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Telecom's Merger Fever

In the telecommunications sector, mergers are the trend of the moment. Though there has been a rash of combinations between the large national and regional telecom service providers, rural operators such as CenturyTel (CTL) and Commonwealth Telephone (CTCO) could be ready to do some deals with smaller outfits, says Todd Rosenbluth, who follows telecom services stocks for Standard & Poor's Equity Research. "We believe the next wave of consolidation is likely to be focused more on the smaller rural properties and see the large independent rural providers such as CenturyTel as being among the acquirers," he says.

Rosenbluth has a neutral investment outlook for telecom services stocks given the intense competition from cable as well as wireless substitution. However, he likes rural players CenturyTel and Commonwealth based on his belief that they operate in a stronger, more stable environment than the larger providers.

BusinessWeek Online's Karyn McCormack recently spoke with Rosenbluth about these companies and stocks to avoid, along with the latest merger announcement between Lucent Technologies (LU) and Alcatel (ALA) (see BW Online, 4/5/06, "The Alcatel Effect"). Edited excerpts of their conversation follow.

Note: Todd Rosenbluth is a Standard & Poor's 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 story.

Will the planned Lucent-Alcatel merger change the way telecom service providers buy equipment?

Prior to this announcement, telecom service providers such as Verizon (VZ) and AT&T (T) had, in our view, gained significant buying power over their suppliers. This power has helped to bring pricing down for their fiber initiatives, broadband rollouts, and other projects. While we believe an enlarged supplier such as a combined Lucent-Alcatel can somewhat offset the current pricing landscape, we believe the telecom service providers continue to have the ability to set demands in the near term.

Do you see more consolidation?

The AT&T-BellSouth deal that was announced earlier this year follows recent mergers among the largest of the telecom providers. We expect sizable integration issues for the combined companies and have sell recommendations on AT&T and BellSouth (BLS) shares. We believe the next wave of consolidation is likely to be focused more on the smaller rural properties and see the large independent rural providers such as CenturyTel as being among the acquirers.

What about concerns that AT&T could return to a monopoly?

The AT&T-BellSouth deal will gobble up another local property under one roof. However, we think the newly formed AT&T is not as dominant a provider as the old Ma Bell given what we see as formidable competitors in cable and wireless companies.

What's your outlook for the telecom service companies?

We have a neutral investment outlook on the telecom services sub-industry. We think cable competition and wireless substitution will remain intense in 2006. However, cost synergies from recent mergers and an expanding bundle of services should help the industry generate adequate cash flow to support dividends and stock buybacks.

What are your favorite stocks in the group?

We have strong buy recommendations on CenturyTel and Commonwealth Telephone, two rural telecom providers that we believe operate in a stronger, more stable environment than the larger providers. Due to the less densely populated markets they serve and support from the federally mandated Universal Service Fund, we believe customer loyalty and EBITDA margins are stronger than most in the industry, and as such these stocks deserve to trade at premiums to its peer group. Cable competition is extremely limited and wireless substitution is muted in most of the markets these two companies serve.

Are there any stocks to avoid?

In addition to sell recommendations and AT&T and BellSouth previously mentioned, we have a strong sell opinion on Qwest Communications (Q). We believe Qwest is overvalued given its ongoing customer losses, still-leveraged balance sheet, lack of growth from wireless, and EBITDA margins below peers. We have a $4.50 target price on Qwest shares and believe that without a dividend, they have less downsides support than peers.

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