Hold the Line on Telcos

The market has factored in the convergence benefits of the reinvigorated telecoms, says S&P's Todd Rosenbluth. But there are opportunities

Telecom stocks have been hot, driven by cash-flow growth and some high-profile deals. So far this year, the Standard & Poor's Telecommunication Services index has jumped 13.5% through June 29, vs. a 6% gain for the S&P 500 index.

The large telcos are generating strong cash flow, but the positive developments from cost synergies and wireless and broadband growth are largely factored into share prices, says Todd Rosenbluth, who follows telecom stocks for Standard & Poor's Equity Research. "Because of the merger activity, many of these stocks have rallied either on the terms of the deal or in anticipation that future mergers will occur," he adds.

The bottom line for investors: "We look at a 12-month time horizon as to what the stocks are worth, and many of them are fully or fairly valued."

Rosenbluth's favorite stock in the telecom-services group is Citizens Communications (CZN), a Stamford (Conn.)-based provider of wireline services to rural areas and small and midsize towns and cities in 24 states, including Arizona, California, New York, and Pennsylvania. He also likes a few communications gear makers, such as Amdocs (DOX) and Corning (GLW).

BusinessWeek.com's Karyn McCormack spoke with Rosenbluth on July 5 about the deal frenzy in the telecom sector and his favorite stocks. Edited excerpts from their conversation follow.

Note: Todd Rosenbluth is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

Deals in telecom are picking up, with the July 2 news that AT&T (T) will buy Dobson Communications (DCEL), and that BCE (BCE) will be taken private. Do you see more M&A coming? What's driving the dealmaking?

There has definitely been a lot of merger activity in the telecom space. Besides AT&T announcing it will acquire Dobson and BCE agreeing to go private, there was a smaller deal that same day: Consolidated Communications (CNSL) bought a small company called North Pittsburgh Systems (NPSI). These deals come on the heels of Alltel (AT) being acquired by private equity earlier in the year and the handful of small rural telecom deals.

We think that the reason why so many deals are happening in a short time period stems in part from the current stage in telecom where cash flows are stabilizing and many telecom companies are looking to benefit from scale (see BusinessWeek.com, 6/25/07, "Telecom: Back from the Dead"). The AT&T-Dobson deal involves AT&T buying a large roaming partner that's going to add about 3% to its customer base. There will be synergies in roaming costs. But if you're an AT&T shareholder, the price they paid to acquire Dobson, at more than nine times EBITDA (earnings before interest, taxes, depreciation, and amortization), is expensive, before one factors in the synergies that remain uncertain at this time.

So do you think the takeover and going-private prices are getting expensive?

Every deal that we're seeing—BCE, Dobson, Alltel—is valuing these assets at premiums to the industry as a whole and assume significant synergies to get the payback. While we recommend investors hold on to shares of AT&T and Consolidated Communications, we believe the prices these companies are paying for acquisitions are expensive.