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Is Verizon a Champ or a Pretender?

By Jane Black Wall Street is desperate for a champion -- even, it seems, in the battered telecommunications sector. So, analysts and investors have anointed the regional Bell companies -- Verizon Communications (VZ), SBC (SBC), and BellSouth (BLS) -- as winners. They've even given troubled Qwest (Q) the benefit of the doubt (see BW Online, 5/8/02, Tricky Math for Qwest Investors).

Leading the analysts' pack is the No. 1 phone company, Verizon. Its stock is trading at around $42, down 10% since Jan. 1 -- a victory for any telecom in this environment. Bullish analysts predict that Verizon will hit $52 within 12 months. The American Stock Exchange Telecom Index, meanwhile, is down more than 40% so far this year, with no rebound in sight.

The desire for a winner, though, may be blinding the Street to the realities of Verizon's future -- and its stock may be overvalued (see BW Online, 5/1/02, "How Connected Are the Baby Bells?"). A close look at Verizon's financials reveals how the industry's grim fundamentals apply even to the "victors" of the telecom meltdown.

"GROWTH IS ELUSIVE." "Verizon is facing too much competition to keep thinking of it as a sleepy utility with guaranteed growth," says Todd Rosenbluth, a Standard & Poor's telecommunication analyst, who has a sell rating on the stock. "You have to look deeper. Margins are narrowing, debt is mounting, and growth is elusive."

And competition hasn't disappeared. Although the upstart telecoms -- known as competitive local exchange carriers (CLECs) -- have been wounded, they're not dead. Take Allegiance Telecom (ALGX). While its stock is trading below $1, it's reporting gangbuster growth -- at the expense of the Bells, including Verizon. Allegiance's 2001 revenues rose 80%, to $500 million, from $278 million in 2000. This year, it expects an additional 50% increase.

According to a Federal Communications Commission report released in February, 2002, CLECs served 17.3 million, or 9%, of the 192 million access lines in June, 2001, up from 7.7% in December, 2000. This growth occurred in a year when many of the CLECs were imploding.

"OUT OF BALANCE." Competition, even if relatively weak, is eroding prices -- and the fat margins Verizon needs to launch wireless and data services. On June 4, Verizon Vice-Chairman and President Lawrence Babbio told an audience at the Supercomm trade show in Atlanta that low prices on cellular, long-distance, and high-speed Internet service had eroded profits and accelerated telecoms' woes.

"Everyone seems to want every service to every home or business at an ever-decreasing price," he said. "Don't get me wrong: I'm all for lower prices.... [But] I would contend that today, we are out of balance. We are driving huge benefits for the customer, but we are not creating enough value for the shareholder."

Babbio was quick to add that Verizon remained profitable because its size has created scale and efficiency. But the numbers show that even Verizon's size can't protect margins. In 2000, its margins on earnings before interest, tax, depreciation, and amortization (EBITDA) were 61%. In 2001, EBITDA margins fell to 57%.

RATINGS REVIEW. This year, S&P estimates margins could fall as low as 55%. It's no wonder: In the first quarter, Verizon lost $500 million, or 18 cents a share, compared with net income of $1.6 billion, or 58 cents, a year ago. Revenues were $16.4 billion, down 0.7%.

Declining margins and profits are raising questions about Verizon's $60 billion debt load. On May 31, Moody's announced it was reviewing Baby Bell's long-term debt ratings for a possible downgrade. The rating agency is concerned about expanding competition and the increasing use of e-mail and cell phones, resulting in flat growth in the bread-and-butter local-phone business.

Moody's won't make its final decision until late July or August. Many analysts are expecting it to lower Verizon's ratings by one notch, to investment-grade A2. That could spell trouble.

VIRTUAL MONOPOLY. To upgrade its wireless network and deliver promising new data services, Verizon may need to tap the capital markets, and a downgrade would make it more costly. "That's problematic anytime, but it's especially troublesome for a phone company facing declining revenue growth," says S&P's Rosenbluth. In a statement, Verizon expressed confidence that its rating would remain unchanged. "We feel that any review of our company will bear out that we are better positioned to take advantage of changes in the industry than any other telecom company," said Doreen Toben, Verizon executive vice-president and CFO.

Bulls point out that Verizon can still rely on its local-phone business. Although it's not growing, they say, Verizon maintains a virtual monopoly in that market. However, that business too is eroding -- faster than many realize. Verizon's access-line growth rate slowed in 2000 and finally went negative in the first quarter of 2001.

Since then, the rate of decline has continued to accelerate: In the first quarter of 2002, Verizon access lines declined 1.1%, down sharply from the 0.1% drop in the year-ago period. Verizon executives say the future lies in the launch of digital subscriber lines (DSL), long-distance, and wireless. But the company appears intent on protecting its local-phone monopoly: From 1999 to 2001, 70.2% of Verizon's capital expenditures went toward domestic telecom services.

DISAPPEARING CASH. That would make sense for a company developing an emerging market, but the local-phone business isn't emerging -- it's supposed to be the mature cash generator, says Philip Jacobson, a telecom analyst at Vienna (Va.) research firm Network Conceptions. "Instead of a cash cow throwing off funds for the development of wireless and other markets, the cash is disappearing back into the property, plants, and equipment used to support its core business, and no material growth drivers are apparent," he says.

Verizon spokesman Robert Varettoni counters that domestic telecom expenditures include investments in long-distance and DSL. In the short term, he adds, Verizon is scaling back its capital expenditures in 2002 to $14 billion to $15 billion, from $17.4 billion in 2001.

Verizon does have competitive advantages. It's the longtime phone company in the Northeast, one of the nation's most densely populated regions. "We sometimes lose sight of Marketing 101 fundamentals: The greatest marketing force is inertia," says Richard Nespola, president and CEO of TMNG, a Kansas City telecom consultancy. "With a commoditized product such as phone service, inertia is even greater. That will benefit an incumbent like Verizon."

REALITY CHECK. However, in this environment, that may not be enough. Right now, Verizon's stock price depends on perpetuating its reputation as a victor in the telecom wars. But they're still raging. "For me, the jury is still out. The traditional business is eroding, and the new growth areas look neutral at best on a profitability basis," says Susan Kalla, a telecom analyst at Friedman, Billings and Ramsey.

If so, it's time for a reality check on Wall Street. Otherwise, Verizon investors could pay a heavy price. Black writes about technology for BusinessWeek Online in New York

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