Will the Baby Bells Crack, Too?

As telecom reels, they've been stalwarts. But the slowdown and new rivals could take their toll

Amid the wreckage in the telecom industry, the giant local telephone companies have been pillars of stability. With near-monopolies in providing local phone service, Verizon Communications (VZ ), Qwest Communications (Q ), Alltel (AT ), and similar companies overseas have been able to crank out steady financial results while their rivals have suffered from overcapacity and the slowing economy. The result? Many of them scored top spots in BusinessWeek's annual ranking of the top technology companies in the world. Verizon hit No. 2, Alltel took the No. 31 slot, and Qwest showed up as No. 78.

So are local phone giants truly safe havens in the telecom maelstrom? Plenty of experts think so, including Lehman Brothers Inc. analyst Blake Bath, who did some of the best research that anticipated the industry's current troubles. He believes the Bells will continue to perform well, while the long-distance companies will suffer from falling prices, and the upstarts will run out of cash. That could set the stage for Verizon, SBC Communications (SBC ), and BellSouth (BLS ) to each buy one of the Big Three long-distance companies: AT&T (T ), WorldCom (WCOM ), and Sprint (FON ). "It's over," says Bath. "They've won the war."

But telecom's giants are hardly without risk. There are early signs that the slowing economy will take a toll on them in the months ahead. SBC recently conceded that it won't meet Wall Street's earnings estimates for the rest of 2001. On June 1, BellSouth said it will miss its earnings estimates for the second quarter. And some analysts fret that Verizon will be next. Analyst Dan Reingold of Credit Suisse First Boston downgraded Verizon to "buy" from "strong buy" because he doesn't think the company can earn the $8.6 billion this year that Wall Street is expecting.

Why the concerns? While customers don't unplug their phones when times get tough, they do slow their purchases of the new services that have provided strong growth for local phone players in recent years. They may, for example, be less willing to buy a new mobile phone or extra local-phone services, such as voice mail and caller identification. On top of that, competition is bringing prices down for everything from long distance to wireless service. Already, SBC's wireless-revenue growth is expected to slow to about 15% this year from 20% in recent years, according to Sanford C. Bernstein & Co. "We're a little concerned about growth over the next year," says Brian Hayward, portfolio manager at Invesco Telecommunications Fund, which held stakes in all of the Baby Bells, ranging from 57,000 shares in Verizon to 182,000 shares in Qwest, as of Mar. 31.

Of more concern is the data market. Verizon and others are counting on a surge in revenues from Internet and data services in the next few years to help boost growth. Verizon's data revenues are projected to rise from about $5 billion last year to $15 billion in 2005, according to Bernstein. But competition from giants such as WorldCom as well as smaller players remains intense. That could drive down prices and crimp revenue growth. Consider upstart Cogent Communications, which has raised $426 million in financing so far. It offers companies a 100-megabit connection to the Net for $1,000, which is nearly 100 times the capacity companies typically get from their local phone company for that price. "Our marketing strategy is simple: Bandwidth is a commodity, and we're 100 times cheaper," says Cogent Chief Executive Dave Schaeffer. "That's a very dangerous proposition."

With that kind of pressure, Verizon and its peers are hardly shoo-ins to dominate the industry. They'll have to execute well, particularly in the new markets they are entering--data, long distance, and wireless. "I don't think anyone is a safe haven," says Ivan Seidenberg, co-CEO at Verizon. "Our story is that we got ahead of the industry. As long as you stay one step ahead of the posse, you're O.K."

EXPANDING. Verizon is doing more than O.K. in the long-distance market. After winning regulatory approval to enter New York last year, the company has swiped about 22% of the state's consumer market. That helped boost its long-distance customers to 5.2 million at the end of March, up 500,000 from last year. And that's just the beginning: As Verizon wins regulatory approval in more states, Bath figures its long-distance revenues will rise from $3.2 billion this year to more than $5.2 billion in 2003.

Verizon's future in the data market may not be as bright. Its data business Genuity (GENU ) was spun out as an independent company to satisfy regulatory concerns last year and is expected to be reacquired as early as 2003. But Genuity has struggled since becoming independent as corporations have slowed their spending on data services and its cash supply has become tight. In May, the company laid off 800 employees and revealed that its revenues this year will be no more than $1.4 billion rather than the $1.8 billion it had previously projected. "It's no great shakes these days," says Hayward.

Certainly, the local telephone giants have shown rare stability during the telecom meltdown of the past year. But their future is hardly assured. They'll have to demonstrate that they're capable of executing in new communications markets before they can declare victory in the telecom game.

By Peter Elstrom in New York

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