Technology

Time to Size Up Telecom Stocks


Facing slack demand, fierce pricing pressure, and a cash crunch, the telecommunications industry has experienced a stock-price collapse over the past few months. Since January, the Nasdaq Telecommunications Index, comprising 288 phone-service providers and equipment makers, has dropped 36%. By comparison, even the tech-heavy Nasdaq Composite has fallen by a much less depressing 11%.

So bruising has the experience been that many professional investors have come to regard telecom stocks as pariahs. "I don't hold any," says Erik Gustafson, portfolio manager for the $536 million Stein Roe Growth Stock Fund (SRFSX), 28% of whose assets are in technology. Many funds hold only one telecom stock -- networking giant Cisco (CSCO). It now represents 68% of the market capitalization of the telecom industry's equipment segment, according to investment house SoundView Technology.

UNDERVALUED? Common sense would seem to say, however, that telecom stocks won't remain so depressed forever -- and that some may already be significantly undervalued. After all, many players have chopped their costs so much that their earnings can probably grow even if their revenues simply remain stable, says Arnie Berman, a technology strategist for SoundView. Equipment maker Lucent Technologies (LU), for one, reduced its fixed costs by 13% from the first fiscal quarter to the second, from $3.1 billion to $2.7 billion. Those costs are now running half the level of a year ago.

When orders for gearmakers pick up, incremental revenues essentially will drop to the bottom line, and "Wall Street analysts won't be able to upgrade [telecom stocks] fast enough," Berman predicts.

This doesn't mean investors should now jump in head first. But it does mean it's probably time to start sizing up which companies would be best to buy. "You have to be pretty selective," says Dean Kartsonas, a portfolio manager at Federated Communications Technology Fund (FCTYX) in Pittsburgh. The fund now has $211.7 million in assets, 10% of which are in telecom, compared to 50% to 60% a year ago. It's wise to remember that some sectors of the industry, such as equipment makers and wireless operators, will probably go through a major consolidation -- the natural selection of winners and losers.

"STILL A MONOPOLY." One possibility for investors seeking a relatively safe near-term investment might be rural phone-service provider Alltel (AT), suggests Charlie Pluckhahn, an analyst with investment house Stephens Inc. in Boston. On Apr. 25, Alltel reported a 19% first-quarter earnings increase, to $239.9 million (77 cents) a share. Yet it's trading around $49.75, down 24% from its 52-week high of $65.15. One reason for the recent dip is that Alltel just issued $1.25 billion in equity-linked securities, which diluted the value of the existing shares.

Local-phone service provides steady cash flow

Another not-too-risky bet may be local-phone companies, says Kartsonas, whose fund holds shares in Verizon (VZ), SBC Communications (SBC), and BellSouth (BLS). "The local-phone infrastructure just can't be replicated," he explains. "It's still a monopoly."

And that means the companies are reasonably stable, even if they'll have essentially flat revenues this year. Local services bring in a steady cash stream, giving the Baby Bells the financial wherewithal to participate in the presumed consolidation that may lie just ahead. They should also benefit by selling high-speed Internet access to more subscribers.

STRONG SHOULDER. Verizon, the No. 1 local-phone company, is trading at $40, some 30% below its 52-week high of $57.40. Of the 27 analysts covering Verizon, 20 rate it a buy or strong buy. Many also recommend SBC and BellSouth. They expect that all three companies will benefit from the fast-growing wireless businesses in which they all have a stake, as well as from consolidation.

Investors who can stand the risk might also want to consider Sprint PCS (PCS). Although wireless subscriber growth has slowed, it's performing well -- at least, for a perpetual money-loser. In its most recent quarter, Sprint PCS's revenues of $2.85 billion were slightly higher than its $2.76 billion in sales in the fourth quarter, which traditionally is its best. As the tracking stock of parent Sprint Corp. (FON), PCS also has a strong shoulder to lean on -- a godsend given that it's expected to post a $524 million loss this year.

Yet even after a recent rally, Sprint PCS shares, at $11.20, are trading 61% below their 52-week high of $29.05. Of 38 analysts who cover the company, 34 rate it as a buy or strong buy, and their mean target price for the stock is $22.92.

NEW NO. 1. Cable companies, such as No. 3 Comcast (CMCSK), could be another decent bet, says James Glen at researcher Economy.com. Once its acquisition of AT&T's cable-TV unit is completed, probably in late June, Comcast will be the largest cable operator in the U.S., serving 22 million households. It also offers high-speed Internet connections to homes, a service that's expected to gather traction. Today, 19 of the 20 analysts who cover Comcast rate it a buy or strong buy.

What are the stocks to avoid? Pure plays in long-distance, says Kevin Fogarty, an equity analyst with Citigroup Asset Management, which manages $417 billion in assets. Price competition in that business is severe, and wireless calling plans and e-mail continue to eat away at the telcos' core business.

Another sector to steer clear of, for now: Telecom equipment stocks. Although the Street's view of this business is slowly becoming more favorable, it hasn't yet hit bottom, says Bill Lesieur, an analyst with tech market researcher Technology Business Research in Hampton, N.H.

NOT GOING AWAY. A rebound in telecom usually lags behind the economic recovery by three to four quarters, cautions Glen. And although analysts expect to see major growth in broadband and wireless sectors, they believe the industry won't return to the glory days of the late 1990s anytime soon. "There's a lot of wood to chop [to find good stocks]," says Berman.

About the only thing that's certain is that "the telecommunications businesses isn't going away," says Bill O'Brien, chief marketing officer at equipment maker ADC Telecommunications (ADCT). "There will be a bright future." Those who invest in telecom stocks could share in that -- as long as they can muster the right combination of patience, skill, and luck. By Olga Kharif in Portland, Ore.


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