A Bully Quarter for the Bells


By Todd Rosenbluth Over the past two weeks, the three largest Baby Bells -- BellSouth (BLS

; ranked sell; recent price: $27), SBC Communications (SBC

; hold; $24), and Verizon Communications (VZ

; buy; $34) -- reported second-quarter results. We are pleasantly surprised by the collective results, particularly because growth in wireless services is largely offsetting the continuing erosion in local phone lines.

In the June quarter, local voice-service revenues -- still the bread and butter of the large telecom providers' operations -- for all three telecom providers were weakened by access-line losses of more than 4%. We believe the line losses stemmed primarily from wireless substitution by residential customers and a decrease in wholesale lines. In the future, we expect competition from cable telephony offerings to add further pressure.

CINGULAR ASCENDS. However, reported wireless use for the second quarter has been strong and appears to be continuing to take share from its more traditional wire-line sibling. Indeed, while Verizons' second-quarter wire-line minute usage declined 6.9% from the prior year, total system minutes of use on the network of wireless carrier Nextel Communications (NXTL

; buy; $33) increased 37%, to 44.7 billion, during that period.

Backed by parents BellSouth and SBC Communications, Cingular Wireless, which became the largest national carrier in the fourth quarter of 2004 with its acquisition of AT&T Wireless, had what we view as stronger-than-expected second-quarter revenues and now provides service to 51.6 million subscribers.

Minute usage per subscriber at Cingular was up 24% in the June quarter, aided in part by the carrier's rollover packages. Even though integration of the two carriers' networks, customer care, and other key aspects of the business is still under way, we believe Cingular leveraged the wire-line relationships of its parents to generate $7.7 billion in wireless-service revenues in the second quarter, up nearly 4% from the prior year, adding to the profitability of the Bell parents.

OUT IN THE COLD. Meanwhile, aided by the addition of more than 1.9 million net subscribers in the second quarter and increasing demand for its data services, Verizon derived an increasing percentage of revenues from its wireless joint venture with minority owner Vodafone Group (VOD

; hold; $25).

We believe Verizon, currently the second-largest nationwide wireless carrier with more than 47 million net subscribers, has become a successful addition to the service bundle that the Bell offered to customers because of its high-quality national network capabilities. Revenues in the second quarter for the segment climbed 15%, offsetting the fractional decline in domestic wire-line services, to drive consolidated revenues up 5%.

We do not expect results from Qwest Communications (Q

; sell; $3.70) to similarly benefit from the shift toward wireless. The last of the Baby Bells to report, Qwest is expected to announce second-quarter results before the market opens on Aug. 2. We project that the company will generate a loss per share of 11 cents on flat revenues of $3.5 billion. The Colorado-based telecom carrier is two years into a five-year reseller agreement with national carrier Sprint PCS to offer service under the Qwest name, and it only recently completed the migration of its existing customers in February, 2005.

PRECARIOUS. In the first quarter of 2005, Qwest's wireless revenues declined 1.6% from the prior year, to $124 million, hurt in part by an 11,000-subscriber decline as the migration was being completed. Even if the wireless subscriber base stabilizes in the second quarter and benefits from the nationwide service capability, as we expect it will, we estimate that the segment will generate $155 million, or 4.7% of its quarterly revenues.

This contribution from higher-growth wireless services appears scrawny to us, compared with the 40% and 33% that BellSouth and SBC, respectively, derived from their wireless operations in the second quarter of 2005. With Qwest currently competing with five national carriers and a host of regional providers, we believe investors should keep in mind what we view as the company's precarious position as wireless substitution intensifies.

Qwest's relative weakness on the wireless front became more of a problem earlier in 2005, as it failed to acquire MCI (MCIP

; hold; $25), even after it offered a higher per-share bid than Verizon. MCI's directors focused on the fundamentals of its two suitors in making the decision as to which of the Bells to join.

SERIOUS DEBT. In the end, MCI selected Verizon as its long-term partner for a variety of reasons, including the demands of its business customers that preferred to work with Verizon and the increasing need for scale and comprehensive wireless capabilities. The Verizon-MCI planned marriage still awaits shareholder and regulatory approval.

What happens next for Qwest? Well, at its annual meeting in May, Qwest CEO Dick Notebaert said he plans to rebuild by seeking smaller companies or assets that will put more customers on the company's nationwide fiber-optic network and strengthen its weak balance sheet.

As of March, Qwest had more than $17 billion in debt compared with $2.4 billion cash and short-term investments. Options we believe Qwest will look into include buying assets such as rural phone lines or competitive local phone businesses that could be spun off to satisfy antitrust requirements in the still-pending megamergers of Verizon-MCI and SBC-AT&T.

OVERVALUED? We expect to get more clarity on the direction in which Qwest is heading following the conference call that it will hold to discuss second-quarter results. However, we believe Qwest's fundamentals as a stand-alone company are unlikely to improve much over the next 12 months.

We view Qwest's shares as overvalued due to its relatively weak margins, limited wireless presence, and low interest coverage ratio. Also, we think that, due to the lack of a dividend, the company's stock has less downside support than its peers, which all provide a dividend yield of more than 4%. We have a sell recommendation on the stock.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM"), which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS"), which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from BLS, SBC, VZ, NXTL, VOD, Q and MCIP during the past 12 months.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Analyst Rosenbluth follows telecommunications services stocks for Standard & Poor's Equity Research Services


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