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Dial M for Miserable
When will the telecom sector recover? Maybe not until 2005.
July 21, 2003: 3:02 PM EDT
By Paul R. La Monica, CNN/Money Senior Writer

NEW YORK (CNN/Money) - Telecom companies dominate the earnings landscape this week -- and that means it will probably be a pretty depressing one.

The telecom sector has been notably absent from the euphoria that has swept over the market lately, and with good reason.

While second-quarter earnings for the tech sector are expected to increase 18 percent from a year ago, according to First Call, analysts are predicting a 3 percent drop in telecom services earnings.

AT&T (T: Research, Estimates), BellSouth (BLS: Research, Estimates) and SBC (SBC: Research, Estimates) will all report results this week, and Verizon and Sprint are on tap for next week.

The second-half outlook does not look much better. Telecom services earnings are expected to fall 4 percent in the third quarter and increase just 1 percent in the fourth.

Price cuts kill earnings

Telecoms are thirsting for revenue growth. Baby Bells Verizon (VZ: Research, Estimates), SBC and BellSouth are increasingly trying to gain more long-distance customers, while long-distance titans AT&T and Sprint (FON: Research, Estimates) are attempting to steal local customers.

All that adds up to aggressive price cuts, which eat into already emaciated profit margins.

"Competition is going to rear its ugly head as companies cross over into each other's territory," said Todd Rosenbluth, an equities analyst for Standard & Poor's. "Price has always been the key focus for telecom. It's a commodity business."

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Cisco isn't calling a recovery

Conventional wisdom has it that the telecom sector won't bounce back until the broader economy recovers, particularly business spending. And a telecom recovery typically lags a tech recovery by a couple of quarters.

Cisco Systems CEO John Chambers was recently quoted as saying that telecom probably would not pick up until two to six quarters after tech spending recovers and that tech spending would not come back until at least a few months after the overall economy shows signs of life.

This is a sobering view shared by some telecom analysts. "There's a risk that the telecom recovery may have to wait until 2005," said Patrick Comack, an analyst with Guzman & Co.

He said that the reemergence of WorldCom later this year, which plans to come out of bankruptcy as MCI, will probably hurt the long-distance companies and Bells in the short term since MCI is likely to offer cut-throat pricing in an attempt to win back customers it lost after its accounting scandal.

Equipment companies remain in a slump

And since the big telecom carriers are continuing to struggle, that means telecom equipment firms, which sell networking gear to the Bells and long-distance companies, will also remain in a funk.

The poster child for the telecom equipment malaise, Lucent Technologies, pre-announced last week that it will report a wider-than-forecast quarterly loss for its fiscal third quarter and that sales will drop nearly 20 percent from its second quarter.

"The equipment companies are hurting as capital expenditures by the carriers continue to stay low. It's a vicious cycle," said Patrick Brogan, assistant director of research for Precursor Group, an independent research firm focusing on telecom.

Equipment firms Corning, Tellabs and JDS Uniphase are also expected to post quarterly losses this week while Nortel Networks is expected merely to break even.

Wireless isn't looking much better. Although Nextel reported strong results last week, it appears to be the exception, thanks to its unique (for now) walkie-talkie-like phone service. But bad news from cell-phone manufacturers Nokia and Motorola last week seemed to indicate that wireless growth might be starting to slow as well.

Stocks aren't good bets

So what's this mean for telecom stocks? The Amex Network Index, which tracks telecom equipment firms, has soared 35 percent year to date on hopes that the worst was over for this group, but the index has pulled back sharply since Lucent's warning, falling more than 10 percent within the past week.

And Brogan said that investors should not be fooled by what appear to be attractive valuations and relatively high dividends for the telecom carriers.

"Dividend tax relief and low interest rates tend to buoy some of the stocks, but the sector's fundamentals continue to deteriorate," Brogan said.

Ultimately, telecom is still an industry in flux and until the confusion clears up as to who will emerge as the winners, it's probably not a wise move to jump into the sector. Consolidation is sorely needed at some point to get rid of some of the excess capacity, but since most telecoms sport big debt loads, they will probably need to clean up their balance sheets before mergers are possible.

"The problem with telecom is not only that it's going through the same economic issues as the rest of the market, but that it's also an industry in transition," said Jeff Kagan, an independent telecom analyst. "Five years ago, AT&T's primary competitors were MCI and Sprint, and now it's the Bells and cable companies. Investors aren't sure what the industry is going to look like and which horse to put their $2 bet on."  Top of page

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