Picking Up on Telecom Mergers
Investors, phone home: The Qwest-LCI deal has changed
everything. Here are three ways to play the new telecom trend. By Jim Jubak
The kind of telecom stocks you should buy changed radically
last week. How do I know? The announced merger agreement between
Qwest Communications (QWST) and LCI International (LCI)
tells me so. I think that deal marks the beginning of a new
stage in the effort to reinvent the U.S. phone system.
I love mergers. My favorite kind, of course, involves some
company swooping down to buy up shares of a stock that I
own at a wildly inflated price. But even when a merger doesn't
put a buck in my pocket -- and I don't own shares in either end
of the Qwest-LCI deal -- it gives me a wealth of information about what's most important in an industry right now. And I
can use that to make buy and sell decisions that will increase
the value of my portfolio. Right now, for example, the
Qwest-LCI merger tells me to buy Tellabs (TLAB) and
Advanced Fiber Communications (AFCI), two companies that
make gear for hooking the voice and data network together.
Here's how I read the Qwest-LCI deal.
Qwest is building one of the most modern voice and data
networks in the world. When it's complete in mid-1999, the
company will own a 16,000-mile, 96-strand fiber-optic network
stretching across the U.S. and into Mexico. To date, Qwest
has made most of its revenue -- about 80% in fact -- from
construction contracts with companies such as GTE (GTE),
Frontier (FRO), and WorldCom (WCOM) that want capacity on
the network when it's finished. Qwest has made some moves
toward turning itself into a seller of voice and data services, but
the company had a long way to go before it could generate
much business of its own to put on those fibers. That left the
company with something of a problem: Finishing the network
would mean that all those construction revenues would go
away. How could Qwest replace 80% of its revenues in about
15 months?
LCI is a great solution. The company does bring along about
$1.6 billion in 1997 revenues; fiber routes from Cleveland to
New York, Chicago to Los Angeles, and Washington to Dallas;
and customers from California to New York. But more
importantly, it brings along all those things that a company
needs to actually sell voice and data services -- like a sales
force used to nailing down retail and business accounts, billing
systems that work, and customer-service representatives who
can fix a problem.
The purchase of a sales-and-marketing company by a
high-flying technology company (to simplify both parties to the
deal pretty radically) marks the transition from a world with too
little "bandwidth" (the techno-jargon for the carrying capacity of
the telecommunications network) to one awash in bandwidth.
In the earlier situation, companies and investors made a lot of
money by building networks. Qwest, for example, didn't go
whole hog into building fiber-optical networks until 1995 -- but
it's worth $8.4 billion today if you believe its market
capitalization.
We haven't reached the end of building networks. But
tremendous capacity is in place or about to come on line.
Take just one small example -- undersea cable. Right now,
about 230,000 miles of cable run along the bottom of the
world's oceans. Another 180,000 miles are set for installation
by the end of 1999. And all the new cable will be fiber-optic --
not copper -- capable of handling millions of phone calls at
once. I don't expect that flood of capacity to suddenly dry up, either. Thanks to new technologies that split light into colors -- so that one fiber-optic circuit can handle 16 or more signals at once --
the cost of building and then maintaining a transatlantic
fiber-optic circuit for one year has dropped to somewhere
between $100 and $200. (When you realize that in 1987 it cost
about $40,000 to build and maintain such a circuit, you start to
understand why older phone companies compete at such a
disadvantage.) At that price, you could build a circuit just for
my household and recoup your costs in about six months
based on our infrequent calls to Italy and France, which means
you can be sure companies will keep on constructing more
and more circuits.
That's just my point. The critical task in a world with so much
bandwidth will be finding customers to use all those copper
wires, optical networks, wireless phones, and earth-orbiting
satellites, getting them to sign up at a reasonable cost, and
keeping them on board. (There's another problem too, which is
delivering that bandwidth to the end customer, but that's
another column and another stock pick.)
Right now, it seems, the telecommunications-services industry
has decided that it's easier and cheaper to buy those
customers than to build them. That's what's driving the current
round of mergers. This round isn't over by any means. In fact, I
think it's likely to accelerate as players try to buy size. Just
during the time I spent writing this, Alltel (AT) announced that
it was in talks to buy 360 Communications (XO) to expand its
wireless-phone business in the Southeast. The acquisition, if it
goes through, would triple Alltel's wireless subscribers -- 360
Communications has 2.6 million customers -- giving it the bulk
to go up against BellSouth in the region. Of course, Alltel,
before or after the deal, is itself an acquisition target for a
bigger company.
