SHOULD INVESTORS GO WITH AT&T--OR A CABLE COMPANY?
Little did the residents of Arlington Heights, Ill., know it, but they had a lot to do with the $48 billion merger of AT&T (T) and Tele-Communications(TCOMA), which was announced on June 24. Those citizens were part of a Tele-Communications (otherwise known as TCI) market test of a new cable technology, called IP telephony, that proved to be wildly successful. Thanks to tests such as the one in Arlington Heights, AT&T has decided to wager the house on one big IP telephony bet.
Should investors throw the dice along with Ma Bell? Or should they instead bet on more cable-company buyouts or mergers? To make that call, you first have to dissect the AT&T-TCI merger.
Ever since the Bell monopoly was broken apart by Washington in 1984, AT&T has been prohibited from providing local-phone service. Company boosters thought that the Telecommunications Reform Act of 1996 would force the RBOC's (the Regional Bell Operating Companies, otherwise known as Baby Bells) to open up the local-phone market to AT&T as well as to other telecommunications companies. But so far, the RBOCs have avoided competition by challenging aspects of the Reform Act in court. As a result, AT&T has been left out in the freezing world of long distance, an increasingly competitive business that's facing declining revenues and profit margins.
SURPRISE GUEST. Rather than continuing to politely tap on RBOCs' window to let it into the local phone market, AT&T instead dug a tunnel and popped in the living room uninvited, hand-in-hand with TCI. AT&T already owns trunks of fiber optic cable that crisscross the country. But it can't get access to the "last mile" of phone lines that go directly into customers' homes. Instead of begging the RBOCs for acess to that final mile, it will instead attach its fiber trunks to another piece of wire that goes into a majority of homes: their TV cable.
AT&T is, in effect, betting that IP telephony over cable will work for millions of customers -- and it might. "IP telephony is unproven on a massive scale," says Jessica Reif Cohen, cable analyst for Merrill Lynch. "But it isn't untested. In the last six months, I've seen cable executives go from skeptical to enthusiastic about this technology, thanks to its success in test markets." Markets such as Arlington Heights.
Predicting whether AT&T will be successful at providing Internet telephony is a difficult task. But here's one thing shareholders need to understand: After this merger -- assuming it goes through unchallenged -- AT&T may never again be the same steady dividend-producing utility stock that it was in the past. For one thing, the company's shares will be split into three "tracking stocks," one representing its business services, one representing its consumer services, and one representing TCI's cable content providers, like QVC. Each of those stocks will nevertheless be reliant on the same digital cable technology.
Now that AT&T is basing its future on IP telephony, it would better be classified as a technology stock, or even (gasp) an Internet stock. "I'm not sure if I can define what is a cable company and what is a phone company after today," says Patti Reali, an industry analyst for Dataquest. "This changes the face of telecommunications."
ONE-WAY STREETS. Before you decide whether to endorse AT&T's new strategy by loading up on its stock, look closely at what it has just bought. While TCI is the market leader among cable companies, it also has the most antiquated "plant," or cable infrastructure. According to Reali, only one-third of TCI's plant has been modernized to accept two-way digital traffic, which is necessary for IP telephony. The other two-thirds won't be modernized for a few more years. "TCI had the vision for this years ago," says Reali, "but it never had the cash."
Not until AT&T came along. "To some degree this was a check-writing exercise," says Gary Farber, who follows the cable industry for Cowen & Co. "TCI is a standard-setter in the industry, and this validates the cable pipe. But above all, AT&T bought 33 million eyeballs." AT&T also bought a company that had $7 billion in sales last year yet is bogged down with nearly $12 billion in debt, which AT&T will have to add to its own $6 billion in debt.
In addition, AT&T CEO Michael Armstrong announced that he expects the company's earnings to be diluted over the next three years, meaning the payoff from the merger won't appear until 2001 -- if ever. That's one reason AT&T closed down more than 8% on June 24, at 60.
To top it off, AT&T paid a steep 33% premium for TCI's stock, which has already doubled from its lows of a year ago. That puts TCI at a valuation of 15 times 1999 cash flow, a price that has never before been paid for a cable company.
LIKELY TARGETS? If you aren't willing to gamble on AT&T, there are other, perhaps more appealing, ways to play the merger. The first place to look is the cable industry. "This was an offensive move," says Cowen & Co.'s Farber. "The fallout is going to be a lot of defensive moves as others position themselves around cable." In other words, other telecom giants are going to want a cable company of their own.
The most likely target is Cablevision Systems (CVC). "It's an obvious takeover candidate," says Merrill Lynch's Reif Cohen, who upgraded the stock on June 24, even though analysts on average expect the company to lose $4.41 a share this year, thanks to capital spending on new technology. The Woodbury (N.Y.) cable provider is one-third owned by TCI, which means that AT&T's Armstrong -- who suggested in announcing the TCI deal that he is shopping for other cable companies -- could buy the rest of it.
Cablevision is also active in the prized New York metropolitan area. Reif Cohen figures that each one-point increase in the price-to-cash-flow valuation of Cablevision's stock translates into a $10 gain in stock price. So if Cablevision were to be acquired for the same valuation as TCI, it would be worth more than $100 a share. It closed on June 24 at 76, a gain of 22% for the day.
Another tempting target is Cox Communications (COX), one of the smaller cable providers, with only 5.5 million customers. But it does offer two prizes. Cox's market is focused on just 10 metropolitan areas in the Southeast, which makes a rollout of new digital cable much easier than for TCI, whose systems are spread across the U.S. In addition, Cox has been one of the earliest fans of cable phone service and has spent more money than other cable companies to implement it. "TCI was not focused on telephony before, but it will have to be now," says Yankee Group analyst Jim Wahl. "Cox, on the other hand, has been the most progressive of the cable companies in cable telephony."
Should you play Ma Bell, or play cable instead? There's little doubt at the moment where most analysts would put their money.
By Sam Jaffe, markets writer, Business Week Online
Updated June 25, 1998 by bwwebmaster
Copyright 1998, Bloomberg L.P.