In telecom, the culprit is the slower growth of wireless customers -- significantly, it's harder to find newcomers with good credit. And in power, the villain is one word: Enron. Even companies that bear little resemblance to the once-mighty energy giant have been tainted by the fallout.
Shere says S&P's only buy recommendation in the two areas for which he's responsible is Sprint PCS. But he does have an accumulate rating on BellSouth, which he brands as his favorite Baby Bell, and a similar rating on Broadwing, the old Cincinnati Bell. And he remarks that patient investors could find good returns in these out-of-favor sectors.
These comments came in a chat presented on Jan. 15 by BusinessWeek Online and Standard & Poor's on America Online. Here are edited excerpts from the chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.
Q: Craig, the market edged up a bit today but is still below 10,000. What do you and S&P think is the outlook?
A: S&P anticipates an economic recovery in the first quarter, and if this develops, it should speak well for market conditions.
Q: So how do things look in telecom and power? Recovering?
A: No, unfortunately. In telecom, the one growth sector, wireless, has been hit hard in the first two weeks of this year. And in power, the primary growth sector, unregulated independent power producers (IPPs), is still under enormous pressure following the Enron bankruptcy.Q: To what do you attribute this weakness? Besides the obvious Enron villain.
A: In wireless, the concern is mostly focusing on the rate of, and quality of, new subscriber additions. RadioShack (RSH
) had announced poor handset sales, and Verizon Wireless preannounced a disappointing fourth quarter for net additions. The fear is that wireless penetration has reached a saturation level where fewer new customers with good credit are available.
Q: Is there a silver lining in the weakness you speak of, in the form of bargains for gains later?
A: We're definitely more bullish this year on wireless than on power, but over a two- to three-year horizon, both sectors will probably perform quite well. Our only buy rating among the two groups is now Sprint PCS (PCS
Q: Do you think the DSL sector will make a comeback -- COVD
(Network Access Solutions), DSLN
A: I don't cover these companies specifically, but I am not optimistic about the CLEC [competitive local exchange carrier] industry in general. It is evident that the market is reluctant to provide additional capital to these highly leveraged carriers attempting to steal market share from the incumbents.... The CLEC infrastructures may not disappear, but in many cases, their equity shareholders will.
Q: What is in store for Calpine (CPN
A: Calpine is almost certain not to complete its planned 70,000-megawatt plant buildout by 2005. They will, however, probably double their current megawatts, ending with approximately 30,000 to 35,000 megawatts by the end of 2003. Assuming that they do slow down their buildout, it is likely their credit rating could improve in a year or two.
Q: How do you rank CPN now?
A: We have a hold rating on Calpine. Initially, following the Enron bankruptcy, we were more positive on the company because we believed that more asset-intensive power producers would outperform the energy marketers and traders. Unfortunately, heightened scrutiny by credit agencies has created new problems for the industry, even for companies that have absolutely nothing in common with Enron.
Q: Outlook for BellSouth (BLS
A: BellSouth is our favorite Baby Bell. We have an accumulate rating on it, based on its above-average free cash flow [operating cash flow less capital expenditures].
Q: Where do the other Baby Bells stand in S&P's spectrum?
A: We have hold ratings on Verizon (VZ
), SBC (SBC
), and Qwest (Q
). We had recently upgraded Qwest to hold on the belief that the wholesale interexchange carrier market will recover by the end of the year. However, we prefer Broadwing (BRW
), rated accumulate, to Qwest. Broadwing is the old Cincinnati Bell Telephone.
Q: What's your outlook for Global Crossing (GX
A: We dropped coverage of Global Crossing shortly after its exit from the S&P 500 index. We are very concerned that the company's historical focus on "dark fiber" sales cannot be perpetuated in the current economic environment. A very large second-quarter apparent swap transaction with a major customer also raised significant concerns.
There is the distinct possibility, given their debt burden and limited cash flow, that equity shareholders could be seriously hurt. Those interested in this space are advised to look for companies that have stronger balance sheets. Broadwing is one name I would suggest.
Q: Is MCIT
(MCI Group) likely to continue a dividend yield that exceeds their projected growth rate?
A: I don't follow MCI. However, one can expect the dividend yields on consumer long-distance carriers (including the pending AT&T consumer unit tracking stock) to reflect the significant mature cash flow of this declining business line. Accordingly, the dividends should almost always exceed the growth rate.
Q: What do you see in store for Level 3 Communications (LVLT
A: We have a hold rating on Level 3. Management has done an exceptional job of cutting costs and increasing the probability that Level 3 will be a survivor. If they are in business with their existing shareholders and no debt restructuring three years from now, equity holders should be rewarded quite handsomely. However, the risks are great.
Q: Rumor has it BellSouth (BLS
) is looking at Sprint (FON
). What do you think of that marriage?
A: The RBOCs [regional Bell operating companies] are unlikely to pursue interexchange carriers before they receive full 271 long-distance FCC approvals. I don't think that Sprint is necessarily interested in dividing up its wireless and wireline divisions, despite the existence of two separate tracking stocks. While management control may be an issue, I think a marriage between all of Sprint and Alltel (AT
) makes more sense.
Q: What do you think of AT&T (T
A: We upgraded Ma Bell to an accumulate after they accepted the sweetened offer from Comcast (CMCSK
). And we have a hold rating on AT&T Wireless (AWE
) because we expect their 3G [third-generation] upgrade cycle to be expensive and less timely.
Q: Any thoughts on Nextel (NXTL
A: We just downgraded Nextel today from buy to hold. Nextel is a company you either love or hate. They are the most leveraged wireless carrier in the industry with the lowest credit rating. However, they have consistently gained market share, have the highest average revenue per user in the industry, and have strong prospects for cost containment with new management.
We were concerned that the company's very late fourth-quarter earnings release [scheduled for Feb. 21] offers no fundamental news to counteract the selling pressure the group is under. Nextel presents both significant upside and significant risk at current depressed levels for the industry. However, the stock does not appear cheap on a relative basis.
Q: What is your one-year and three-year outlook for WCOM
A: We have a hold rating on WorldCom. The enterprise-telecommunications market and the interexchange-carrier market have been exceptionally weak, and we do not see any obvious light at the end of the tunnel.
Q: How important is broadband growth to telecom?
A: Broadband growth for the RBOCs comes in the form of DSL for the consumer. Getting DSL to a profitable level is extremely important. This is clearly a growth market, but while it contributes to revenue, there's a question about its ability to contribute to earnings in the near future. Broadband services for the enterprise customer are also a growth market -- but one that is far more cyclical and subject to economic conditions.
Q: What's the bottom line here, Craig? Wait and see before committing new money to telecom and power?
A: If you're very patient, there are good two- to three-year investments in these out-of-favor sectors. In the near term, we do not see much growth outside of wireless. The strength of the broader U.S. economy will have an impact on both sectors. The riskier, more leveraged companies could perform quite well if we manage to get a strong economic recovery.