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They're bleeding red ink, but Wall Street sees future gains

It's a cruel irony. It was the race to get into local phone service that squeezed MCI Communications' earnings, depressed its stock, and made it vulnerable to the unsolicited takeover bid of WorldCom Inc. What's ironic is that while investors have pummeled MCI and AT&T for pouring millions into local-calling ''infrastructure,'' money-losing upstarts have become the toast of Wall Street for doing the same thing.

Take Intermedia Communications Inc., which builds local telephone systems to compete with the Baby Bells. It racked up losses of $57 million on $94 million in the first half of 1997, but its stock has soared 99% since January. Shares of Associated Group Inc., for example, have shot up 129% this year, and those of McLeod USA Inc. have jumped 55%. The most dizzying of all is Craig McCaw's Nextlink Communications Inc. It went public on Sept. 26--after losing $71 million last year on revenues of $25 million. Its stock soared 37% in its first day of trading, giving it a market capitalization of $1.4 billion. That, say its officers, is simply a reflection of the huge opportunity in the $100 billion local phone business. ''The moon and the stars have lined up here,'' says Wayne Perry, Nextlink's CEO.

CONSOLIDATION. Takeovers in the local-calling business are also helping produce astronomical values. Shares of Brooks Fiber Properties Inc. soared after it got a merger bid from WorldCom, which has since nailed down a deal to purchase the company for $2.4 billion. Now, analysts are expecting more deals. ''The root of the enthusiasm is that consolidation is coming to the industry,'' says James H. Henry, an analyst at Bear, Stearns & Co.

So why does Wall Street love it when these companies lose money in local phone service but punish giants such as AT&T for sacrificing some earnings to invest in the market? The distinction actually makes sense. AT&T is valued on steady earnings; small local players are fast-moving growth companies that are forgiven for racking up big, early losses. ''None of our shareholders even knows what net income means,'' says Nextlink's Perry. McCaw Cellular Communications Inc., where Perry once worked, accumulated net losses for years as it grew into the nation's top wireless provider--and Wall Street cheered.

Instead of valuing the upstarts on current earnings, analysts look at how much the new companies are pouring into their networks. A typical company, such as Intermedia, is valued at about four times the assessment of its property, plant, and equipment. But the whiff of a takeover can send that multiple soaring. Last year, when WorldCom bought MFS Communications Co., the largest of the local carriers, it paid $12.5 billion in stock--seven times the company's assets. ''When you look at where the market is going, these assets are very valuable because they're scarce,'' says Robert Annunziata, CEO of Teleport Communications Group, a competitive carrier.

Another plus for the upstarts is that the bigger companies--seared by investors--are looking for ways to get into local calling without a huge investment. That's why AT&T is scaling its network construction plans and building only one local network, in Chicago. To reach other markets, it's making deals with smaller players who will expand where it won't. AT&T plans to franchise its name in second- and third-tier markets to companies such as Intermedia. That way, it can control capital expenditures and leverage its brand.

All this attention makes the fledgling players confident, even cocky, as they line up against the Bells. ''We're competing against people who don't know how to compete,'' says Intermedia's Ruberg. Adds Nextlink's Perry: ''They can't compete on price because we don't have unions or golf tournaments--we'll cream 'em.'' Fighting words. But for now, the small fry have a bruiser in their corner: Wall Street.

By Peter Elstrom in New York

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Updated Oct. 2, 1997 by bwwebmaster
Copyright 1997, Bloomberg L.P.
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