How To Bet On Telecom's Coming Connections

As soon as British Telecommunications and MCI Communications announced their merger plans, investors were abuzz as to which companies might mate in the next monster telecom marriage. There certainly are plenty of suitors, including AT&T and the Bells. The key is to pick companies that are not only tasty takeover targets but also likely to thrive even if they continue to go it alone.

In the U.S. phone market, the competitive local exchange carriers, as they're known in industry jargon, might be strong bets. These upstarts typically have local networks in urban markets that help them woo business contracts with low prices and reliable service. Unlike the Bell operating companies, however, they are free to choose the customers they want to serve. What's more, the Telecommunications Act of 1996 opened up local markets to new competitors, making these companies potential partners--or targets--for long-distance heavyweights who want to crack that market.

CUTTING IN. For example, three-year-old Brooks Fiber Properties has focused on less cutthroat, second-tier markets in such cities as Sunnyvale, Calif., and Grand Rapids, Mich. Kenneth M. Leon, senior vice-president at Chicago Corp., believes that Brooks should start reporting positive cash flow in 1998. Leon estimates the stock is worth about 48 per share, quite a hike above its recent price of 33 1/8. MCI recently took a 3.2% stake in Brooks.

Some smaller long-distance companies could also pair up with a bigger player. Frontier Corp. in Rochester, N.Y., and LCI International, run by a group of former MCI executives, could be tantalizing to a long-distance giant now or to one of the Bells when they get the regulatory go-ahead to enter long distance, probably next year. Frontier, which has local, long-distance, and wireless businesses, is a favorite of Oscar A. Castro, senior portfolio manager at Montgomery Asset Management. He figures Frontier is trading at about 7.4 times its 1997 operating cash flow, slightly below the norm for the telecom industry. "The stock is cheap, and the company is growing very nicely," he says.

Of course, with MCI becoming part of a megadeal, other telephone biggies could emerge as potential targets. Sprint, already 20% owned by Deutsche Telekom and France Telecom, saw its stock jump after the BT-MCI deal appeared. But Uncle Sam would probably make it hard for either of the overseas outfits to buy the entire company until the German and French markets are opened to foreigners in 1998. Still, Smith Barney Managing Director Charles W. Schelke says that, before last week, Sprint was even more undervalued than MCI. He figures Sprint's shares should trade in the 55-to-60 range, compared with its current price of 41 1/2.

Meanwhile, long-distance operators such as BT and MCI might want to add GTE to the stable. GTE boasts an extensive local network in 28 states. Linda Meltzer, an analyst at UBS Securities, figures GTE trades at the same price-earnings ratio of 13 as most local rivals. But GTE has an edge because it has a presence in both local and long-distance phone markets.

In the aftermath of the BT-MCI merger, investors also may want to take another look at cable companies whose shares recently have been laggards. Phone companies might want to use high-capacity cable lines to offer telephone, video, and Internet services. And many highly leveraged cable companies are in need of cash. John Tinker, an analyst at Montgomery Securities, figures that the consolidation trend may benefit Time Warner, which is trading at just under 40. Telecom companies may want to snap up some of the cable assets Time Warner is trying to unload.

WALLFLOWER? For telecom operators with global ambitions, options are narrowing. One of the few attractive companies that has yet to pick a dance partner is London's Cable & Wireless. The company not only has one of the few operations in Britain that competes with BT but also owns 57% of Hong Kong Telecommunications, a major player in the fast-growing Asian market. Salomon Brothers analyst Andrew Harrington wrote in September that Cable & Wireless could be worth up to $35 a share for the American depositary receipts that trade on the New York Stock Exchange. Currently, the ADRs trade around $24.

Certainly, wagering on future takeovers and mergers is not for investors who crave guaranteed returns. But for those willing to place a few riskier bets, the emergence of global phone giants is a trend worth dialing up.

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