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Time to Hang Up on SBC

By Todd Rosenbluth With wireless plans offering buckets of minutes that can be used for local or long-distance calls at an affordable price ($39.99 a month could buy 600 "anytime" minutes), it's not surprising that wireless competition has been pressuring traditional wireline outfits like the regional Bells. According to researcher Yankee Group, the average U.S. wireless subscriber logged 490 minutes per month in the fourth quarter of 2002. This usage surpassed the 480 minutes per person each month for landline voice usage, the research firm estimates, based on the average monthly household total of 1,250 minutes and 2.6 people per household. Besides the attractive price plans, another issue known as local number portability (LNP) is likely to intensify the move from wireline to wireless service.

LNP lets users keep their phone number when changing service providers. Unlike in Europe and in Asia, U.S. customers wanting to switch wireless carriers or completely abandon their wireline phones are deterred from doing so because they must then pass along a new phone number to friends, family, and other contacts. Despite objections from wireless-industry groups, the U.S. Court of Appeals for the District of Columbia in June upheld the legality of a pending regulation from the Federal Communications Commission (FCC) that would allow number portability between wireless service providers. And in an about-face, Verizon Wireless announced on June 24 that it will make number portability easy for its customers.

DIM PROSPECTS. We at Standard & Poor's believe that in November, 2003, LNP will be implemented by the FCC. Not only will this impose additional expenses on all wireless providers but it will also have a potential impact on revenue growth at SBC Communications (SBC), the second-largest regional Bell operating company (RBOC), covering primarily the South and Midwest.

First, SBC's 60%-majority-owned joint venture, Cingular Wireless, stands to be one of the biggest losers when LNP is allowed, since the second-largest wireless carrier has a number of holes its in network and a greater need for spectrum than its wireless peers. Despite joint-venture arrangements with AT&T Wireless (AWE) and T-Mobile to carry each other's traffic, we believe Cingular's poor network quality has been a primary reason why the company had a net loss of subscribers in the third and fourth quarters of 2002.

Although Cingular added 186,000 subscribers in the first quarter, this was driven primarily by the prepaid segment through its rejuvenated "Keep in Contact" offering. We believe customer dissatisfaction continues. Once customers can switch their Cingular phone number to Verizon Wireless, Sprint PCS (PCS), or T-Mobile, we see SBC's wireless-service revenues falling 5% in 2004.

LITTLE LOYALTY? Second, LNP and wireless substitution will hurt SBC's local wireline business. Along with the rising percentage of communications traffic shifting from wireline to wireless, outright substitution will likely occur. About 3% of U.S. customers already have eliminated their wireline phones and gone entirely wireless. We see this rate climbing if customers are able to take their local wireline phone number with them when leaving the house, a proposal being discussed at the FCC.

This substitution will hurt all wireline carriers, including fellow RBOCs Verizon (VZ) and BellSouth (BLS). However, we believe SBC's customers are less loyal than in the rest of the industry due to the company's lack of a long-distance offering in four Midwestern states and also because of the federally mandated wholesale access rates offered by SBC to competitors in its service areas.

Although we anticipate SBC gaining FCC approval to offer a bundle of local and long-distance service in all of its markets by the end of 2003, the lack of allegiance to SBC is already evident in its 5.7 million unbundled network element (UNE) lines in service as of March, 2003. UNE provisions permit competitive local exchange carriers (CLECs) to obtain wholesale access to RBOC network elements they do not own, interconnect them with their own network elements, and put their equipment on RBOC premises to connect between unbundled elements.

LOSING SHARE. Although UNE rates vary according to assumed usage levels and retail revenues per access lines, SBC is generally required to sell its services to CLECs at discounts of at least 35% on what their phone operations charge retail customers. The low price allowed competing carriers to enter the local market and offer households a cheaper calling plan. Thus, CLECs and interexchange carriers (IXCs) AT&T (T) and MCI (formerly named WorldCom) have become the cheaper alternative to SBC, particularly in Ohio and Michigan.

We believe that the FCC's Triennial Review Order -- anticipated by July -- focused on wholesale access rates, and that it will be consistent with the initial decision in February, 2003, fostering a low UNE rate environment. We contend that the ruling will likely allow competitors such as AT&T the opportunity to take market share away from SBC, particularly in those Midwestern states such as Michigan and Illinois where SBC cannot yet offer a similar bundle of local and long-distance service. We also believe AT&T will have sufficient time to switch these new customers to a facilities-based network if and when the UNE platform ceases to exist.

We see the access-line losses SBC incurred in 2002 and to date in 2003 continuing. We expect SBC's local-voice revenues to fall an additional 5.6% in 2004, after an expected 8% decline in 2003. In addition, although SBC is increasingly penetrating the market with DSL offerings by bundling the service with its local calling plans, it's competing aggressively on price with a number of cable companies that enjoyed a head-start in the broadband market.

TIME TO SELL. Furthermore, we believe SBC's earnings quality is poor due to its historic use of pension benefits. In 2002, we estimate that SBC's Standard & Poor's Core Earnings of $1.21 per share, restricted by pension and postretirement cost adjustments of 82 cents per share, was 45% lower than its operating earnings.

While SBC has some positives, including a higher dividend yield than its peers and a relatively strong balance sheet, we would recommend selling the shares given the multitude of operational challenges and the stock's high valuation. In our view, SBC is the most expensive of the Baby Bells on a price-earnings basis, trading at 16 times our operating 2003-04 estimates, vs. a peer average of 14 times.

We also believe that the stock, which settled at $25.94 on June 26, is more than 15% overvalued on a discounted cash-flow basis. Key elements of our discounted cash-flow model include a beta (a measure of volatility) of 0.77, a weighted average cost of capital of 8%, and modest declines of cash flow from 2004 through 2006, but 1% to 3% growth thereafter. Analyst Rosenbluth follows telecommunications services stocks for Standard & Poor's

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