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S&P's Call on AT&T: Buy

By Todd Rosenbluth After a long period of underperformance, things may be starting to look up for AT&T's stock (T

; recent price, $19). We at Standard & Poor's Equity Research perceive Ma Bell's fundamentals to be stabilizing, especially in regard to its margins, which could create the potential for upside earnings surprises. We are also positive on the company's rollout of voice over Internet protocol (VoIP) services, its improving balance sheet, and strong cash generation.

And based on three different measures, we consider the shares undervalued. AT&T trades at multiples below its peers on a net earnings and EBITDA (earnings before interest, taxes, depreciation, and amortization) basis. In addition, we see the shares as undervalued based on our

discounted cash-flow analysis. AT&T is a top pick in Standard & Poor's telecommunications-services universe The stock carries S&P's highest investment recommendation of 5 STARS, or buy.

BUNDLES OF JOY. Following the spin-off of AT&T Wireless (AWE) in 2001 and the sale of AT&T's broadband unit to Comcast (CMCSA

; recent price, $19) in 2002, AT&T provides long-distance and local-phone service to businesses and consumers throughout most of the country. In 2004, AT&T has widened its offerings to include wholesale digital subscriber line (DSL) services and wireless services under the AT&T brand.

AT&T's Business Services segment (72% of 2003 revenues) provides regular and custom voice services, data and Internet protocol services (IPS), hosting, outsourcing, and other consulting services to more than 4 million small, midsize, and large domestic and multinational businesses.

Its Consumer Services segment (28%) is the largest U.S. provider of consumer long-distance services. It offers inbound and outbound domestic and international long-distance, transaction-based long-distance services (operator assistance and prepaid phone cards). Consumer Services also offers local service by gaining wholesale access to the local carrier's network.

In our view, the insights offered by AT&T at its analyst day in late February on its IP network and services -- as well as its integration capabilities -- supported our thesis that it can partially offset intense business competition through the strength of its network and its breadth of services. We expect AT&T to benefit from its bundling of local-phone service with its historical long-distance offering. During the meeting, AT&T discussed the planned introduction of local services to 11 more states in the first quarter of 2004, bringing the total to 46. It has more than 4 million local-service customers.

COST CUTS. The local-services market accounts for about $37 of consumers' average monthly communications spending, which is more than four times the average spending for stand-alone long distance, the market AT&T has historically dominated. While the Baby Bells are moving to retain their telecom customers and defend their local share, we believe that AT&T's entry into the local-services market offers the company the opportunity to expand its share of consumers' wallets beyond the small price of long distance.

We also view favorably AT&T's expansion of its DSL offering to 17 additional states in the first quarter of 2004, and on the business side, its growth in IP traffic and hosting services. Furthermore, we believe that, despite likely increased competition from the Bells in the large-business market, AT&T will remain the carrier of choice for Fortune 500 companies given its brand name and, in our view, a network that's stronger than its competitors.

Pricing pressure from Baby Bell and wireless competition caused EBITDA margin erosion of nearly 300 basis points in 2003. In 2004, we expect the margin-erosion trend to dissipate somewhat, as AT&T rolls out VoIP. It already serves hundreds of businesses with its managed VoIP services and is the industry leader in IP networking. AT&T plans to expand its VoIP portfolio and aggressively market a full suite of VoIP-enabled services to business customers worldwide. It has also begun rolling out a new VoIP consumer offering in major cities across the U.S.

APPEALS AND STAYS. AT&T has said that through the use of VoIP -- and bypassing the Baby Bells' networks -- it can reduce U.S. and international outbound costs by up to 30%, as it has with wholesale local offerings. We anticipate that the Federal Communications Commission will continue to classify VoIP as an information service, allowing AT&T and other carriers the opportunity to keep access costs low.

In March, 2004, the District of Columbia Circuit Court ruled to vacate parts of the FCC's rules that have enabled AT&T to gain wholesale access to the Bells' networks through the unbundled network element platform (UNE-P), remanding the issue back to the FCC (see BW Online, 3/4/04, "For Whom the Bells Toll"). We believe that this process is far from complete and expect additional appeals and stays to cause the status quo to remain in place over the next year. We expect AT&T to continue to penetrate the local wireline markets of the Bells throughout 2004.

We look for AT&T's revenues to decline 7.5% in 2004, to nearly $32 billion, hurt by minutes-of-use-substitution and competitive pressures. We see Business Services accounting for about $24 billion of that figure, and Consumer Services $8 billion. We expect AT&T's bundle penetration to increase throughout the year as the company offers local and long-distance bundling to new markets in the first half of the year.

DROPPING INTEREST EXPENSE. Despite workforce and access cost reductions, we believe EBITDA margins will narrow by about 200 basis points, to 23% from 25% in the prior year, due to higher pension-related expenses, lower call volume, and increased selling expenses. We expect depreciation charges to decline following recent capital-spending reductions. In addition, with total debt declining by $8 billion in 2003 and with AT&T expected to repurchase additional notes this year, we project interest expenses to decline by more than $250 million in 2004.

We see 2004 EPS of $1.58, vs. 2003's $2.36. We note that our EPS outlook for 2004 remains ahead of the Wall Street consensus estimate, which is for $1.33. For 2005, we expect EPS of $1.36, reflecting a 5% revenue decrease and EBITDA margins of 23.5%.

Over the next few years, we expect AT&T to use its free cash flow to continue to pay down debt and to expand its VoIP network capabilities. We believe AT&T's future prospects are dependent upon the company moving traffic away from the traditional Baby Bell carriers' networks and onto its own network.

EXCESSIVELY DISCOUNTED. In our view, AT&T's quality of earnings is low. After a series of adjustments made to net income (based on generally accepted accounting principles, or GAAP) to conform to Standard & Poor's Core Earnings methodology, our 2004 EPS estimate of $1.58 would be reduced by 54%, to 73 cents. The difference reflects an estimated 28 cents in option expense and a 59-cent pension-related credit. This variance compares similarly to the differential estimated for telecom peers SBC Communications ( SBC

; S&P rank 2 STARS, avoid; $24) and BellSouth (BLS

; S&P rank 2 STARS; $27).

Using our 2004 estimates, AT&T trades at an operating price-earnings ratio of about 12 and enterprise value to EBITDA of 3.2, which, in our view, are excessive discounts to the respective peer averages of 16 and 5.9. We believe that AT&T faces fewer operational hurdles than some its peers that trade at premiums to it. Our expectation is for this discount to narrow over the next 12 months, as AT&T executes on the programs discussed at its February analyst presentation.


discounted cash-flow model calculates a value of approximately $22.50 per share, which implies price appreciation potential of about 18% from recent levels. Blending our valuation techniques, we arrive at our 12-month target price of $25. With that potential for price appreciation -- and AT&T's quarterly cash dividend of 24 cents a share (a 5% dividend yield) -- we would purchase the shares.

Potential risks to our investment recommendation and our 12-month target price include aggressive pricing wars from distressed carriers, consolidation in the wireline industry, unfavorable regulatory changes, weak economic demand, and geopolitical events. Analyst Rosenbluth follows telecommunications services stocks for Standard & Poor's Equity Research Services

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