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Cellular Stocks: This Year, Tread with Care

By Olga Kharif Investors who jumped into wireless-service-provider stocks in 2003 are far from sorry. In one of the strongest tech performances, the sector was up 71% year-over-year, according to rating service Standard & Poor's. Fueling the rise were improved industry fundamentals and the less-than-expected impact of newly effective wireless number portability (WNP), which allows customers to take their numbers with them when switching carriers.

This year, however, wireless investing might not be nearly as rewarding, says S.G. Cowen analyst Thomas Watts, who notes that the sector's shares look pricey, and that carriers could feel the delayed impact of WNP by spring. More important, 2004 may well kick off a wave of consolidation, which would reduce the Big Six wireless operators -- Verizon Wireless, Cingular Wireless, AT&T Wireless (AWE), Sprint PCS (PCS), Nextel (NXTL), and T-Mobile -- to three or four survivors.

PICK A PARTNER. The stars for one or two megamergers are aligning. First, a rapidly rising stock market has provided potential acquirers with capital, notes Tole Hart, an analyst with market consultancy Gartner. And ongoing competition means per-minute prices likely will slide an additional 20%, to 8 cents, as new subscriber additions slow, says Roger Entner, an analyst with tech consultancy Yankee Group. All this means the strongest players will be hunting for new revenue sources.

Rumors have risen a notch lately now that Cingular, a joint venture between local phone companies BellSouth (BLS) and SBC Communications (SBC), will do an initial public offering to raise funds for acquiring AT&T Wireless. The combined outfit would be the second-largest, behind Verizon Wireless. Other combinations are possible as well, although for now the companies mentioned decline to comment on the merger speculation.

The possible turbulence means that wireless-carrier stocks are not for the faint of heart this year. And investors will need to be quite selective. "I don't see a need to move out of the group, but there's less of a chance that all boats will rise in the water," says S&P analyst Ken Leon. Here are a few ideas on how to navigate this turbulent industry.

A Cingular IPO: This is likely to be one of the more volatile situations. Cingular's customer churn is among the industry's highest. It also lags behind rivals significantly in other key metrics, such as lifetime revenue per user, according to Yankee Group.

Instead of putting money in the IPO, investors might want to bet on a short-term bump in shares of BellSouth, the stronger of Cingular's parents, says Michael Mahoney, portfolio manager with EGM Capital hedge funds, who does not own the stock. BellSouth would benefit from a successful Cingular IPO even though its core business might continue to deteriorate further this year. Mahoney recommends getting in at around $25 if possible -- a 15% discount on the current price.

A Cingular Acquisition of AT&T Wireless: Investors who are convinced this merger will happen might want to pick up shares of AT&T, which S&P rates accumulate. Analysts say it has been plagued by glitches in transferring customers to other carriers, but AT&T Wireless is working out the problems. And thanks to cost-restructuring efforts, its service margins have risen from 26% in 2002 to 30% in 2003. Those margins should climb a few more points this year, says Leon. Based on discounted-cash-flow analysis, the shares are worth as much as $11 -- a 37% premium over its current price, he notes.

U.S. Cellular (USM): To counter Cingular's move, Verizon Wireless might start acquiring smaller service providers such as U.S. Cellular, says Leon, who holds an accumulate rating on its stock. U.S. Cellular and Verizon Wireless use similar technologies and own contiguous territories. U.S. Cellular is trading 41% higher than a year ago, at $36, so there may be room to run.

Off the Beaten Track: Stocks not expected to be involved in mergers strike quite a few portfolio managers as preferable. Stand-alone Nextel is S.G. Cowen's top wireless pick. It boasts the industry's highest revenue per user, a loyal customer base, and is expected to pick up some government business in January. That could give the stock a bump, says S.G. Cowen's Watts.

Many portfolio managers avoid the Big Six altogether, instead preferring stocks of traditional telcos or smaller service providers. EGM Capital's Mahoney owns Vodafone (VOD), which, along with local telco Verizon (VZ), is the parent of Verizon Wireless -- the largest and most successful U.S. wireless carrier. Most of Vodafone's revenue comes from its wireless businesses around the world, giving it faster growth than traditional telecoms. Also, a Verizon Wireless IPO isn't out of the question -- and could boost Vodafone's stock as well.

Mahoney also likes small wireless outfits like Western Wireless (WWCA), which he has held for more than a year. He believes the stock should appreciate further. Western Wireless isn't as affected by the new number portability law as the bigger national carriers are.

Also, this spring many corporations might begin consolidating their wireless plans under one carrier, ending the usual practice of employees buying separate plans and then getting reimbursed, says Martin Dunsby, vice-president for operations at wireless consultancy InCode Telecom in San Diego. That could lead to a spike in large carriers' churn -- but wouldn't affect Western Wireless. Plus, it could eventually lead consolidation of rural carriers, say some analysts.

A Recombination of Sprint PCS and Sprint: One sure deal is the return of Sprint PCS to its parent, telco Sprint (FON), expected in early 2004. The two hope the deal will save costs and speed the introduction of more bundled services. Short term, however, investors might want to avoid both stocks, despite recent good news from Sprint PCS, which, on Jan. 6, gave better-than-expected guidance for fourth-quarter results.

Because Sprint is the wireless outfit's largest shareholder, "getting fair value is not as likely," says Leon. And the parent company faces ever-increasing competition in its core business.

In the end, mergers and other deals will benefit the survivors by slowing the relentless pace of price competition. But it could make for a turbulent, risky year for wireless stocks. More conservative investors might want to look elsewhere until the industry's consolidation fever passes. Kharif writes for BusinessWeek Online in Portland, Ore.

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