPAT Margin vs. IC Turns: 1998 to present

Image Source: New Constructs, LLC

Sources: New Constructs, LLC and company filings.

[1] See Appendix I for analysis for ROIC from 1998 to present.