Telecom sector takes cues from Bells
Stick to dominant firms or find niche players, analysts say
By Jeffry Bartash, CBS.MarketWatch.com
Last Update: 12:03 AM ET Dec. 21, 2001
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WASHINGTON (CBS.MW) - Incumbents are in. Upstarts are out.
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That's the theme for telecommunications investors in 2002. With the economy mired in a recession, Wall Street unwilling to open its wallet and corporate spending on the wane, it makes sense to stick to relatively healthy market leaders.
Of course, there are exceptions. Some dominant providers, such as long-distance giant AT&T and equipment powerhouse Nortel Networks, need to remake themselves. They face stiff competition and financial strain - the result of overextending their industry empires.
Still, many dominant suppliers such as the Baby Bells tend to possess monopoly-like characteristics and the resources to ride out a recession - great size, captive customers, lots of cash and revenue. Leaner economic times, moreover, often force would-be rivals to collapse or sell out, usually at fire sale prices.
For that reason, it's counterproductive to invest in market leaders and their smaller challengers at the same time, noted William Whyman, president of The Precursor Group, an independent research firm.
"The problem for investors is that market power stunts competitive growth and innovation," he said. "These are two sides of the same coin, and you can't have both."
Ringing everyone's Bell
The driving force these days are the Baby Bells. Their actions have reverberated like a tsunami throughout the entire telecom industry, dealing severe blows to independent local carriers, long-distance operators and equipment makers alike.
For starters, the Bells are reshaping the phone industry. By the end of 2002, analysts believe they could win approval to sell long-distance in every U.S. state. Now, the Bells offer long-distance in only a handful, but they've quickly captured millions of customers.
Those gains have already dented the revenue of the market leaders, particularly top dog AT&T (T: news, chart, profile).
"They'll get in more trouble as the Bells get long-distance approval," said Pat Brogan, assistant director of research at Precursor Group.
AT&T is also engaged in a major restructuring and agreed this week to merge its cable broadband business with Comcast. See related story.
By and large, analysts believe investors should pass on the big long-distance carriers. Their core businesses are under siege and they're more susceptible to the economic cycle.
The one possible exception is WorldCom (WCOM: news, chart, profile ). It has less exposure to long distance, targets lucrative business customers and operates the most extensive global network, notes Drake Johnstone of Davenport & Co.
Yet Paul Wright, a researcher at the Loomis & Sayles mutual fund firm, argues that WorldCom is overpriced at $15 a share, probably because of takeover speculation.
The more likely takeover target is Sprint (FON: news, chart, profile ). It's the cheapest of the Big Three - Sprint's market value is less than half of AT&T and WorldCom -- and it owns valuable local and wireless operations.
"Sprint's long-distance business is unstable," Wright said. "They have to do something."
Newcomers neutered
Analysts are even less kind to the new kids on the block: independent local phone carriers, called Clecs in industry lingo, and "next-generation" long-haul carriers.
Small local carriers, once a Wall Street favorite, have especially been brutalized. Most complain that the Bells have stymied their efforts to expand - Clecs have to connect to portions of the Bells' networks to reach customers.
Yet the bigger culprits have been mismanagement, big debts, failed customers and plunging sales. Many Clecs have gone out of business and more are expected to fold.
"I wouldn't put any new money into upstarts at all," Johnstone said.
The lone exceptions: Time Warner Telecom (TWTC: news, chart, profile) and perhaps Allegiance Telecom (ALGX: news, chart, profile). Both avoided most of the excesses that plagued their brethren and they are led by strong management teams.
Next-generation carriers such as Level 3 Communications (LVLT: news, chart, profile) and Global Crossing (GX: news, chart, profile) are also on the To-Avoid List. They face the same problems as the Clecs, on a broader scale.
"You've got these huge networks. You're not putting much traffic on it. And your pumping in low-margin services," Wright said.
Alluding to Sprint's difficulties despite 20 years in the business, Wright added: "I can't conceive how these companies will ever make money."
