Telecom Temptation Long-suffering telecom investors are finally getting a breather in 2004. Here's how to avoid pitfalls--and seize opportunities
By Pablo Galarza and Jonah Freedman

(MONEY Magazine) – Suddenly, telecom stocks are hot again. After shunning the sector for much of 2003, money managers are flocking to the likes of AT&T Wireless, Nextel and Verizon, making the industry one of the best-performing groups of late, up 14% vs. the S&P 500 index's 12% gain over the past four months.

Why have telecom stocks gone from pariahs to darlings so quickly? Morgan Stanley's much lauded telecom analyst Simon Flannery believes many managers are betting that the industry is at a turning point. "They're thinking that perhaps a recovering economy, progressive cost cutting, the specter of consolidation, and new products and services will drive better growth," he says. Robert Gensler, manager of T. Rowe Price's Media & Telecom fund, says that bottom fishers are also flocking to the group, betting that the flow of bad news will slow or pause long enough to entice others to jump in. Plus, media reports of Cingular Wireless' $30 billion bid for AT&T Wireless has reignited interest in the sector.

If you find the sector's recent buzz--and plump dividend payouts (the three dividend-paying Bells, for example, average a 4% yield)--tempting, there are some things you should consider. Telecom's woes have not disappeared. In fact, in many cases they have worsened. Below, we outline the competitive landscape, technological threats and regulatory issues--and highlight three stock plays that should benefit from the shake-out.


The industry isn't growing, but the number of competitors is. Cable companies are rolling out telephone service, and wireless providers are stealing away landline customers. The Bells--BellSouth, Qwest, SBC and Verizon--are fighting back by offering bundled services such as Verizon's Freedom Package, which offers local, long-distance, broadband and wireless services for one fee. Meanwhile, AT&T, MCI and Sprint are battling the encroachment on their long-distance business by the Bells and wireless providers by attacking the Bells' local service franchise. In large part, rather than signing up new, profitable customers, companies are seeing consumers and businesses replacing one service provider with another, cheaper one--which puts pressure on profits at all of the players.

COMMODIFICATION Since the companies' offerings are nearly identical, they compete on price alone. And that puts the Bells at a big disadvantage due to their aging, unionized work forces, outmoded and labor-intensive infrastructure, and heavy debt loads.

WIRELESS The growing use of wireless phones is eating away at the traditional landline business. But the brutal competition in the wireless business means that profit margins are getting crunched. And now that subscribers can take their phone number with them if they move to another provider, customer turnover rates are starting to escalate, meaning that the cost of luring and keeping customers increases while the price paid per minute decreases. Turnover rates will worsen once this so-called local number portability rule reaches all markets on May 24.

BROADBAND As Americans shift to high-speed Internet access, they are dropping the phone lines they used for their computers. As many as 8.5 million new customers will sign up for broadband this year, according to Morgan's Flannery. That means the Bells will continue to lose sales on second phone lines; in 2003 some 10.3 million landlines were lost in what ranks as the sharpest annual decline ever.

VOICE OVER INTERNET PROTOCOL (VOIP) This industry-shattering technology, which routes phone calls over the Internet, gets lots of press (all four Baby Bells, AT&T and even cable companies are planning to roll it out, say analysts). But don't expect VOIP to add much to revenue until 2005, when it becomes a truly viable consumer product. And even as it generates some revenue, the spread of VOIP--a cheap technology that is easy to roll out and maintain--threatens the bottom line of all the players, but most significantly the Bells' lush local phone profits.

REGULATORY CHALLENGES To all of the competitive issues roiling the industry, add telecom's unsettled regulatory climate. Currently, the Bells must sell discounted access to their networks to competing carriers, who in turn resell local phone service to Bell customers. Federal courts may force the Federal Communications Commission (FCC) to lift or modify this mandate. This could give the Bells a boost if it results in lesser discounts to their competitors. But putting any regulatory changes that might benefit the Bells into place would take years--by which point VOIP will be the bigger threat anyway.


In such a fast-changing industry, there will be big winners and big losers. Here's how we'd play the sector.

BEST BELL BET Verizon has arguably the industry's top management team and controls the best wireless company, but those perceptions are already reflected in its share price. At $38, the stock is up 14% since we recommended it in November 2003. It now trades for 16 times estimated '04 profits, at the upper reaches of its historical valuation. That's why we'd go with BellSouth (BLS), which owns 40% of Cingular and has defended its turf by aggressively pricing bundled telecom services. It's the most profitable Bell, with 26% profit margins, which gives it room to continue its assertive ways. The company's fourth-quarter results displayed improved margins thanks to its Latin American divisions. And it's the only Bell expected to increase earnings per share in '04. The stock goes for $29, or about 14 times '04 earnings of $2.09.

CHEAPEST TELCO For a company that generated $5 billion in free cash flow in 2003, AT&T (T) is pretty much ignored by investors. Measured on enterprise value (market capitalization plus debt minus cash) over cash flow, its shares trade for half as much as the next closest Bell, which is Verizon. True, competition is decimating AT&T's retail division--sales fell by 18% in 2003. And now its business unit is feeling the heat. Still, the No. 2 local phone company has an enviable business division, which contributes the bulk of profits and sales and makes it a prime takeover target.

OUTSIDE SHOT Time Warner Telecom (TWTC; 44% owned by Time Warner, MONEY's parent) focuses on business customers in 44 metropolitan areas, where it has lines into 14,500 buildings. It bills itself as an alternative to the Bells for broadband, voice and data services. It's been hurt by woes at MCI, which buys access to its network and accounts for 5% of its $700 million in sales. But as MCI emerges from bankruptcy, TW Telecom should regain momentum. Its financials are strong, with $465 million in the bank, and it's stopped burning cash. At $11, it trades for seven times estimated '04 cash flow of $255 million. --PABLO GALARZA AND JONAH FREEDMAN