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Wireless: Harsh Signals for the Telecoms

The biggest challenge for the traditional telephone companies is the migration to wireless. Indeed, the latest numbers from the Federal Communications Commission showed slightly more wireless customers than wireline phone lines. That's the report from Todd Rosenbluth, Standard & Poor's analyst focusing on telecom-services stocks. Rosenbluth thinks this trend will continue, especially among people 25 and younger.

One result: stocks of telecom-services companies have lagged so far this year, with a drop of 9.9% at a time when the broad S&P 1500-stock index is up fractionally. Rosenbluth attributes this to lower profitability stemming from customers switching to cable or wireless and from price reductions to meet the competition.

In this environment, Rosenbluth has strong buy recommendations on only two stocks he personally covers. One is CenturyTel (CTL), which covers rural areas less affected by competition. The other is Amdocs (DOX), a provider of billing and customer-care services to telephone and cable companies.

These were among the points Rosenbluth made in an investing chat presented Nov. 1 by BusinessWeek Online as Rosenbluth answered questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts of the chat follow:

Note: Todd Rosenbluth is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

Todd, how has the telecom sector been doing as S&P sees it?

Year to date through October, the telecom-services sector has underperformed the broader market. Specifically, telecom-services stocks are down 9.9%, vs. an S&P 1500-stock index that's up fractionally. We at Standard & Poor's continue to recommend investors underweight the telecom-services sector of their portfolio.

What's your diagnosis of why telecom is lagging?

We believe that competitive pressures from cable and wireless substitution have had a significant impact on the telecom-service providers. In addition to the loss of customers to these newer technologies, the phone carriers have had to react with a reduction in pricing, which we believe has hurt their profitability.

The MCI (MCIP) and Verizon Communications (VZ) deal -- good for the consumer, stockholder, or neither?

We expect that Verizon will complete its acquisition of MCI by early 2006, and we see the deal helping the combined company as it offers a suite of services to consumers and business customers nationwide. We believe this pending deal, along with SBC Communications' (SBC) planned acquisition of AT&T (T) will line these two telecom behemoths up to compete aggressively against the smaller carriers.

What's your current rating on Verizon?

We have a hold recommendation on the shares of both Verizon and the soon-to-be-acquired MCI [see BW Online, 10/17/05, "Cutting the Cord on Local Service?"].

Do you have strong buy ratings on any service providers at the moment?

The only telecom-service provider that we have a strong buy recommendation on is CenturyTel (CTL), a rural provider. We believe CenturyTel is buying back shares, and we see the company as a potential buyer of additional rural lines. We view it as attractive relative to its peers and have a 12-month target price of $40.

Among the other stocks that I cover for Standard & Poor's, we have a strong buy opinion on Amdocs (DOX), which provides billing and customer care for telecom and cable providers. Amdocs is set to report quarterly results Nov. 9, and we see continued demand for their services to keep driving the stock. We have a 12-month target price of $34 on DOX.

If cable and wireless companies have been hurting the traditional telecoms, how have they been doing? Any recommendations from S&P there?

I don't cover pure wireless-services stocks, but my colleague has a buy recommendation on Sprint Nextel (S), which derives the majority of its revenues from wireless services. The cable companies are soon to report their third-quarter results, but we expect that in the third quarter, the original Bell companies like Verizon will have gained a sizable amount of broadband customers in the recent period.

Do you see even more consolidation among the wireline-service providers you follow? Seems like they're undoing the breakup of Ma Bell so many years ago.

We expect the SBC and Verizon mergers to go through as planned. Then for 2006, we expect that there will be local phone lines on the table, as Sprint Nextel plans to spin off the local rural phone part of their business, and Alltel (AT) is reviewing strategic alternatives that include a similar spinoff of its rural wireline phone base. We think CenturyTel could be a buyer of some of these lines in the near term.

What's the outlook on wireline, etc., competition from the Internet via VoIP [voice over Internet protocol]? Any investment plays there?

We don't cover any of the pure-play VoIP providers but have a hold recommendation on the shares of Level 3 Communications (LVLT) and see growth for this data transporter stemming in part from a pickup in VoIP traffic. We have a $3 12-month target price on LVLT.

We cover a few wireless broadband, or WiMax, companies at Standard & Poor's. We have a buy recommendation on the shares of Alvarion (ALVR). Given what we believe is its time-to-market advantage, we view Alvarion as well positioned to benefit from the growing interest in WiMax technology. We have a 12-month target price of $11. My colleague at S&P covers Alvarion.