Looking at the leaders
Amid all the carnage, the Bells appear to represent the best opportunity in the phone sector, but it's not cut and dried.
Analysts, for example, believe Verizon and BellSouth are the best positioned, followed by SBC Communications (SBC: news, chart, profile). Verizon (VZ: news, chart, profile) is the nation's largest local and wireless company, while BellSouth (BLS: news, chart, profile)is considered the best run. Holding up the rear: Qwest Communications, whose stock has been beaten down in recent months.
Yet most analysts prefer Qwest (Q: news, chart, profile) as an investment play. Like Sprint, it's very inexpensive and has good assets, making it an attractive acquisition candidate.
Conversely, whichever company eventually makes a bid for Sprint or Qwest is seen as a short-term market loser. That means the Bells. After all, they are the mostly likely suitors because of their size and relative financial health.
Takeover talk aside, the Bells are considered cheap when stacked up against other stocks in the Standard & Poor's 500. Barring a major acquisition, analysts say, they'll appreciate nicely once the economy start to recover.
Another sector to keep a close eye on: wireless. While analysts don't care for AT&T and Sprint, they like AT&T Wireless (AWE: news, chart, profile) and Sprint PCS (PCS: news, chart, profile). Both companies continue to register solid growth despite the U.S. slowdown.
Smaller wireless firms, meanwhile, could end up as buyout targets amid recent changes in U.S. law that relax rules on acquisitions.
Equipment malaise
The Bells' actions have also shaken up the telecom-equipment industry. Collectively, they are the biggest equipment spenders, but the U.S. slump has eroded revenue growth and forced them to chop purchases.
"The phone companies have slashed everywhere," said Maribel Dolinov of Forrester Research. "They've built enough networks, but now they have to wait until demand catches up."
In 2001, for example, the RHK research firm expects spending on wireline equipment to sink 28 percent to $66 billion from $92 billion last year. Next year, spending is projected to sink 20 percent more to $53 billion.
Those cutbacks have devastated vendors in the intensely competitive equipment market, which also faces a manufacturing glut. Few analysts believe those conditions will improve anytime soon.
As such, equipment leaders like Nortel (NT: news, chart, profile), Lucent Technologies (LU: news, chart, profile) and JDS Uniphase (JDSU: news, chart, profile) aren't investing hot spots. Each is undergoing massive internal renovation.
"Our message has been that the world is too unsettled to play those names," said Jim Kedersha, a veteran equipment analyst at Adams Harkness & Hill.
Finding a niche
Analysts say risk-taking investors need to look for niche players that sit astride key technological bottlenecks. That includes suppliers of gear to enable cable firms to offer video on demand, or vendors that develop products for Ethernet-based telecom networks.
Concurrent Computer (CCUR: news, chart, profile) and SeaChange International (SEAC: news, chart, profile), for example, are two hot suppliers of video-related cable equipment. In the Ethernet space, Foundry Networks (FDRY: news, chart, profile) and Extreme Networks (EXTR: news, chart, profile) are two of the emerging leaders, Kedersha said.
Another area where spending is expected to increase is in wireless. Demand for wireless phones and services remains strong worldwide, so manufacturers such as Nokia (NOK: news, chart, profile) and Ericsson (ERICY: news, chart, profile) can expect to make some headway.
Similarly, independent operators of cell towers and wireless networks stand to benefit. John Bensche of Lehman Brothers touts SpectraSite Holdings (SITE: news, chart, profile), American Tower (AMT: news, chart, profile) and SBA Communications (SBAC: news, chart, profile).
If all else fails, investors can take a look at the used-car salesman of the equipment industry: Somera Communications (SMRA: news, chart, profile).
Even though phone-company spending has lessened, pressure on managers to improve network service hasn't, Kedersha said.
As a result, network managers have turned to Somera to buy barely-used telecom-equipment gear on the cheap. Not surprisingly, it's stock has jumped 65 percent since mid-September to $6.95.
Jeffry Bartash is a reporter for CBS.MarketWatch.com in Washington.
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