The Qwest For Bandwidth
The High Tech Arena 3/28/99
By Joe Arena
Editor
Although we normally concentrate on our ten best ideas as outlined in
the
January newsletter, there are other companies which we are focused on
that are
suitable for more risk oriented investors to build positions in. Qwest
Communications is such a company, as it is arguably one of the best
positioned
companies to benefit from the prolific growth and dramatic changes
occurring
in the telecom sector. We believe Qwest to be one of the most
significant new
participants in the long distance industry; the company will soon
realize
tremendous top line growth as the result of the completion of a 18,500
mile
broadband fiber network. (currently 13,000 miles of this network is
finished)
Certainly, Qwest is by no means cheap, especially relative to its
long
distance peers such as MCI WorldCom, AT&T, and Sprint. However, it is
our
contention that a case can be made for awarding Qwest a premium
multiple due
to several factors. First of all, the company is achieving greater
economies
of scale as a result of the recent LCI merger. For example, they will
be able
to expand data sales to the small/medium business market, a core
competency of
LCI. The LCI salesforce should prove to be a great asset in
accomplishing
this goal. This salesforce is not only experienced, but should be able
to
leverage their existing relationships with traditional telecom
customers in
the process of selling new data services.
In addition, Qwest has secured substantial contract wins which
underscores
their increasing competitive viability. To illustrate, consider the
recent
contract signed with the US Treasury department, which is worth $1
billion.
Qwest believes that it is within the realm of probability that this
seven year
deal could increase to as much as $2 billion. This deal provides some
evidence of the results being produced by a national accounts sales
team which
has increased from 40 about 8 months ago to over 160 currently. By the
end of
this year, Qwest expects national accounts to generate roughly 33% of
new
business versus about 10% currently.
Moreover, a potential for upside earnings surprises as well as
revisions to
topline growth projections relative to consensus estimates may be the
most
compelling argument for justifying the stocks valuation. The biggest
opportunity here lies in wholesaling broadband capacity to ISP's,
(Internet
Service Providers), traditional long distance carriers, CLEC's,
(competitive
local exchange carriers), and RBOC's. (Regional Bell Operating
Companies)
Qwest plans to increase its market share in this business to 9%
compared to
their current 5.6% share. This will be done primarily by undercutting
competitors pricing structure.
Furthermore, the company has demonstrated the ability to develop
partnerships with some major players. As we discussed at length
several
months ago, consider the Internet services joint venture planned with
Microsoft, as well as the European joint venture with KPN. The alliance
with
Microsoft should bode well for Qwest in terms of their ability to
penetrate
the high end corporate market for advanced data services. Also, Qwest
has an
alliance with Netscape to market discount long distance calling plans.
In a recent analyst meeting, Qwest confirmed that they were on track
to meet
consensus estimates of 30-35% CAGR (compound annual growth rate) in
terms of
service revenue, 20-30% total revenue growth, and 50-60% EBITDA growth
through
2001. However, it is important to assert that 1999 is back end loaded
in
terms of EBITDA, with 65% occurring in the second half. This is a
function of
spending for advertising and ramping up its salesforce in the first
half, as
well as costs for completion of its network, which is expected by the
middle
of this year. Therefore, the picture gets a little cloudy in terms of
earning
visibility for the year until Q3 is reported in October.
The good news is that we expect Qwest to realize a favorable shift of
revenue to higher margin market segments, such as data and business
customers.
Approximately 55% of total revenues should come from businesses in
1999,
versus 50% in 1998. Relative to revenue from voice/data, this segment
should
account for 25% of Qwest's revenue, versus only 14% in 1998. We
believe this
objective to be easily achievable as the company starts to sell more
advanced
network services as compared to LCI's private line business.
Ultimately,
gross margins should increase from 39% to close to 50% in 1999.
It is axiomatic that the most formidable strategic risk that Qwest
must
confront is the lack of local connectivity. Although the company has
taken
steps to address this weakness, (via building local fiber runs in 10
cities
and acquiring a minority stake in a CLEC i.e. Competitive Local
Exchange
Carrier) their total dollar investment in these 10 cities is only $100
million. Thus, it is obvious that Qwest must commit large increases in
capital spending to continue overcoming this, which could put pressure
on
earnings. The company has planned $1.4 in capital spending in 1999,
this
number is in excess of their original forecast. However, once the
18,500 mile
network is completed, this should more than negate a planned 50%
capital
spending increase on data/broadband. It is also germane to note that
Qwest is
now receiving more than 25 orders per day for broadband capacity, which
represents a tenfold increase versus last year. It would appear that
the
investments the company is making in broadband are justified given the
prolific growth this business is experiencing.
