Telecom’s Equity Rebound: Will It be Short-lived?

Standard & Poor’s Integrated Telecommunications Services Index outperformed the S&P 500 during the first 10 days of the year, demonstrating optimism for a sector that has been hammered by losses for more than two years. 

But Todd Rosenbluth, telecom services equity analyst with S&P, says he does not expect the telecom index to outperform the S&P 500 for long.

Last year the telecom index was down 36.1 percent compared to 2001 while the S&P 500 was down 23.4 percent compared to the prior year.

During the first 10 days of 2003 – this is the most recent data available – the telecom index was up 6.8 percent, compared to the S&P 500’s 5.4 percent gain.

 ”We think that is going to be short-lived,” Rosenbluth says in an interview. “There is a lot of debt that is still out there, there is customer losses the entire industry is going to face and we are suggesting investors take caution in the sector.”

The Baby Bells – the nation’s telecom cash cows – posted gains this month in their stock values on news that the phone giants would be granted regulatory relief in the local telephone market. But subsequent reports have painted a less rosy outcome for the Bells, driving down the stocks. 

“We don’t think regulatory changes will be significant and even if they are approved will take at least two years to be implemented and in the interim the fundamentals will get worse,” says Rosenbluth. “During that timetable there will continue to be substitution towards wireless and cable competitors” and pressures on the incumbents’ pension plans.

Moody’s Investors Service, one of the agencies rating the debt of public companies, says in a November report it “believes that incumbent local telephone companies possess still solid franchise values, modest growth opportunities and good credit fundamentals which will likely result in their maintaining upper medium investment grade ratings for at least the next couple of years.”

But the analysts also point out a number of threats facing the incumbents, including increasing competition from long-distance companies, such as AT&T Corp. and MCI, and CLECs that have emerged from bankruptcy free of high debt.

In a report issued today, Blaylock & Partners L.P. analysts say they expect the economy and unbundled network element - platform (UNE-P) regulations governing the local resale phone market to “negatively impact RBOC core wireline revenues” in the fourth quarter.

The analysts have a similar outlook for AT&T.

“We expect weakness in 4Q02 across both the business and consumer units due to the economy and RBOC encroachment respectively,” they say.

However, Rick Black, Blaylock’s senior telecom analyst, sees rays of promise in the wireless sector. 

For instance, wireless carriers are moving towards generating free cash flow positive and slashing their debt.

“These things are all not certain and they are going to take time to come about,” but “all these guys are pushing the goals towards positive free cash flow,” the analyst says.

Another good sign: The removal of spectrum limitations effective Jan. 1, paving the way for consolidation, Black says. “We anticipate mergers but not on the large scale and not in the near-term,” Black adds.

However, Moody’s cites a “negative” outlook on the country’s six largest wireless carriers. “The recent slowdown in U.S. wireless industry subscriber growth rates has led to a more competitive market place, where the same number of players is chasing fewer subscribers,” Moody’s analysts say in a December report.

“The intense competition has propped up the cost of acquisition per additional subscriber, put pressure on revenue per subscriber, has kept network spending high and is conducive to churn. All of this is further delaying meaningful free cash flow generation.”

The analysts say those pressures could be allayed through consolidation, though barriers, such as access to capital and regulatory issues, exist. Meantime, “With large current maturities for most industry players and promises of free cash generation in 2003, performance over the next 12 to 18 months is critical,” they say.

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