Dialing for Dollars
Cheaper prices, better service. Consumers are profiting from a new era in telecom competition. Investors can too
By Pablo Galarza

(MONEY Magazine) – Price wars. Turf battles. New services. Ever-cooler gadgets. For consumers, what's going on in telecom these days is nothing short of boom times. Baby Bells and upstarts have come in with low-priced broadband. The cable companies are starting to push hard into the Internet phone business, promising to slash your monthly residential bill. Your mobile phone just keeps getting better as service providers battle hard for your buck. (For more, see "Who's Ready for a Change?" on page 118.) While competition is great for the customer, for telecom companies it means lower margins, big investments and uncertain business prospects. This has to be a disaster in the making for their investors, right?

Hardly. In fact, there's plenty of opportunity to profit from the competition, no matter who ultimately wins. And even the Baby Bells, which seem to have the most to lose, are likely in good shape for the near term. Here's why.

Plenty of fight left You haven't had much to gloat about lately if you own shares of a Baby Bell—and chances are good you do, given that these stocks remain among the country's most widely held. The stocks on average lagged the S&P 500 by 10 percentage points over the past year; it isn't hard to understand why. First, cable giants Comcast and Time Warner (which owns this magazine) and a host of smaller Internet service providers are launching voice over Internet protocol, a Web-based phone service that could make landlines obsolete. They've already built the networks to do it. The Bells, on the other hand, are just starting to spend the first of many billions on upgrades so they can offer TV signals and Internet telephony. Meanwhile, the cash cow that has to fund that expansion—the residential landline service that accounts for half the Baby Bells' profits—is in decline as customers turn to their mobile phones, a less profitable business.

But the Bells—BellSouth, SBC Communications and Verizon—are all financially strong enough to build out their networks while continuing to pay generous dividends, at least for the next several years. All pay out more than 4% based on current stock prices, and SBC and Verizon are among the five top-yielding stocks in the Dow Jones industrial average. "They've become your classic widows-and-orphans stocks," says Robert Gensler of T. Rowe Price's Media & Telecommunications fund. (A fourth "sort of" Baby Bell, Qwest, once known as U.S. West, pays no dividend and trades at more than 90% below its high after a disastrous coupling with Global Crossing.)

That doesn't mean shareholders can assume the Baby Bells are safe forever. Depending on how quickly their landline businesses deteriorate, their financial positions could worsen. But for now, their debt loads are actually lighter than those of the cable companies, and they generate better levels of cash. Also, don't forget they're the incumbents in the fight for your home phone, and they own the big wireless services. If you're losing customers, lose them to yourself. "These are big icebergs that will take a long time to melt," says Timothy O'Brien, manager of the Evergreen Utility & Telecommunications Fund.

The Bells also know how to fight: By aggressively pricing their flavor of broadband, known as DSL, they signed up more high-speed Internet customers in 2004 than the cable industry.

Each Baby Bell has its strengths, and there's no overwhelming argument for trading shares of one for those of another. Verizon is lauded for its management and wireless unit, and BellSouth, which MONEY recommended a year ago, has the industry's highest margins. But SBC Communications (SBC) looks like the stock to watch now if you're thinking about new investments. First, its dividend of 5.2% is the highest of the three. Moreover, SBC has withstood the fiercest attacks on its franchise. It now sports the lowest profit margins as a battle scar, but in the near term, says Morgan Stanley telecom analyst Simon Flannery, competitive pressures will abate and margins will start to recover, giving SBC's stock price a better chance at recovery than its peers'.

Like the other Bells, SBC isn't without risk. The company is accelerating the build-out of a fiber-optic network that will let it offer video and other services. Capital spending is expected to grow from $8.5 billion in 2004 to as much as $11 billion in 2006. And because SBC will be the third purveyor of TV signals, behind the cable companies and satellite operators, returns on that spending are far from a sure thing. But with $18.8 billion in annual cash flow, SBC has the wherewithal to make the bet.

Look, no wires! Just as everyone is going wireless, there are fewer ways to invest in the trend. The two biggest wireless companies, Cingular and Verizon, are owned by the three Bells. And Sprint, which owns the self-named third player, is buying No. 5 Nextel. There are investors gobbling up Sprint shares in hopes that it will in turn be bought. But there is a second wireless play that offers faster growth, cheaper valuations and the opportunity to invest alongside a world-class investor: America Movil (AMX), one of the top sellers of mobile-phone service in Latin America. Its reach starts at the Rio Grande and ends at Tierra del Fuego. Based in Mexico City, the company is controlled by Mexican billionaire Carlos Slim Helu. A value hunter, he cobbled together wireless assets that BellSouth, among others, put up for sale. Then, through aggressive marketing and promotion, he turned his acquisitions into top players. The stock, traded as an American Depositary Share on the NYSE, went public at $13 three years ago and has run to a recent $49. Yet T. Rowe Price's Rob Gensler is still a big fan. "It's my single best idea," he says. Cash-flow growth is expected to exceed 20% annually over the next five years. And shares trade for just 14 times 2005's estimated profits, compared with 17 for Sprint. America Movil gets 75% of its profits from Mexico, and Brazil is its second-largest market, so shares tend to bounce up and down on any economic news coming out of those countries. But the company bought back stock throughout 2004, and Helu has been steadily increasing his stake, which now stands at 38%. So you know that a great investor is betting big on the company's prospects.

Guns and ammo There's an old Wall Street axiom that says in times of war, you buy arms dealers. On the telecom battlefield, that would be the telecom-equipment makers. Companies such as Alcatel, Cisco Systems, Ericsson, Lucent Technologies, Nortel and Siemens were battered by the dotcom collapse. Now they "are two years past from emerging from hell and are selling at 10-year lows," says Susan Kalla, a senior analyst with Friedman Billings Ramsey Group who presciently told investors to dump these stocks in early 2001. Kalla notes that the telecom-equipment makers' debt loads have lightened. Meanwhile, sales and profits are on an uptick, and margins are improving. "They look very good at this point," she says.

Adds Sanford Bernstein's Paul Sagawa, another analyst acclaimed for his candor: "The carriers are awash in cash, and when they have cash they invest it in their networks." Capital spending in 2004 rose 12% over the prior year, and that trend will continue, Sagawa says. Which equipment-maker stock do you buy? In this case, buy them all. The iShares Goldman Sachs Networking Index Fund (IGN), an exchange-traded fund (you buy and sell it like a stock, not a mutual fund), is an easy way to build a portfolio. The ETF invests in 33 equipment makers; if any one company's core technology or chief customer falls out of favor, the ETF as a whole won't be badly hurt. Given the battle ahead, lessening that risk is a good idea.

Baby Bells vs. Cable Guys

The Bells want to be your television company. Cable wants to sell you phone service. Here's how an investor needs to think about the competition.

Three Ways to Make the Call

Competition is intense, but the telecom industry's growth could yield big profits

Note: As of Jan. 20. N.A.: Not applicable. Source: Thomson/Baseline.