investing

Two Surprising Telecom Stocks With Great Growth Potential

These opposites are both attractive.

I own two telecommunications stocks. One is a well-known blue chip. The other, some say, is a cow chip. I think the cow chip has better prospects.

The more-speculative holding, MagicJack VocalTec (symbol CALL, $21), is a provider of voice-over-Internet phone service with 3.2 million customers. MagicJack has terrific name recognition. But until recently, the Israel-based company was known for loud, tacky commercials and a brassy CEO whom many considered a clown. Today, MagicJack is under new, serious management (no more clowning around), and its ads and Web site are classy. With 70 million landline households in the U.S., MagicJack’s potential market is enormous. (Share prices are as of March 13; see May 16, 2014, author's note below.)

Bargain calling. As the new ads make vividly clear, MagicJack offers a much better deal than its rivals. MagicJack charges just $30 a year, compared with more than ten times as much for Vonage, three times as much for Skype and at least 12 times as much for service from your local phone company. (Yes, when you Skype someone who is logged in to the service, the call is free. But such synchronicity is rare.) Plus, the tiny MagicJack device that connects to a computer or router can yield great savings when you travel abroad.

Hedge fund manager Whitney Tilson, who scored huge gains on shares of Netflix, thinks MagicJack has similar growth potential. “MagicJack could have five times as many customers,” he says, speaking via his MagicJack. “One lesson from Netflix is that when a service is so cheap, people renew without even thinking about it.”

However, many of MagicJack’s customers don’t automatically re-up, so it loses an average of 3.5% of them every month. To combat that, the company will soon introduce prepaid cards at major retailers to remind people how easy it is to renew.

The stock, at 12 times estimated 2014 profits, is cheap, though not as cheap as it was before it surged 20% on March 13 after a solid earnings report. The firm sees 2014 revenues rising an impressive 10% to 14%.

With a market cap of $130 billion, Qualcomm (QCOM, $76) dwarfs MagicJack by a factor of some 400. Qualcomm chips power most of the world’s smart phones, and it collects license fees for use of its operating systems. The smart-phone market is booming. Sales should grow 18% a year through 2017, says Canalys, a forecasting firm. Research firm Gartner predicts that about eight billion wireless phones (smart and dumb) will be sold between 2014 and 2018.

Detractors see Qualcomm as a lumbering tech giant that, like Cisco Systems, will inevitably disappoint. But Qualcomm isn’t Cisco. Qualcomm does hold a boatload of cash ($31.6 billion at last word), but unlike Cisco, its earnings are growing at double-digit percentage rates. And the stock, at 15 times 2014 earnings and yielding 2.2%, is inexpensive. (It trades at just 11 times earnings when you back out the cash holdings from Qualcomm’s market value.) I could easily see the shares returning an annualized 17% over the next four years.

True, Qualcomm is facing new competition. Samsung, for example, plans to use its own chips for some of its models. And bears also say that many new smart phones will be cheaper devices sold in emerging markets. But the enormous growth in the smart-phone market should more than make up for the lower prices.

The company also profits from booming tablet sales and will benefit from the trend toward smart wearable tech. Its Qualcomm Life subsidiary has a partnership with WebMD to produce biometric health-monitoring devices. Their readouts should say: Qualcomm is healthier than many investors think.

Author's note; May 16, 2014: I recommended the purchase of MagicJack in my May magazine column. But I have changed my mind about the company and have sold my shares. The stock, which is now trading at about $15, could fall to as low as $10, in my opinion. MagicJack's first-quarter results were lousy, and the company said the current quarter would also be poor. I knew the transition to new products and a new management could be problematic, but things were much worse than I feared. MagicJack is adding customers (196,000 in the first quarter) at a slower rate than I had expected, and every week seems to bring new potential competition. MagicJack is luring more free customers to its app than paying customers to its discount phone device (by a ratio of seven to one). The conversion of free users to paying customers doesn't seem to be happening yet. Someday the company may figure out how to solve this problem, and that could make the stock soar, but I don’t see it happening soon. I could see getting back into the stock at $10 or $11, but I don’t want to own it at the current price. To all Kiplinger's readers who bought the stock in response to my recommendation, I apologize.

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