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Hang up already!
Telecom is a mess and 2004 is probably going to be worse. So none of the carriers is a value.
October 21, 2003: 5:14 PM EDT
By Paul R. La Monica, CNN/Money Senior Writer

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NEW YORK (CNN/Money) - "Wait until next year."

For shell-shocked fans of the Chicago Cubs and Boston Red Sox this mantra may help them get through the winter after their epic collapses in the baseball post-season. Delusional? Probably.

But for telecom companies and their investors, "Wait until next year" is an even more egregious instance of Pollyannaish optimism. While this year has been awful, 2004 isn't looking much better.

Long distance provider AT&T (T: Research, Estimates) and Baby Bell SBC Communications (SBC: Research, Estimates) (both Dow components) reported disappointing third quarter results Tuesday. Both companies pointed to continued erosion of their main business of providing traditional wireline phone services. Both mentioned continued pricing pressures in the long-distance and local phone businesses, and indicated that this will remain a problem.

The only reason to look forward to next year if you are a telecom investor is if you happen to be a glutton for punishment.

Too much competition

Simply put, the telecom business remains in a shambles because of hyper price competition. Now that the Bells are allowed to offer long distance packages, they are targeting consumers more aggressively with bundled packages of services (local, long distance, wireless, etc.). And to counter this, AT&T and Sprint are trying to lure consumers to sign up for local services with low rate plans.

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Todd Rosenbluth, an equity analyst with Standard & Poor's, added that telecoms will soon have to reckon with a slimmed down WorldCom, once it emerges from bankruptcy under the name MCI as well. "The big question is how aggressive MCI will be with pricing," Rosenbluth said.

But wait, there's more. The telecoms, which are already fighting a tough battle against cable companies for high-speed Internet access customers, will also come up against competition from them for phone services, since voice over Internet protocol (VOIP) technologies are gaining some buzz.

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And even more worrisome for AT&T, the Bells are going after business customers as well, which had seemed to be the last bastion of strength for the once proud Ma Bell. Not anymore. Business services sales, which accounted for 73 percent of AT&T's total revenue, slipped 6 percent from a year earlier.

Even more alarming is the effect that competition has had on profit. Operating margins in the business services division were nearly cut in half, coming in at just 6.6 percent in the third quarter, compared to 12.7 percent in the same period a year earlier.

But it's not as if the Bells are doing much better. SBC reported operating margins in its wireline business (both consumer and corporate) of 11.3 percent, down from 15.6 percent in the third quarter of 2002.

These weak results do not paint a pretty picture for BellSouth (BLS: Research, Estimates), Sprint (FON: Research, Estimates) and Verizon (VZ: Research, Estimates) either. BellSouth is on tap to report its third quarter results Wednesday, Sprint will do so Thursday and Verizon will give its latest quarterly update next Tuesday. The telecom sector doesn't have a company like Dell, one that is so lean and mean that it can cut prices without sacrificing margins.

"This is just the tip of the iceberg," said Drake Johnstone, an analyst with Davenport & Co. "The outlook for fourth quarter and beyond is pretty bleak."

Stocks are trading at a wrong number

So is there any solution for telecom's woes? Patrick Brogan, assistant director of research for Precursor Group, an independent research firm focusing on telecom, said consolidation must eventually happen. But the fact that telecom stocks have struggled so much makes it unlikely for any mergers to take place soon.

High price for little growth
Given the expected earnings declines and sluggish sales growth, telcos look overvalued.
Company Est. EPS Gr. (2004) Est. Rev. Growth (2004) Fair Value* Current Price* 
AT&T -25% -5% $17.50-$21 $19.78 
BellSouth -1% 1% $19.80-$23.76 $23.87 
SBC Communications -4% 0% $15.40-$18.48 $21.59 
Sprint -6% -3% $12.90-$15.48 $15.69 
Verizon Communications -9% 2% $23.60-$28.32 $32.05 
 * Fair Value based on multiple of 10-12 times '04 EPS estimates as of 10/20. Current price as of midday 10/21
 Sources: Thomson/Baseline, Davenport & Co.  

And he adds that consolidation will merely slow the rate of decline. Having fewer competitors could help improve prices but that would do nothing to stop what seems to be an irreversible trend: technologies like wireless and VOIP are causing more customers to drop traditional landline service, Brogan said.

With that in mind, it looks like most telecom stocks still appear to be overvalued, even with the bludgeoning that most took Tuesday following AT&T's and SBC's grim news.

Analysts expect earnings to fall in 2004 for the three major Baby Bells and AT&T and Sprint. As such, Davenport thinks that telecom stocks should not trade at a multiple any higher than 12 times 2004 estimates and that fair value is probably closer to 10 times earnings.

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Using this math, SBC's stock price should be trading in a range of $15.50 and $18.50. The stock was trading at $21.50 Tuesday morning. AT&T's fair value would be about $17.50 to $21 and the stock was hovering around $20 Tuesday. But these estimates are based on earnings estimates from Monday, before both companies issued their poor results.

Johnstone said his earnings estimate for AT&T is just $1.54 a share and that he expects the consensus to move closer to this level given AT&T's weak outlook. So that would imply a price of $15.50 to $18.50 for AT&T as well.

So is there any reason to think that telecom stocks are compelling values? In a word: No.

Analysts quoted in this story do not own the shares of any of the companies mentioned and their firms have no investment banking relationships with the companies.


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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.