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Telecom Stocks to Dial For

The telecommunications industry seems to have a better ring these days, as evidenced by two moves Standard & Poor's has just made: It raised its asset-allocation recommendation for telecom services from underweight to market weight, and it upgraded AT&T (T) stock from hold to buy.

That's the report from Todd Rosenbluth, analyst for Standard & Poor's Equity Research Services, who adds that the S&P Telecom-Services index was up 5.9% through the end of February, vs. a 3.2% rise in the S&P 1500. He expects the improvement to continue along the overall economic expansion. Despite pricing pressures, he sees benefits for both wireline and wireless services, even as the boundaries between the two varieties tend to blur.

Among the pluses Rosenbluth sees for AT&T is an ability to add Internet phone service, via voice over Internet protocol (VoIP), in many markets and to reduce access costs. In addition to his buy on AT&T, he mentions similar rankings for stocks such as Alltel (AT), Nextel (NXTL), Nextel Partners (NXTP), and Intrado (TRDO).

These were some of the points Rosenbluth made in an investing chat presented Mar. 2 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 is a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Q: Todd, in this somewhat jagged upward climb of the stock market, how has the telecom sector been doing?

A: This morning, Standard & Poor's Equity Research raised our outlook on the telecom-services sector to market weight from an underweight position. We believe the telecom-services sector has tended to be a strong performer as the economic expansion matures. Through the end of February, the S&P Telecom-Services index was up 5.9%, vs. a 3.2% rise in the S&P 1500.

Q: Does that apply to wireline as well as to wireless companies? Or is the line between them blurring, as a story today on BW Online suggests (see "Tearing Down the Walls in Telecom")?

A: The line is blurring between wireline and wireless companies -- something I am happy to discuss is greater detail during this live chat. Our recommendation for a market weighting in telecom services is for both wireline and wireless stocks. Although we see challenges facing many companies in the industry due to pricing pressures, we have selective buy recommendations on both sides of the telecom fence.

Q: What do you think of the CLECs [competitive local-exchange carriers], and particularly US LEC (CLEC)?

A: Standard & Poor's does not have stock recommendations on any pure-play CLECs. However, part of the basis for S&P's upgrade of AT&T (T) shares to a buy recommendation from a hold is due to its growing local presence, which is similar to the business model of the CLECs.

Q: Is SBC (SBC) still a good defensive play with its dividend, or is it going to be dragged down by AT&T Wireless (AWE), which SBC and BellSouth (BLS) are buying via their Cingular joint venture?

A: We have an avoid recommendation on SBC shares. We believe the planned deal to acquire AT&T Wireless creates large risks for SBC, including the need for a wireless rebranding. We believe that the benefits of the AWE deal are highly uncertain.

For telecom investors looking for a strong dividend yield, we recommend buying AT&T, which yields roughly 5%, and Alltel (AT), which yields 3%.

Q: Are there any young telecom companies up and coming you would invest in, and why?

A: We have a buy recommendation on Intrado (TRDO) shares. Intrado is a small-cap company that provides 911 and e-911 wireless services for most major telecom companies. We see 25% EPS [earnings per share] growth potential for Intrado and find the shares appealing on the basis of discounted cash flow and a below-peer p-e/growth ratio.

Q: What are the next three to five years going to look like for telecom-equipment stocks like Cisco (CSCO), Nortel (NT), and Lucent (LU)?

A: While I don't follow telecom-equipment stocks for S&P, we have selective buy recommendations in this space, including Qualcomm (QCOM), Nokia (NOK), and Cisco. Our time horizon is on a 12-month target-price basis.

For Cisco, we see the stock reaching $36. For Nortel, we have a 12-month target price of $7. We have a hold recommendation on Nortel, as well as one on Lucent.

Q: What do you think of WorldCom MCI Group (MCWEG) reorganizing and having a viable stock?

A: Until MCI emerges from bankruptcy, Standard & Poor's has no investment opinion on the shares. We expect the company to emerge from bankruptcy during the next few months and to create challenges for other telecom carriers, such as SBC and BellSouth. MCI historically has been an aggressive competitor.