For those investors buying the stock on anticipation that Qwest will
be
acquired by a larger carrier, we would surmise that this scenario is
highly
unlikely. The company's business model is based on strategic alliances
and
partnering designed to build demand for broadband services and surmount
their
lack of local connectivity. Also, until its business plan is executed
over
time, Qwest's current market capitalization is in excess of any amount
than a
potential acquirer would pay. This lofty valuation not only reflects
the
tremendous growth potential of the company, but also confidence in
management's ability to execute, which to date has proven to be
exceptional.
In conclusion, we would assert that Qwest should still be considered
a
highly speculative investment, and suitable for only those investors
with a
high risk tolerance. Even for such investors, we would also not
recommend
overweighting it in a portfolio. While we do not anticipate adding
Qwest to
our list of top ten high tech investments, we do believe this is a
company to
keep on your radar screen.
TRADING UPDATE: We took profits on the MSFT Jan 01 150 calls last week;
this
trade generated a 41% return in 4 weeks. (purchased at 39 7/8, sold at
56.25)
Given that this trade was done on margin, there was too much
uncertainty going
into this week to justify the risk/reward ratio involved in continuing
to hold
this position. The settlement talks with the DOJ, (which we believe
will
prove useless, and are simply a PR ploy on the part of Microsoft) the
hearing
to decide on the date on which the trial will resume, the situation in
Yugoslavia, all were factors contributing to our decision to take
profits.
Given the announcement of Microsoft's restructuring tomorrow, the
market may
very well bid the stock up further on this positive news. Given that
70% of
our assets are in MSFT stock and the MSFT Jan 01 100 calls, we have no
regrets
about missing out on any additional short term upside move on a trade
which
was 100% on margin. For those of you who have followed our position in
the
MSFT Jan 01 100 calls which we purchased in July 1998 at 33 1/2, this
position
is now up 174% in about 8 1/2 months. This objective of this position
is to
hold until Jan, 2001. At that time, we anticipate taking profits on
50% of
it, and exercising the other 50%. Of course, this may change relative
to the
fundamental outlook for the stock in 12-18 months.
The March puts we were short on CSCO also worked out well. The March
95
puts, which we took in $5250 for each 10 contracts we shorted, expired
worthless. The March 90 puts, which generated $4250 for each 10
contracts we
shorted, also expired worthless. The March 105 puts we decided to let
expire,
and the stock closed at 104.5 at expiration. Given the recent rule
changes
made by the NASD, assignment of puts in the money at expiration is
still done
at random unless they are more than 3/4 of a point in the money. Thus,
40% of
the contracts we were short expired worthless, we were assigned at 105
on the
other 60% of our position. We sold the shares of Cisco that we were
assigned
3 days later at 106 5/8, thus generating another $1625 for every 10
contracts
we were assigned at 105. (we did not want to hold this assignment any
longer
than necessary, since this position was purchased 100% on margin)
Regarding
the CSCO July 105 puts that we shorted for 16 7/8 (taking in $16,875
for every
10 contracts we sold), they are now asking 9 3/4, giving us a paper
profit of
$7125 for every 10 contracts we shorted. The objective of this trade
is to
hold the position open until options expiration in July.
We also initiated our April short put position, writing the CSCO
April 110
for 7 1/4, thus taking in $7250 for every 10 contracts we shorted. We
also
shorted the CSCO April 105, for 5 5/8, taking in $5625 for every 10
contracts
we shorted.
In addition, we began to build a position in EMC Leaps, going long
the Jan
01 80 calls, with an average cost basis of 48.25. Based on the current
bid
price of 59 3/8, this trade has already generated a return of 23% in
two
weeks. However, given the strong buy recommendation we have on EMC, the
objective is to hold these Leaps until Jan, 2001.
We do, however, anticipate trading a half position in EMC leaps when
the
opportunity presents itself. We also anticipate shorting EMC front
month puts
when the opportunity presents itself. As a general rule, we do not
short puts
on a stock that has rallied sharply and is close to an all time high.
Therefore, we will patiently wait for a meaningful pullback in the
stock
before initiating a short position in EMC puts. |
