Static from a Telecom Tie-Up

The proposed megamerger between AT&T and BellSouth will have a huge effect on vendors and peers

From Standard & Poor's Equity Research

The proposed $67 billion merger between AT&T (T) and BellSouth (BLS) announced Mar. 5 has resonated throughout the market -- especially among the two telecom titans' vendors and competitors. If approved, the deal would spawn a newly created behemoth far larger than rivals Verizon (VZ) and Qwest Communications (Q), while also potentially affecting the profitability of some vendors.

The combined entity, which would have a 1.39% market-cap weighting in the S&P 500, would be the biggest provider in the wireless, broadband, video, voice, and data markets. Its estimated $165.9 billion market value would push its capitalization past that of Verizon, valued at approximately $94 billion, and Qwest, at about $12 billion.

AT&T boasts that the BellSouth merger would create one entity "better able to speed the convergence of new and improved services for consumers and businesses, and embrace the industry's shift to Internet Protocol network-based technologies."


  What that translates into for its telco peers is volatility, S&P equity analyst Todd Rosenbluth believes. He expects the merger will further shake up the U.S. telecom industry. "Over the long term, we see the potentially enlarged telco better integrating its wireline and wireless business to compete with national carriers such as Verizon Wireless," says Rosenbluth. "We think it's a negative for rivals because it increases the national presence for AT&T in their backyards," he adds.

Before the market opened on Mar. 6, S&P Equity Research downgraded its opinion on AT&T shares to sell from hold and reiterated its sell ranking on BellSouth. S&P thinks there will be many pressures on AT&T stock over the near term -- and not necessarily coming from telecom companies. Rosenbluth says competition from cable companies will likely continue in the markets AT&T and BellSouth operate.

In the short term, S&P expects BellSouth to be less aggressive in its spending efforts in calendar 2006 as it awaits merger approval.


  Qwest, which traded higher on Mar. 6 on the belief that it may be an acquisition target, is already trading at a premium to its peers. That valuation is unwarranted, in Rosenbluth's view. He maintains his sell recommendation on the stock, citing its lack of wireless ownership, low margins, and the expectation of continued access line losses.

In addition, he doesn't see Qwest as a near-term acquisition candidate and views the pending AT&T/BellSouth deal "as meeting company-specific wireless needs rather than industry developments." Rosenbluth reiterated his hold recommendation on Verizon on Mar. 6.

Stocks in related industries felt the ripples from the telecom blockbuster. Shares of Tellabs (TLAB) -- which supplies access equipment to BellSouth to support its fiber-to-the-curb efforts, which have been under way for the past few years -- fell on Mar. 6. Rosenbluth, who's maintaining his hold opinion on the shares, notes that Tellabs' vendor relationship is stable in the near term due to the likely lengthy integration period for the new technology.


  Longer term, there will be some operational benefits, Rosenbluth believes, as the merged companies leverage their platforms to integrate the company's wireless, wireline, and IP products and services over a single global IP network. Together, they will also have much more buying power, pressuring suppliers to lower their prices. That, in turn, prompted S&P to reevaluate its opinion on some vendors' shares.

The proposed merger -- as well as the continued trend of carrier consolidation around the globe -- will likely make some suppliers' shares more volatile than others, S&P believes. This has prompted Ken Leon, S&P equity analyst, to reassess the rankings of companies for which he sees convergence and competition to new Internet-based solutions leading to price pressure and lower margins.

These factors will have negative investment implications particularly for Lucent (LU) and Nortel (NT) in S&P's opinion. As a result, Leon downgraded his investment opinions on both to sell from hold and cut his target prices prior to the market opening Mar. 6.


  On the other hand, exposure to the AT&T and BellSouth deal is minimal for Cisco (CSCO) and Motorola (MOT), S&P believes. S&P equity analyst Ari Bensinger thinks that because Cisco's total sales to providers such as AT&T and BellSouth are less than 25%, it's less exposed than peers to the proposed deal. "We see solid growth in Cisco's enterprise market, as businesses upgrade their networks to handle increased bandwidth requirements," Bensinger noted in reiterating his buy opinion on Cisco shares on Mar. 6.

Likewise, S&P's Leon believes wireless-handset vendor, Motorola will remain unaffected by the deal. Leon reiterated his strong buy opinion of the stock on Mar. 6. "Compared to its two major U.S. peers, Lucent and Nortel, Motorola is a market leader to cable-TV operators. So with more than 70% of total sales from non-telco markets, we believe Motorola is well positioned to grow faster than [its] peers," Leon says.

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