Q: What's the likelihood of Nextel (NXTL) being bought?

A: There have been consolidation rumors for the wireless companies ongoing for the past two years. The most recent deal -- the proposed deal for AT&T Wireless, which we discussed earlier -- is likely to close in late 2004.

Our buy recommendation on Nextel shares is the result of our belief that the company offers a superior differentiated service in a crowded operating arena. We expect Nextel to benefit from the havoc that should result, in our view, from Cingular's planned acquisition of AT&T Wireless.

Q: Do you have an opinion on the recombined Sprint (FON) and Sprint PCS (PCS) going forward?

A: Yes, we do. S&P has an avoid recommendation on Sprint FON shares. Given our view of the high dependence on wholesale operations in the wireless segment, Sprint's long-overdue cross-selling efforts, and challenges from wireline competition, we think Sprint shares trade at an unappealing valuation. Our 12-month target price for FON is $16.

Q: Do you think rural companies will continue to exist, i.e., CenturyTel (CTL)?

A: We believe that rural companies -- such as CenturyTel, which we have an accumulate recommendation on -- will be around for the foreseeable future. Rural carriers such as CenturyTel and Alltel provide local and long-distance service to customers in less densely populated markets.

In our view, due to the limited competition in these markets, rural carriers such as CenturyTel offer an appealing investment vehicle.

Q: How do you see the risk of voice over Internet for regional Bells?

A: We believe that VoIP adds an additional challenge for the operations of the Baby Bells, such as SBC and BellSouth. We believe that carriers such as AT&T, which we have a buy recommendation on, and Vonage [a privately held company, which S&P doesn't follow], will be able to reduce their cost structures by avoiding the traditional access to the Bell's networks.

Q: Is there any good way to participate in VoIP?

A: We believe that buying shares in AT&T is one such avenue to benefit from the growing presence of VoIP. S&P sees AT&T's VoIP service rollout helping to control AT&T's cost structure. AT&T has told us they expect to offer VoIP in major metropolitan markets throughout 2004.

Q: What's your recommendation on Verizon (VZ)?

A: We have a hold recommendation on VZ shares. We expect Verizon to be among the near-term beneficiaries of Cingular's planned acquisition of AT&T Wireless. We expect Cingular to face sizable integration issues that should allow Verizon to gain market share.

However, we still see wireline challenges for Verizon, stemming from pricing pressures and wireless substitution.

Q: What about ADC Telecommunications (ADCT)?

A: My colleagues at S&P have a hold recommendation on this company's shares. Based on our view of ADCT's strong market position, we see the company as one of the few broadband vendor survivors.

Q: Todd, you've mentioned several of your "selected" buys in telecom -- can you give us any more?

A: We mentioned earlier buy recommendations on AT&T, Alltel, and Nextel. The only one I had not mentioned earlier is a rural wireless carrier, Nextel Partners (NXTP). Nextel Partners' largest shareholder is Nextel Communications, which owns 30%. NXTP benefits from NXTL's support in marketing in second-tier U.S. cities.

We also have accumulate recommendations on some other stocks not mentioned. Besides CenturyTel, we have an accumulate opinion on Canadian telco BCE (BCE). We believe BCE shares are appealing relative to U.S. Bells on both valuation metrics and customer loyalty.

Another accumulate recommendation is rural telco Commonwealth Telephone (CTCO), which continues to exhibit access-line growth in its Pennsylvania territory. CTCO shares trade below peers, despite our view of stronger customer loyalty and wider margins.

Q: Can you comment on Qwest (Q)?

A: We have a hold recommendation on Qwest shares. Although we expect operating challenges to persist in 2004, we're encouraged by the company's wholesale-wireless arrangement.

Q: What impact will wireless have on the fiber-optic buildout?

A: We expect telecom carriers to spend a large portion of their capital spending on both wireless and fiber to the premises (FTTP). Both offer opportunities for the telcos to grow their business in the face of intense pricing pressure on the wireline side of the business.

We have mentioned throughout this segment the pricing pressures, which we expect to hurt not only the Baby Bells but also Cincinnati Bell (CBB). CBB is one of the stocks that S&P has a sell opinion on.

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