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JANUARY 31, 2005
By Steve Rosenbush SBC and AT&T: Now for the Hard Part There are signs investors have shed some of their skepticism about the deal's growth potential, but in the long term, it remains a tough sell
SBC Communications has started a massive campaign to convince telecom investors that its $16 billion acquisition of AT&T makes financial and strategic sense -- and so far, it has met with some success. Shares of SBC (SBC ) rose $0.23, or 1%, to $23.85, on Jan. 31, the day the deal was formally announced. That reversed a two-day decline that began when news of talks between the companies leaked out. While SBC has yet to recover all of its 5% loss, the fact that its share price is rising at all is significant, because the stock of an acquiring company often declines on news of a significant deal. The next step will be convincing longtime AT&T (T ) shareholders, because $16 billion is far less than what AT&T wanted several years ago, when it came close to selling itself to BellSouth (BLS ). Execs at the local-phone giant balked at AT&T's then-$24 billion price tag after taking a good look at the older company's books. "NOT THE DUMBEST IDEA." There's another reason AT&T investors may be lukewarm to SBC's overtures: SBC is paying for nearly all of the purchase with its own stock, which has declined 10% over the last year. It will contribute only $1 billion in cash, in the form of a special dividend to AT&T shareholders. As a result, AT&T shares fell $0.62, or 3.2%, to $19.09, on Jan. 31. But one telecom investor who panned the idea of the combination last week was a little more receptive on Jan. 31. Hedge fund manager Michael Mahoney, of EGM Capital in San Francisco, said he had conducted his own valuation of AT&T months ago, and determined that it was worth less than $10 billion because prices in the corporate long-distance phone market were continuing to fall by 20% to 25% a year. Last week, Mahoney said combining the companies was a questionable strategy. But he conceded on Jan. 31 that it might make a bit more sense than he originally thought, because SBC is eliminating itself as a rival to AT&T. That could help stabilize prices in the telecom market. "It's not the dumbest idea in the world," concedes Mahoney, who doesn't own AT&T or SBC. But he does own shares of Sprint (FON ), and there's a connection there. If SBC/AT&T gets the thumbs up from investors, it's more likely that some other outfit will try to acquire Sprint. The SBC/AT&T deal was concluded after a weekend of intense phone negotiations. While SBC directors approved the plan Sunday, the AT&T board didn't make a decision until early Monday. IMMENSE SAVINGS. Efforts to sell the combination of telecom giants began with a conference call for investors soon after that decision was made. "The agreement we announced this morning is a tremendous positive step forward," SBC CEO Ed Whitacre said during the Monday conference call. SBC executives, which is based in San Antonio, Tex., are scheduled to fly to New York to meet with investors Feb. 1. Whitacre said huge cost savings could be achieved through the merger. How so? Telecom analyst David Barden of Banc of America Securities says such cost cuts' net present value -- an accounting term that gauges the current value of future savings -- approaches $15 billion. The cost cuts could be worth $2 billion in 2008 alone, with half coming from the elimination of operations and facilities, 25% from combining sales and support staff, and the rest from the elimination of duplicate corporate functions and other measures. Whitacre said SBC also would benefit from the sale of AT&T's high-end corporate telecom services to SBC's small and midsize business customers. The deal, expected to close in mid-2006 after winning approval from investors and regulators, would establish SBC as the nation's largest telecom company. It also would establish SBC as the leader in the sale of telecom services to so-called enterprise customers, a category that includes large corporations and government agencies. FEROCIOUS RIVALS. Many analysts still question just how valuable that prize will be. Certainly, the enterprise market is big and prestigious. But revenue is contracting and profit margins are declining. AT&T's own revenue is expected to decline between 15% and 18% this year. Its profit margins are in the range of 20% to 30%, while profit margins in SBC's consumer market are in the mid-30% range, while those in the small and midsize business market approach 40%. While the sale of telecom service to Big Business is important, it's become something of a commodity in the corporate information technology world. Such services bring in about $85 billion -- less than a tenth of the $1 trillion global IT market. While CEOs and chief information officers are deeply involved in a companies IT strategies, the question of choosing a phone company is often relegated to lower-level executives. SBC may find that its effort to sell AT&T's higher-end consulting services to its customers puts it in competition with tech stalwarts such as IBM (IBM ) and HP (HPQ ). If that competition crimped growth, it could hurt SBC's stock price for years to come. Daniel Zito, a telecom analyst at Legg Mason, thinks SBC shares will be valued at about 4.5 times corporate profits after the AT&T acquisition closes. He expects Verizon (VZ ) and BellSouth (BLS ) to be worth the somewhat high multiple of five times profits. GROWTH ABOVE ALL. For all its financial trouble, AT&T has a clean balance sheet and strong cash flow. For years it has practically begged investors to take those factors into consideration for years, but with no success. Stock and bond investors still regard growth as the crucial benchmark for both AT&T and SBC. "Some might argue that despite declining margins the AT&T business segment does offer strong cash flows. But so what?" Gimme Credit bond analyst Dave Novosel wrote in a report shortly after the deal was announced. "SBC has plenty of cash flow. It needs growth," he said. He has a "sell" recommendation on SBC bonds. SBC has had some early success in convincing investors that its bid for AT&T makes sense. But to win investors over to its side for the long term, it will have to make good on its promise to turn AT&T into a growth vehicle. Given the economics of AT&T's markets, and the weight of its history with investors, that won't be easy.  Rosenbush is a senior writer at BusinessWeek Online based in New York Roger Crockett in Chicago contributed to this report
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