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AT&T Has Trouble on the Line

By Jane Black In the world of telecommunications, everything is relative these days. The way investors and analysts see it, companies are in terrible shape (WorldCom and most of the competitive carriers), pretty bad shape (Sprint), and not-so-bad shape -- the Baby Bells, including Verizon, SBC, and BellSouth. Where does AT&T (T) fit in? Ma Bell has seen its shares rise steadily from around $8.50 in August on news that it's rapidly gaining share from the Baby Bells in the local-phone market and profiting from WorldCom's woes. It closed at $12.53 on Oct. 21.

Could the past be the future for the U.S. telecom biz, with AT&T leading the way? Don't bet on it. Sure, the giant has made some great strides. On Oct. 16, it reported that it had grabbed 2 million local residential customers, far exceeding its own projections. And, anecdotally at least, AT&T appears to be attracting some of WorldCom's skittish corporate clients. But with long-distance prices in freefall and the Baby Bells grabbing millions of its residential long-distance customers, AT&T is still fighting an uphill battle, analysts say.

At best, the new corporate and consumer customers should slow expected declines in revenue, which is projected to fall 9%, to $47.7 billion in 2002, and an additional 15%, to $40.5 billion in 2003, according to a consensus estimate from Thomson Financial First Call. But the most valuable piece of AT&T right now, its cable-TV/Internet broadband unit, gets handed over to Comcast (CMCSA) at the end of November.

"BE VERY CAUTIOUS." After that merger is consummated, you're left with stock whose implied value is around $5.60 a share, with most analysts saying it's fairly valued at anywhere from $2 to $5. "No matter how good a quarter they have, I'd be very cautious. This is the incredible shrinking company," says Patrick Comack, a telecom analyst at Miami-based Guzman & Co.

AT&T declined to comment for this story, citing a quiet period before it announces third-quarter earnings on Oct. 22. For that period, it's expected to bring in revenues of $11.9 billion, or 5 cents a share, vs. $13 billion, or 4 cents a share, a year ago, according to a consensus estimate from Thomson Financial First Call. But one quarter's results can't mask the fact that the telecom industry is undergoing its most profound shift since the Justice Dept. split up Ma Bell in 1984.

Gone are the days when one company offered local service and another offered long-distance. Today, telecom is a free-for-all. The local-phone providers, the Baby Bells, are getting into long distance. The long-distance providers, led by AT&T and what analysts say is a wounded MCI, are getting into local. And as competition heats up, the prices any company can charge are falling -- fast.

PAIN IN THE MARGINS. Even worse, it seems no one stands to lose more than AT&T in this high-stakes competition. The Bells are expected to capture 28 million residential long-distance customers, bringing their market share to 40% by yearend, analysts say. Chances are that some of the Bells' gain will come from AT&T's current 60 million residential long-distance customers. UBS Warburg telecom analyst John Hodulik expects AT&T's revenues in that business to fall 22.3%, to $2.9 billion, in the third quarter, vs. a 21.8% decline in the second quarter.

Those declines will weigh heavily on AT&T. Telecom, after all, is a high fixed-cost business. In theory, a provider has to maintain its networks for the optimum number of users regardless of the actual number. When customers defect or new customers aren't found, the result hits margins hard. Warburg's Hodulik estimates that third-quarter margins before interest, taxation, amortization, and depreciation will fall to 22% from 28.5% in the second quarter. By yearend, Hodulik believes margins could drop as low as 19.5%.

On the corporate side, the sluggish economy and increasing use of e-mail and wireless phones continue to lower call volumes on land lines. In the third quarter, Hodulik expects revenues for AT&T's business-services division to decline by 3.7%, to $6.6 billion, from $6.7 billion. EBITDA (earnings before interest, taxes, depreciation, and amortization) margins will remain flat, at 29.6%. And although business spending should recover by the second half of 2003, continued price pressure will keep margin growth flat at best. "Price decline is still the only thing you can count on in telecom," says Guzman's Comack.

LONG-DISTANCE LOSSES. Nor can gains in the local market be expected to pull Ma Bell out of a slump. AT&T's 2 million new local customers won't contribute much to revenue. In states such as Illinois and Ohio, AT&T is offering a $5 discount on long-distance service for customers who also sign up for local service. The result: below-average revenue per line and negative margins, says Legg Mason analyst Daniel Zito.

AT&T is betting, however, that long-distance customers who sign up for its local service will stick with the company. It's a notoriously fickle market. On average, 35% of long-distance customers switch carriers each year. "Customer gains in the local market allow AT&T to prolong cash flow in the consumer business. But I don't think it will ever offset their losses to the [Bells] in long-distance," says Zito.

Not surprisingly, AT&T CEO and Chairman-elect David Dorman disagrees. On Oct. 2, he told investors at a Goldman Sachs conference that his company is "very focused on operational results and what we can do for our customers." He emphasized that AT&T has significant advantages in size and scale on the business and consumer side.

SEEKING STABILITY. Still, the brightest spot for AT&T may be WorldCom's dark days (see BW Online, 6/27/02, "Is WorldCom Opening a Door for AT&T?"). Since most large businesses are locked into multiyear contracts, significant change won't happen overnight. Anecdotal evidence suggests, however, that big customers are indeed seeking a more stable company to provide phone and data services. On Sept. 15, Holmes Group, a $700 million consumer-products company and former WorldCom and Global Crossing customer, awarded AT&T a three-year contract to manage data, hosting, and voice services.

Before the WorldCom bankruptcy filing, Bernstein Research analyst Jeff Halpern had predicted that AT&T would lose share in the corporate data market. Now he's forecasting that its share will range from its current 39% to perhaps 40% by 2005.

Such gains, though, cannot turn the telecom tide, which is flowing against AT&T. That's one reason why, in June, it hired Tom Horton as its new CFO. A former executive at American Airlines parent AMR (AMR), Horton was attractive because he helped AMR navigate through what AT&T execs call "a period of uncertainty." That same uncertainty is coming AT&T's way. Investors should remain wary. Black covers technology for BusinessWeek Online in New York

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