That "buy vs. build" strategy makes sense if selling and
marketing will be crucial to success. Those are expensive
activities in the best of situations, and they become
prohibitively expensive if a company doesn't have a critical
mass of customers in a market. It costs the same to run a TV
ad in a market where you have a 1% share as it does in a
market where you have 40%. It's just that the number of
existing customers who will see the ad -- getting reinforcement
on their choice of vendor -- and the number of prospective
customers likely to sign up -- pre-sold because they know
someone who uses your company already -- is far smaller in
the less penetrated market.
I've got three suggestions for how to take advantage of this
trend. First, since I think this merger activity has still got room
to run, you could buy shares in any of the smaller telephone
and wireless companies with a solid customer base. This idea
isn't exactly news to the market -- Jubak's Picks did quite
nicely last summer by recommending McLeodUSA (MCLD)
and Brooks Fiber Properties, (which was acquired by
WorldCom), for example. Acquisition candidates are now
pretty pricey, but you can still count on a modest buyout
premium. Alltel offered $34 a share for 360 Communications --
about $5 above its pre-rumor close, even though the stock was
already trading at a price-to-earnings ratio above 40. Here are
some other names to research:
ICGX, MCLD, FRO, ICIX, IIXC
I've already suggested a second way to profit from this telecom
free-for-all. Saville Systems (SAVLY), a Jubak's Pick in my
Nov. 21 column, "The Real Future of Telecom," sells billing
software that lets a telecom company consolidate all the
service a customer has ordered -- from wireless to internet
access -- on a single bill. That lets a company track what
services a customer doesn't yet buy -- an important weapon in
the marketing wars to come. Saville Systems is up about 60%
since I recommended it.
But I think there's a third way to play the industry if it develops
in the way that I've sketched out. The world may be about to
drown in bandwidth, but that bandwidth will come in all shapes,
sizes and flavors. It will come over wireless phones and by
satellite, over coaxial cable running to your TV, over copper
phone lines using exotic protocols such as DSL or plain vanilla
dial tones. Customers won't care how their messages or data
are carried. Just make it fast, reliable and as cheap as
possible.
Not only will that create networks of horrific complexity for the
telecommunications companies to manage, but any company
that has to tell a consumer, "Sorry, I can't hook up your kind of
equipment" will be at a tremendous disadvantage. That's why
I'm adding two companies that make products for managing
that jumble of wires and standards to Jubak's Picks. I think
both Advanced Fiber Communications (AFCI) and Tellabs
(TLAB) make products that telecom companies will have to
use in order to compete.
Advanced Fiber Communications makes something called a
Universal Modular Carrier. It's the universal part of that clunker
of a name that makes me interested in the stock. The device
can handle any protocol from plain old telephone server to
ISND and DSL on copper wire, plus anything fiber, coaxial and
wireless can throw at it. That lets phone companies hook up
any customer's phone to their network, no matter what
language the consumer's device uses. The company's
customers include Ameritech (AIT), France Telecom (FTE),
GTE and Sprint (FON), so I know they can sell to the big guys.
The stock's still below its 52-week high, but it's started to
move up on recent upgrades from several analysts. I wouldn't
pay too much attention to the high price-to-earnings ratio on
this one. The company is still tiny -- just $270 million in sales
in the last 12 months, and it's clearly got a lot of headroom.
Analysts project a five-year growth rate of 46% annually.
I like Tellabs because of a product that's just getting rolling. Its
Cablespan technology lets cable operators deliver telephone
service over their coaxial cable. Add in projected 30% growth
from the company's products to handle multiplexing (the
division and reunification of signals so that more than one
signal can travel over a single circuit) and digital cross
connects (connecting incoming and outgoing calls) and I think
Wall Street's projections of 29% growth annually over the next
five years could wind up a bit low. It doesn't hurt that many of
Tellabs products, such as its cross-connects, actually save
money over older generations of equipment.
I like these stocks because they might give me a bit of revenge
as well. When I think of all the time I've spent waiting for
phone-company technicians -- well, the telecommunications
industry owes me. Big. Here's hoping I can collect.
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