Markets & Finance

Cutting the Cord on Local Service?


By Todd Rosenbluth Heading into another earnings season, we at Standard & Poor's Equity Research will focus on local phone customers, who have been more fickle than in years past. The local phone business has long served as the cash generator for integrated telecom service providers.

Over the past decade, phone companies -- from behemoths like Baby Bell SBC Communications (SBC

: Hold; $23), with 51 million local access lines, to smaller players like Telephone & Data Systems (TDS

: Hold; $37), with fewer than a million lines in its incumbent territory -- used the relative stability of the business to support the capital and operating expenses related to launching their own wireless, DSL, and other value-added services.

EXPECT A SALE. However, this year, the local phone business has declined in consistency. Competition from cable, wireless, and -- to a lesser extent -- wholesale local services has put pressure on the voice businesses of the nation's top local phone providers.

In turn, we believe some carriers will spin off or sell their local phone business.

Third-quarter earnings season for the local telecom providers begins on Oct. 20 with SBC Communications and extends through early November. We expect the financial results and the subsequent conference calls to reveal that the decline in local customer bases persisted in the third quarter.

BUNDLING UP. In the 12 months ended June 30, the Baby Bells lost 4.5% to 5.5% of their access lines. Even the smaller providers were not immune to the customer dissipation, as Cincinnati Bell (CBB

: Sell; $4.30) lost 4.7% of its local customers in its regional market, and Alltel's (AT

: Hold; $61) wire-line customers declined 3.7%.

To combat customer migration and improve loyalty, the telecom providers have bundled broadband, long distance, and satellite services for a discounted price and have begun deploying higher-speed fiber-based services. Thus we believe investor attention has shifted partially away from the local service base and toward the size of the DSL base and the pace of fiber rollout.

So far, the success of companies' bundling efforts has been mixed. Even though the penetration rate of these services has increased, operating margins have been squeezed from the price reductions, and the rate of access-line losses has continued to rise.

KIDS' INFLUENCE. We think the continuing drop in local lines will come, in part, from such cable companies as Time Warner (TWX

: Buy; $18) that are further rolling out and marketing their telephony offerings in a triple-play package with broadband and video services.

In addition, we expect that the recent graduation of hundreds of thousands of college students -- many of whom have grown accustomed to using their wireless phones as their primary numbers -- will lead a decline in the setup of wire-line phones.

We also expect that the devastation of hurricanes Katrina and Rita will lead to a decline in local phone lines. In early September, BellSouth (BLS

: Hold; $25) reported that Katrina affected 1.75 million access lines, or 8.5% of its base.

HEAVY HITTERS? While we believe that BellSouth succeeded in restoring service to the majority of these Gulf Coast lines, it remains unclear how many subscribers returned to their homes to continue their local service from BellSouth.

To a lesser extent, the hurricanes also affected local phone lines in markets served by CenturyTel (CTL

: Strong Buy; $33) and Sprint Nextel (S

: Buy; $23). Even though wireless service was spotty in certain regions for the national cell-phone providers in September, we expect that wireless substitution increased in the third quarter, as residents were displaced.

In addition to focusing on the trend in access-line counts, we await third-quarter commentary from Sprint Nextel and Alltel, the two largest independent non-Bell local carriers that appear to have a stronger interest in wireless market opportunities.

DENSELY POPULATED. Sprint Nextel has begun separating the operations of Sprint's local telecom business of 7.5 million lines, and will seek regulatory approval to spin off the local business to Sprint Nextel shareholders in a tax-free transaction, which the company expects to complete in 2006.

Meanwhile, in late September, Alltel announced that it will assess strategic repositioning options related to its wire-line business. We believe this will result in a decision to spin off or sell its local phone operations, consisting of 3 million lines, in the next six months.

We think the Baby Bells are also reviewing options that include spinning off or selling access lines in less densely populated regions, as they have begun to roll out their expensive fiber-based broadband and video services to some existing customers. (In 2002, Verizon Communications-- VZ

: Hold; $30 -- generated $4 billion by selling 1.3 million primarily rural-based local lines.)

FIVE-STAR PROSPECT. While Alltel and other telecom providers are strategizing about the merits of offering local phone service now that wireless and other services are generating cash, CenturyTel management told analysts at a meeting in September that it would be interested in bidding for a bundle of local phone lines at the right price.

The timing and the size of such an offer remain uncertain, in our view. We think CenturyTel has had success in acquiring rural access lines and integrating these customers into its business.

As we wait to hear more details about what the carriers will do with their local services business, we recommend investors purchase CenturyTel, which has our highest rank of 5 STARS (strong buy). We think the rural carrier's wire-line prospects look more favorable than those of the Baby Bells, based on our view of CenturyTel's limited competitive pressures from wireless and cable carriers, and what we see as higher earnings quality.

Required Disclosures

S&P Global STARS Distribution

In the U.S.

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 28.7% of issuers with buy recommendations, 60.3% with hold recommendations and 11.0% with sell recommendations.

In Europe

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.8% of issuers with buy recommendations, 44.8% with hold recommendations and 20.4% with sell recommendations.

In Asia

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 28.1% of issuers with buy recommendations, 51.1% with hold recommendations and 20.8% with sell recommendations.

Globally

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 29.3% of issuers with buy recommendations, 57.7% with hold recommendations and 13.0% 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 SBC Communications, Telephone & Data Systems, Cincinnati Bell, Alltel, BellSouth, CenturyTel and Verizon 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

Photo:

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