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For Whom the Bells Toll

By Todd Rosenbluth The Baby Bells -- BellSouth (BLS

, recent price $28.80), SBC Communications (SBC

, $25.50), and Verizon Communications (VZ

, $39.50) -- which have faced a multitude of operational challenges in the past six months, received some relatively good news on Mar. 2. In the latest development in their long-running tussle with competitors over the access fees charged for traffic on the Bells' local phone network, the District of Columbia Circuit Court ruled to vacate parts of the Federal Communications Commission's rules enabling wholesale access by competitors -- principally AT&T Corp. (T

, $20.10) and MCI Communications Corp. -- to the Bells' network through the unbundled network element platform (UNE-P). The court remanded the issue back to the agency.

The UNE-P framework was established by the FCC in its implementation of the Telecom Act of 1996. It allows competitors to purchase access to the Bells' local network at prices that often represent a significant discount not only to the company's retail price, but to its wholesale service tariffs as well (see BW Online, 3/2/04, "How VoIP Hits the Sticks").

While the ruling appears to be a modest victory for the Baby Bells, we at Standard & Poor's Equity Research Group are keeping our negative outlook on the group, also known as the Regional Bell Operating Companies (RBOCs). We believe that the legal tussle over the wholesale-access issue is far from over. We expect additional appeals and stays in the case. The ultimate result: The status quo should remain in place over the next year.

WIRELESS DRIVE. Meanwhile, we expect competitors such as AT&T to continue to penetrate the local wireline markets of the RBOCs, helping to restrict their profitability.

The wireline skirmish comes as two of the RBOCs -- SBC and BellSouth -- have intensified their push into wireless communications through the Feb. 17 offer of their jointly owned Cingular to buy AT&T Wireless (AWE

; $13.70). We think the planned deal creates large risks for both SBC and BellSouth. Once the acquisition is completed, they will need to rebrand the wireless unit to Cingular in major East Coast and Mountain region markets.

For its part, Cingular sees merger benefits from cost synergies, including staff reductions, which we believe may distract AT&T Wireless employees in servicing its 21.9 million customers, as of the end of 2003. In our view, benefits from the deal in future years for BellSouth and SBC are highly uncertain.

WEIGHT GAIN. Looking at BellSouth, we see operating earnings per share declining from $1.95 in 2004 to $1.58 in 2005. We're keeping our 2-STARS (avoid) opinion on the stock, which recently traded above our 12-month target price of $24. As for SBC, we see its operating EPS declining from $1.41 in 2004 to 91 cents in 2005. We also have a 2-STARS ranking on SBC, which is trading at levels above its peers based on price-to-earnings and cash-flow measures.

The best-situated of the Baby Bells with direct wireless exposure, in our opinion, is Verizon. We expect it to be among the near-term beneficiaries of the Cingular-AT&T Wireless deal. Although Verizon Wireless is likely to lose its ranking as the largest U.S. wireless carrier, we believe that it will take additional market share in 2004, while Cingular is distracted with sizable integration issues.

Also, Vodafone (VOD

; $24.60) remains on board as the company's partner in Verizon Wireless after its own failed bid to buy AT&T Wireless. As a result, Verizon Wireless's pockets should remain deep. This should enhance its competitive position as it looks to poach Cingular customers. We still see challenges ahead for Verizon's wireline business, but we have a 3-STARS (hold) opinion on the stock, given our expectations for likely relative stability of earnings.

While we're not bullish on the Baby Bells, Standard & Poor's recently raised its recommended weighting in the entire telecom-services sector to marketweight, from underweight. While we see pricing competition remaining high, we believe investors should be gravitating selectively toward higher cash-generating and dividend-paying wireline stocks such as AT&T Corp. and Alltel (AT

; $51.80), as well as wireless companies offering a differentiated service - e.g., Nextel (NXTL

; $26.41) and Nextel Partners (NXTP

; $13.18). Each of those stocks carries S&P's highest investment ranking of 5 STARS, or buy. Analyst Rosenbluth follows telecommunications services stocks for Standard & Poor's Equity Research Group

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