MSN's Juback revisits his QWST call ... now, he likes what he sees
Jubak's Journal
July 12, 1999
Why Qwest did the deal everyone hates
Buying U S West means taking on some heavy baggage -- but I think the acquisition will look real smart two years down the road.
By Jim Jubak
Why'd they do it? Why did management at Qwest Communications (QWST) ruin their stock, a fast-growing, Internet-based, fiber-optical telecommunications company, by acquiring U S West (USW), a slow-growing, regional Baby Bell so despised that many of its customers called it "U S Worst." U S West even pays a 4% dividend. How much duller and more stick-in-the-mud can a stock get?
That was my initial reaction to the July 18 deal that ended the bitter battle between Qwest and Global Crossing (GBLX). The two companies agreed to split the spoils with Global Crossing taking Frontier (FRO) and U S West going to Qwest. I simply couldn't understand why Qwest was dishing out $35 billion (in stock, I grant you) to buy this weak sister among the regional Bell phone companies.
A sea change in thinking
But you know what? I finally understood the deal just the other day. MCI WorldCom's (WCOM) latest salvo in the long-distance price wars -- the company announced Aug. 9 that it would sell long-distance minutes in the evening and on weekends for 5 cents -- suddenly brought it all into focus. I now think that this stock, which I found such a bitter disappointment not so long ago, will be a solid buy sometime in 2000. (I sold Qwest out of Jubak's Picks in April at $45.44 because I thought it had moved up too far too fast.)
Let me explain why I now think that a stock I had written off just a few weeks ago deserves a place on your watch list.
With its Aug. 9 announcement, MCI WorldCom finally got around to trumping the 10-cents-a-minute rates offered (with varying restrictions) by Sprint (FON) and AT&T (T). I say "finally," because last quarter's numbers showed MCI WorldCom's growth in long-distance revenue just barely keeping up with growth at those two competitors. The company actually lost ground in the wholesale long-distance market. Its revenues fell while Sprint and AT&T grew their revenues in this area by 17% and 20%, respectively. MCI WorldCom had to counterattack.
In the weeks to come, Sprint and AT&T, as well as other competitors, no doubt will announce their own price cuts. In fact, the MCI WorldCom deal didn't stay king of the hill for even a day. On Aug. 10, Qwest announced a package of 250 long-distance minutes plus Internet access for $24.95 a month. It's just this kind of price war that has taken the starch out of telecommunications stocks recently.
I find the package deal from Qwest intriguing. I think it tells an investor just about everything he or she needs to know about the economics and direction of the "phone" business. Long-distance service is the loss leader in Qwest's package, the cheap can of coffee or the sale-priced tin of tuna that gets a customer into the store. Think about it: Internet access alone goes for $21.95 a month from AT&T Worldnet or America Online (AOL). Qwest is throwing in 250 minutes of long-distance calls a month for just $3. The point isn't to make money on that long-distance sale, but to get the customer into the Qwest "store" and sign up him or her for Internet service or whatever.
Making money in the phone business
To make money in the phone business today, you've got to have lots of "whatever" to sell. AT&T, for example, can sell a customer a bundle of long-distance service and wireless phone service, Internet access, data services such as virtual private lines and, increasingly, cable TV, cable-modem Internet service and Internet-protocol phone service.
AT&T's disadvantage -- and the reason I don't care for the stock at the moment -- is that it has a very high-cost long-distance operation, built on one of the oldest networks in the industry. To match the loss-leader pricing of competitors who own newly built, more efficient and, hence, less-costly-to-operate networks, AT&T has cut into its profit margins. A long-distance price war is thus going to hurt AT&T more than almost anyone else in the industry. I would like to buy AT&T after this round in the price war has had a chance to work its way through analyst estimates and third-quarter earnings reports.
These newer and more efficient telecommunications companies have a very different problem. They can afford to cut prices low enough to attract a flood of new customers -- in both the consumer and business segments -- but they don't have a large menu of other services to sell. For example, Qwest doesn't have a wireless product. Its Internet hosting and application service provider businesses are still rudimentary. Broadband? Forget about it.
True, despite that handicap, Qwest hasn't been doing a bad job selling services other than plain vanilla long-distance. In the most recent quarter, the company continued to shift its revenue stream from consumer and commercial voice products to data and data services. About 20% of Qwest revenue and better than 30% of the company's revenue growth came from data products in the most-recent period, according to estimates by Lehman Brothers, up from 13% of revenue in the second quarter of 1998.
And Qwest has been busy adding partners -- such as KPMG, KPN in Europe, Hewlett-Packard (HWP) and MSN MoneyCentral publisher Microsoft (MSFT) -- that can help it develop new products. The company made good progress in the second quarter of 1999. For example, Qwest doubled its Web-hosting capacity and increased the size of its data centers sixfold. But it still didn't have a presence in key parts of the developing market -- broadband and wireless, for example -- and growing some of these solutions internally clearly was taking longer than the company had projected.
How U S West fits
That's where U S West comes in. The company, which has a well-earned reputation for mediocre phone service, actually has relatively advanced products in the new data and Internet markets. The prize here is U S West's 7-year-old !NTERPRISE unit, which is expected to account for about 70% of all growth at the company in 1999. This unit maintains two data-hosting centers that focus on databases and streaming media, for example.
I think it's likely that sometime in 2000, Qwest will clearly be a buy again.
U S West has a partnership and equity stake in USinternetworking (USIX), which operates an additional four data centers. U S West is the exclusive distributor for USinternetworking in its 14-state service region, and USinternetworking will host U S West's new e-commerce services. U S West also has plans to roll out information appliances such as Web TV and screen phones in the fall of 1999. The company has been one of the more-aggressive regional Bells in marketing such high-speed broadband Internet connections as DSL. For good measure, throw in U S West's wireless PCS business -- 285,000 customers at the end of the most-recent quarter -- and its Internet Yellow Pages site, which saw usage grow by 23% in the second quarter from the previous period.
A bright future, but it will take time
All of this will give Qwest lots of product to bundle with its long-distance service, and that's why I think the company has a far brighter future than I first imagined. But that future won't arrive tomorrow. The acquisition, which has to jump several regulatory hurdles, won't even close until mid-2000.
More
Integrating the two companies won't be easy, even if both are in Denver. Joseph Nacchio, the CEO of Qwest before the deal and the CEO of the eventual combined company, will have to cut costs and lay off workers at the heavily unionized U S West. He'll also have to build a working relationship with current U S West CEO Solomon Trujillo, who will become chairman of the board at the combined company and will head its wireless and local broadband businesses.
Nor will investors find the shift easy to digest. U S West shareholders, who currently receive a 53-cents-a-share quarterly dividend, will see that payout cut to 12.5 cents per Qwest share after the deal. Qwest shareholders, who are accustomed to revenue growth of 46%, as in the second quarter of 1999, will have to get used to 15% to 17% growth rates, if the combined company meets CEO Nacchio's projections.
I think that means that it's still early to buy Qwest; the stock and the company still have a long shakedown period ahead of them. But I think it's likely that sometime in 2000, Qwest will clearly be a buy again. And that's not something I thought I'd be saying about this deal just a few weeks ago.
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