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"Tread Carefully" in Telecom Stocks

Telecommunications is an area rife with challenges, and investors should "tread carefully," in the words of Todd Rosenbluth, Standard & Poor's analyst of telecom stocks. Even with the broad market testing new highs, Rosenbluth reports that S&P recommends underweighting telecom-services stocks.

Among the challenges weighing on the industry are increasing competition between wireline and wireless service and the advent of two potentially powerful new trends: local-number portability and phone service via voice over Internet protocol (see BW Online, 12/12/03, "The Sound of Phone Cords Severing"). In addition, Rosenbluth considers that some telecom stocks "are currently trading at unwarranted multiples."

However, he sees a few bright spots. He likes rural wireline carriers Alltel (AT) (ranked buy) and accumulate-rated CenturyTel (CTL) and Commonwealth Telephone (CTCO). S&P also has buy ratings on Nextel (NXTL) and Nextel Partners (NXTP), he reports (see BW Online, 12/2/03, "An Easy Call on Nextel Partners").

These were among the points Rosenbluth made in an investing chat presented Dec. 9 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Todd Rosenbluth has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Q: Today was a banner day for the market, with the Dow touching 10,000 again. Is there any equivalent excitement in the telecom sector? How does it look?

A: We remain negative on the wireline-services stocks and underweight the telecom-services sector, regardless of today's developments. We see a number of challenges facing the telcos as we head into 2004.

Q: Is that because of business problems, valuations, or some of each? Amplify on those challenges, if you will.

A: It's both business challenges and valuation challenges. On the business side, particularly for wireline telecom companies, we see challenges from wireless substitution, from cable competition, and increasing operating expenses to restrict profitability growth. Meanwhile, some of the telcos have climbed in value and are currently trading at unwarranted multiples.

Q: What are some dividend-paying stocks in the telecom sector?

A: A number of dividend payers are out there. Our favorite -- and only buy-recommended stock in the wireline space, is Alltel Corp. (AT) -- its dividend yields more than 3%. There are less attractive total-return plays, such as SBC Communications (SBC), which we believe faces greater operational challenges that will restrict overall investor gains in the stock.

Q: Time-Warner (TWX) just announced a deal with Sprint and MCI for cable Internet phone service using voice over Internet protocol, or VOIP. What's your feeling toward voice over Internet stocks?

A: I don't cover Time-Warner or any pure-play VOIP stocks. However, we think that over the longer term, VOIP creates a challenge for the traditional telcos such as SBC and Sprint FON (FON), which we have an avoid recommendation on. We think that VOIP is still a 2004-05 issue but remains a threat to the telcos.

Q: How about Verizon (VZ)?

A: We currently have a hold recommendation on Verizon. We have concerns regarding the wireline side of the business from increased competition. And we also are concerned about Verizon's earnings quality, given the significant charges the company will take regarding workforce cuts. However, due in part to the wireless arm and our valuation methodology, we would hold Verizon shares near our 12-month target price of $32.

Q: When is Nextel (NXTL) going north instead of sideways? The company is making money.

A: Nextel, which my colleague Ken Leon covers, is one of our favorite telecom stocks. We have a buy on Nextel and believe its nationwide Direct Connect offers it differentiation in a challenging operating arena. We have a 12-month target price on Nextel shares of $31.

Q: When will consolidation take place in the wireless sector?

A: We believe that consolidation will need to happen in both the wireless and wireline space in order to reduce aggressive pricing competition. However, we don't expect anything to develop until all the potential players complete their balance-sheet restructurings and local-number portability shakes out. We expect local-number portability to be a bigger issue for the wireline companies in 2004.

Q: What are your top picks?

A: We favor rural wireline carriers, such as Alltel, CenturyTel (CTL), and Commonwealth Telephone (CTCO). And on the wireless side, we like Nextel (NXTL) and Nextel Partners (NXTP). Despite increased competition in the telecom space, these carriers stand out to us.

Q: Are those last all buys?

A: Nextel, Nextel Partners, and Alltel are buy-recommended shares. CenturyTel and Commonwealth Telephone are among our accumulate, or 4-STARS, recommendations.

Q: Can AT&T (T) make a recovery? If so, to what extent?

A: We have a hold recommendation on AT&T shares. We believe the company will likely offset some of the challenges in its long-distance operations with an increased focus on local-service bundling and the enterprise space. However, we see margin pressure and operational risks restricting significant share price growth.

Q: What are your thoughts on Vodafone (VOD)?

