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Are the Baby Bells a Buying Opportunity?
Think the regional phone companies are down for the count? Analysts say they might pack a counterpunch
Itís easy to imagine that the forces of natural selection will send the regional Bell phone companies the way of the mastadon. Big beasts such as AT&T have made it plain that they intend to break into the Bells' local markets via cable-TV hookups. Other lugs, such as MCI WorldCom and Sprint, are luring the Bellsí business customers with promises of a smorgasbord of long distance, data, and wireless services.
So far this year, in fact, the market has pegged regional phone companies as lackluster -- perhaps not tar-pit fodder, but not in the same class as AT&T or MCI WorldCom. As of Apr. 1, the Bells were bringing up the rear of the telecommunications industry. While cellular stocks and long-distance service providers were up 46% and 14%, respectively, well in advance of the 5.2% gain for the Standard & Poor's 500, local phone shares were down 6.7%. SBC, one of Wall Streetís favorites in the group, is down 7% for the year. U S West has slid 14%, while BellSouth has backtracked 17%.
The Bells and other regional players could well turn the tables over the remainder of 1999, however. Start with the fact that the slumping group now looks cheap relative to the market. Local-phone stocks have historically traded at a 25% to 30% discount to the market at their lowest and perhaps even with the marketís price-to-earnings multiple on the high end. Currently, the entire roster is mired at the bottom of that range. SBC, for instance trades at about 22 times Wall Street consensus 1999 earnings estimates as compiled by Zacks Investment research. That's a 24% discount to the S&P 500ís multiple of 29. The gap is even larger for Bell Atlantic, which is trading at 18 times 1999 estimates.
GROWTH AHEAD? Then, thereís the Bellsí reputation for steady dividends, a factor that should buoy them in case of any near-term turbulence in the market. While itís true that Bell companies no longer offer up yields of 5%, l the 3.9% U S West or 3% Bell Atlantic forks over to investors is quite a bit richer than the 1% or so the S&P 500 can muster these days. "This is a defensive group," says Philip D. Wohl, an analyst with Standard & Poorís, "and now with Dow above 10,000, weíre seeing some investors gravitate to stocks with a dependable yield as shelter."
Increased competition may counterbalance these Baby Bell strengths to some extent: The regionals are facing attacks not only from AT&T and MCI WorldCom but also from small competitive local exchange carriers, or CLECs -- rivals that set up local networks in cities to compete for business customers. CLECs such as Intermedia Communications and Teleport, a division of AT&T, now account for about 3% of local-phone revenues, according to S&Pís Wohl.
Still, the market may be overlooking some substantial growth opportunities for the Bells. Start with their traditional wireline service. Thanks to the Internet, the telecommuting boom, and rising residential demand for second phone lines, this mature business, which accounts for about 60% of Baby Bell earnings, is stirring anew. In fact, Legg Mason Wood Walker analyst Michael J. Balhoff estimates that demand for second lines is growing 20% a year. Thatís enough to boost overall line growth to 5% or so a year.
Data transmission could also prove a bonanza for the regional companies. Legg Masonís Balhoff believes that data revenues could grow 35% to 43% annually over the next five years. Pile on top of that the rapidly growing cellular franchises of the regional phone companies, which account for about 20% of their earnings, and many analysts expect some local-phone companies to bag annual earnings gains in the low-teens over the foreseeable future.
FCC TEST. Another factor to take into account is the cost-cutting the chubby Bells can no doubt stand to do. "Michael Armstrong came into AT&T and magically found ways to trim the company," says Richard Klugman, a Goldman Sachs analyst. "I think when the time comes, the Bell companies, too, will find they can get by quite well without a substantial minority of their employees." And once mergers such as SBC-Ameritech and Bell Atlantic-GTE are wrapped up, there should be plenty of redundancies to cut away.
The wild card in this picture is long distance, a segment in which the locals could one day compete nationwide. Before the Baby Bells can enter the sweepstakes, though, they have to meet 14 criteria set by the Federal Communications Commission to prove that theyíve opened their local markets to competition. None of the Baby Bells have passed the test so far, although indications are that one or more could break through by the end of the year.
Add it all up, and three of the four remaining Baby Bells -- SBC, Bell Atlantic, and BellSouth -- could enjoy 10% annual earnings growth over the next five years according to Zacks, well ahead of the 7% increase it predicts for the Standard & Poorís 500. A prime candidate to lead the pack is SBC Communications. Under the leadership of Edward Whitacre, the Texas-based company is using acquisitions -- of Pacific Telesis in 1996 and Ameritech in 1998 -- to execute its strategy of competing coast-to-coast (see BW, 4/12/99, "The Last Monopolist").
1999 GAIN: 24%. "Weíre tickled with [SBC] management," says Liam D. Burke, a co-manager with the Flag Communications Fund. "They execute well, not only incorporating acquisitions quickly but by paying close attention to costs, too." Those abilities are an important reason why some analysts feel that SBC could hold its own among the global telecommunications giants that salivate over the Bells' local markets. "SBC is one of the few Baby Bells poised to make it to the world stage and compete with the big boys," says S&Pís Wohl. Wall Street looks for the company's earnings to grow an average 11% annually over the next five years, according to Zacks. Of the 27 analysts who follow the company, 20 rate it a strong buy or buy.
With telecom giants elbowing for position, local carriers can get lost in the smoke of battle. That's the case with Cincinnati Bell (CSN), whose shares are down 40% since the beginning of the year. Last August, it spun off Convergys, its billing unit that served a number of big telecom clients. Now that Cincinnati can focus on its core operations, analysts say, its earnings should grow at a 15% annual clip over the next five years, helped in part by its strong wireless franchise. "This is essentially a new company, one which can survive and even thrive as an independent company," says Robert Venable, an analyst with Robert W. Baird. One drawback: Cincinnati already trades at a strong 28 times estimated 1999 earnings. Still, six of the seven analysts who follow the stock currently rate it a strong buy or buy.
If the whirlwind changes in telecommunications leave you a bit dizzy, you might opt to leave the stock-picking to a portfolio manager. According to Morningstar, the Flag Investors Communications Fund (TISHX) leads all comers in the sector. The fund posted a total return of 87.94% last year and has averaged an annual total return of 52.74% over the past three years. So far in 1999, it's up 23.98%.
James Anderson who teaches journalism for the City University of New York, writes Sector Scope every other week
EDITED BY DOUGLAS HARBRECHT
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