Are the companies you follow boosting their budgets, and what are they spending money on these days?

We're seeing an increase in capital spending from both Verizon and SBC communications heading into 2006, driven by wireless growth and their fiber-based video and broadband initiatives. We think the increased spending could help to drive the stocks of telecom-equipment companies, at least some of them. My colleagues at S&P have strong buy recommendations on the shares of Motorola (MOT) and Scientific-Atlanta (SFA).

Do you see hope for Qwest Communications (Q)?

We have a sell recommendation on the shares of Qwest, which reported its quarterly results this morning. Although revenues were slightly ahead of our projection, we still believe shares are overvalued and the company has weaker fundamentals than its dividend-paying peers. Our 12-month target price on Qwest is $3.

When will telecom providers be able to provide video service? Who is the leading company in this technology?

Verizon Communications is the first of the telecom providers to get its fiber-based video product into the market with a launch in Texas earlier this year. We expect that Verizon will roll out its video service more aggressively in 2006 after receiving the necessary franchising rights. Its peer, SBC, is still testing and trialing its video services.

It should be noted that these telecom providers and many others across the U.S. are bundling satellite service from companies like DirectTV Group (DTV) with their telecom services, and they have had some success to date in signing up customers through this bundled service.

If an investor seeks dividends, what are the best bets in your area?

Among the stocks we cover that pay a dividend yield higher than that of the S&P 500-stock average, we have buy recommendations on Citizens Communications (CZN) (with a yield north of 8%), as well as Canadian-based BCE (BCE) (which has a yield of more than 4%). We also have a buy opinion on Tel?fonos de M?xico (TMX), which has a yield of close to 4%. What makes these stocks attractive in particular is that, in our view, they face less competitive pressure than telecom providers such as Qwest or SBC Communications.

Does S&P follow any foreign telecoms besides Telmex that might look interesting?

We have a buy recommendation on Philippine Long Distance Telephone (PHI), which is set to report third-quarter results on Nov. 8. We expect revenue growth of 11%, driven primarily by wireless services. With the shares priced below its peers, we believe the ADRs are attractive.

Are you recommending any stocks to take advantage of growth in China? Would that be wireless services?

My colleagues overseas have hold recommendations on the ADRs of China Unicom (CHU) and China Telecom (CHA). We believe that one way to participate in the growth of wireless services in emerging markets is through Motorola, on which we have a strong buy recommendation, as mentioned earlier.

You have a sell recommendation on Qwest. Any other stocks on which you have a sell, or worse yet, a strong sell?

We have sell recommendations on the shares of telecom-related companies such as Syniverse Holdings (SVR), which provides transport and clearing services for wireless carriers. We believe the stock is overvalued relative to its peers, and we have a 12-month target price of $16. We also have a sell recommendation on Convergys (CVG). We believe Convergys has narrower margins and still faces greater customer-migration risk than its peers. We have a 12-month target price of $15 on Convergys.

How can regular analog lines ever compete with cable providers and digital-phone services? I just don't see that regular phones will survive when people go digital.

While the telecom providers are facing increased competition from cable telephony services, we still expect the majority of consumers will continue to get their phone service from their traditional wireline-phone provider, as these phone companies further bundle wireless and broadband capabilities into the mix.

While there are, in our view, some folks who are always looking for a cheaper or newer alternative out there, we continue to believe that the phone companies will remain in business for decades into the future, even as they have to reduce pricing to keep customers more loyal.

Are there any recent numbers on how far wireless phones have penetrated the market, either as someone's only phone or as a supplement to wireline?

The latest numbers that we've seen from the FCC (from the end of 2004) show slightly more wireless subscribers in the U.S. than wireline phone lines up and running.

We have seen more recent results from Verizon Communications, for example, that show that it's losing some of its traditional land-line customers who are migrating to wireless service. And we think this trend will continue -- in particular with the 25-and-under population. Wireless substitution, in our view, is the greatest challenge the phone companies are currently facing, and we think that rural phone providers such as CenturyTel are affected to a lesser degree, due to the less densely populated markets they serve.

So where should investors go to capitalize on this trend?

I don't want to keep coming back to the same recommendations, but we think Motorola is well positioned with its selling handsets to wireless subscribers, and we have a buy recommendation on the shares of Sprint Nextel, one of the national wireless carriers.

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