Communications Sector Outlook Gets a Bit More “Cloudy”

Posted by George Smith, CFA, CAIA, CIPM, Portfolio Strategist

Thursday, October 26, 2023

Additional content provided by Kent Cullinane, Analyst

Earnings season for the third quarter of 2023 is underway, as 86 constituents of the S&P 500 reported results last week and 160 more are reporting this week, totaling nearly half of the S&P 500. As of October 25, 2023, earnings for the S&P are projected to increase 0.75% year-over-year, a slight increase from the 0.3% gain projected at the end of the September. So far, 78% of companies have reported earnings that have surpassed estimates, a bit higher than the 5-year average of 77% and 10-year average of 74%. The average earnings beat stands at 7.5%, slightly above with the 10-year average.

When looking at earnings by sector, 8 of the 11 sectors within the S&P are projected to report positive year-over-year earnings growth, with the communications services and consumer discretionary sectors expected to rise 32.1% and 21.5%, respectively. At the other end of the spectrum, the energy, materials, and health care sectors are expected to report earnings declines of more than 20%

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Strong year-to-date performance. The communications sector has been the best performing sector year-to-date, driven mainly by strong earnings growth and price-to-earnings multiple expansion. The sector is up 37% this year, roughly 3.5% ahead of the next closest sector (technology at 33.5%) and nearly 30% ahead of the broader market (S&P at 9%). This is in stark contrast to 2022 when the communications sector was the worst performer in the S&P, tumbling 40% compared to the S&P’s 19.4% decline (excluding dividends).

Focus on the big hitters in this concentrated sector. Today we focus on the communications sector as two of the largest components of the sector, Alphabet/Google (GOOG/L) and Meta/Facebook (META), representing roughly 50% of the sector’s market capitalization (cap), reported results this week.

GOOG/L reported earnings after close on Tuesday, and while they beat both consensus sales and earnings estimates, sentiment on the advertising behemoth soured due to underwhelming results from their cloud-computing segment. Analysts were expecting the cloud segment, considered to be one of the largest drivers of growth for GOOG/L, to be stronger. Despite the investor reaction to the disappointing cloud segment, GOOG/L increased revenue by double-digits after four quarters of single-digit expansion.

META reported better-than-expected results after the close on Wednesday, beating on both the top and bottom line, highlighted by 23% growth in revenue. The impressive sales growth number comes after a dismal 2022 in which revenue shrank for three consecutive quarters. META has weathered the challenging digital advertising market fairly well, while also cutting costs and driving engagement across platforms, but the digital media giant’s shares sold off in after-hours trading following cautious comments about the macro outlook.

Elsewhere in the communications sector, traditional telecommunications companies AT&T (T) and Verizon (VZ) reported encouraging earnings results, while streaming giant Netflix (NFLX) surged more than 12% following impressive subscription growth numbers.

Communication services offers good growth for the price. From a valuation perspective, the communications sector looks cheap relative to the broader market, with an average PE-to-Growth ratio of roughly 0.8 (for reference, the S&P is near 1.5), making it the cheapest sector relative to projected growth in the S&P. For more on how communication services offer the best bang for your P/E buck, see here.

Finally, although the negative market reaction to Alphabet and Meta results will do some technical damage to the sector’s chart, we would note that LPL Research rates the sector’s relative trend as positive, the sector remains in an uptrend, and has among the better breadth readings among S&P sectors.

Top Sector Picks

LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) continues to favor the energy and industrials sectors and rates communication services neutral, but with a positive bias. A combination of encouraging technical analysis trends, a solid earnings growth outlook, and quite reasonable valuations are some of the reasons why STAAC is warming up to the sector even as these mixed results from Google and Meta create a tougher path to outperformance in the near term. On the flip side, STAAC suggest caution toward consumer staples and real estate and maintains negative views of those sectors.


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