A: S&P has an avoid opinion on VOD shares. Our analysis suggests that VOD lacks the competitive advantage to achieve industry-leading profitability and higher-than-average returns on capital. We believe the shares trade at an unwarranted premium to its European peers.

Q: Will tax-loss selling affect prices in Qwest (Q) the next two weeks?

A: We believe Qwest shares will keep pace with the broader market. We're encouraged by the company's debt-reduction steps and that it has resumed filing quarterly statements. However, we see multiple operational risks in its wireline and wireless offerings and also believe this stock trades above its peers. Our 12-month target price is $4. We would hold Q shares.

Q: What about Global Crossing? They should emerge soon.

A: We do not follow Global Crossing, as they are still in bankruptcy proceedings. However, we follow one of its peers, Level 3 Communications (LVLT). We have a sell recommendation on LVLT shares.

Given the pricing pressures on both its telecom and software segments, we don't see Level 3 reaching profitability in the near term. Given its relatively high valuation, we would sell LVLT shares.

Q: Any update on Telephone & Data Systems (TDS)? They seem undervalued, given everything they own.

A: We have a hold opinion on TDS. We have a 12-month target price of $68. However, TDS is a majority owner of shares in U.S. Cellular (USM). USM is an accumulate-recommended stock, given EPS [earnings per share] growth and relative valuation analysis.

Q: What's your feeling on Nokia (NOK)?

A: Nokia, which we classify as a technology stock, is a buy-recommended opinion of one of my colleagues. We expect TDMA handset market share gains to be a key growth driver for NOK. Given the company's dominant market share and our view of superb execution, S&P recommends investors buy NOK shares.

Q: What's your opinion on Comverse Technology (CMVT)?

A: CMVT, one of our technology stocks, is an accumulate recommendation. We believe CMVT has benefited from strong demand for its wireless products. With the shares trading below peers, in our opinion, we would add to positions in CMVT.

Q: Has Sprint PCS (PCS) any chance of recovery?

A: We have a hold on Sprint PCS but see losses in 2003 and 2004. We believe the company needs to do a better job integrating with its brother stock Sprint FON. We have an avoid on Sprint FON shares, believing that pressure in its local and long-distance markets make the stock unattractive.

Q: The other recent big news in telecom was the advent of number portability. How will that affect telecom stocks?

A: We believe number portability, both from a wireline-to-wireless perspective and a wireless-to-wireline perspective, will be a negative factor. On the wireline side, a study we're completing this week -- which will be available upon request -- is indicating that wireline-to-wireless will lead to increased substitution and pricing pressure. More details on the impact of local-number portability will be made available later on this week.

Q: A related question -- do you think mobile operators are a threat to the residential market of the Baby Bells?

A: Yes, we definitely do, both from pure land-line substitution and increased wireless usage. We believe the wireless carriers are putting sizable pressure on the Baby Bells, such as SBC Communications. We expect an increased impact from wireless substitution to occur, given local-number portability.

Q: What are your thoughts on BellSouth (BLS)? Do you see merger possibilities?

A: We have a hold opinion on BellSouth. We're modestly encouraged by the company's bundling efforts, but we see competitive pressures in both wireline and wireless products, leading to a 2% decline in 2004 revenues.

Given BellSouth's intention of stock buybacks and increased dividends, and the company's current valuation, we have a hold on BLS shares. The wireless challenges we mentioned for BLS are identical for co-parent SBC, as they jointly share in Cingular Wireless' prospects. We believe Cingular is one of the weaker of the national wireless carriers and has to improve on a number of metrics to better compete with its peers.

Q: What about Talk America (TALK)?

A: We don't cover Talk America, but believe the company is competing aggressively against SBC, which we have mentioned throughout this chat. TALK is a small-cap stock. One of our favorite small-cap telecom-related plays is Intrado (TRDO), which provides 911 emergency infrastructure for wireline and wireless companies. We see continued expansion of TRDO's earnings and free cash flow and have a 12-month target price of $30.

Q: Finally, Todd, any quick tips on strategy for would-be telecom investors at this point?

A: We [would] tread very cautiously in the telecom arena, given sizable competition in both the wireline and wireless spaces. Our favorite stocks -- Alltel, Nextel, and Nextel Partners -- are unique for the space, given the lack of direct competition in their operating markets.

We don't believe this is the case for stocks such as SBC, FON, or Cincinnati Bell (CBB). We again have an underweight recommendation for the telecommunications sector.

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