Bigger Telecom, But Not Stronger Stocks
For traditional wireline telecommunications companies, big mergers won't mean higher stock prices. The group has already had a strong run this year: Year-to-date through June 16, the subindustry index was up 15.3%, vs. a 0.3% increase in the S&P 500. Plus, we at Standard & Poor's Equity Research see competitive challenges that will restrict growth for the rest of the year.
Our fundamental outlook for the Integrated Telecommunications Services (wireline) subindustry is neutral. We at S&P believe that the large integrated services providers will generate adequate free cash flow in the near term, even after making large acquisitions and battling newer competitors.
We think that the telecom landscape was significantly altered with the formation of AT&T (T) via the merger of SBC Communications and AT&T in November, 2005, and the acquisition of MCI by Verizon Communications (VZ) in January, 2006. Further shaking up the industry, in our view, will be the recently proposed merger of AT&T and BellSouth (BLS), subject to necessary approvals.
We see AT&T and Verizon causing imbalance in the second half of 2006 as they begin to compete with each other and other telcos by leveraging their national presence with customers and suppliers. Furthermore, we believe that the second half of 2006 will begin to see some of the synergies of the already completed deals adding to free cash flow.
In the first quarter of 2006, the top four telecom carriers—AT&T, Verizon, BellSouth, and Qwest (Q)—lost in excess of 5% of their access-line relationships due to technology substitution to digital subscriber lines as well as competition from cable and wireless substitution. In the second half of 2006, we project these companies will continue to lose access lines at an accelerated pace as telephony rollouts from top cable providers continue and telecom providers keep prices for DSL service low to attract former dial-up customers.
We believe growth in wireless units should be the driver of results for the major telecom providers in 2006. While voice services have become a commodity, evidenced, in our view, by the decline in voice average revenue per user (ARPU) in the 2006 first quarter, data services and overall customer growth should help to increase wireless revenues in the low double digits.
We expect the telecom providers to further roll out fiber-based broadband and video services to their customers in 2006 in an effort to combat cable competition and offer a quadruple play of services to gain a greater share of consumer spending. By the end of 2005, consumers were spending approximately $170 a month on wireline, wireless, Internet, and TV services. With spending on wireline services declining in the past 12 months, we expect telecom providers to focus on growing their share of the other communications categories.
We see Verizon deploying fiber-based broadband and video services to an additional 3 million households in 2006, and expect AT&T to launch its own service in the latter half of the year. We expect smaller telecom providers to wait until equipment pricing for such services declines before rolling out faster broadband speeds. However, even with an increased focus on capital spending for fiber initiatives, we believe the telecom providers will generate sufficient cash flow to support share buybacks and modest dividend increases, some of which were already announced in the first quarter of 2006.
Rural incumbent carriers should, in our view, continue to operate in a less competitive arena, but we see wireless and cable competition increasing in 2006, causing access-line losses of 3%-4%.
Here's our outlook for the four largest U.S. telecom-service providers:
We have a 3 STARS (hold) ranking on Verizon shares. We expect total revenues of $93.5 billion in 2006, including the acquired MCI operations, up from $75 billion in 2005. Organic revenues should rise, in our view, with strong customer growth in the wireless joint venture, and long-distance and DSL penetration outweighing a decline in the domestic telecom unit's voice revenues, stemming from fewer access lines. We estimate operating earnings of $2.52 a share in 2006. Even with an increase in capital spending, we believe Verizon will generate free cash flow to buy back some shares in 2006.
AT&T and BellSouth
We have a 3 STARS (hold) ranking on AT&T and BellSouth shares. We expect 2006 normalized revenues, including the wireless joint venture and acquired operations, to be $86.3 billion. Organic revenues should be driven primarily by Cingular Wireless.
On the wireline side, we expect access-line losses and price discounting on bundled services to persist amid increased competition, but data and long-distance revenues should be higher. Our operating earnings estimate for 2006 is $1.95 a share.
We expect BellSouth's 2006 normalized revenues (including the Cingular wireless joint venture) to be up 2%, driven primarily by customer growth at Cingular. We project operating earnings of $2.00 a share.
In the proposed acquisition, BellSouth shareholders are expected to receive 1.325 AT&T shares for each BellSouth share, but there is no downside protection. As a stand-alone company, we believe BellSouth faces investment risk given that recent growth at Cingular stemmed from lower-margin prepaid and wholesale customers. We also believe that wireless substitution and cable competition should lead to continued residential-line losses. In the first quarter of 2006, BellSouth lost 8.8% of these lines.
Qwest is ranked 1 STAR (strong sell). We believe Qwest's wireline customer retention and revenues will perform in a similar fashion in 2006 to 2005, even as the company further bundles services, given increasing cable and wireless competition.
We project that revenues will rise 1.2% in 2006, aided by DSL gains and estimate operating earnings of 7 cents a share, including 2 cents for projected stock-option expense. In our view, Qwest faces challenges similar to those faced by other large telcos, but does not have as many positive characteristics.
We believe the shares are overvalued, based on our view of the company's relatively weak margins, high debt leverage, the absence of a dividend, and a limited benefit from wireless operations. With its high percentage of access-line losses and weak margins, Qwest, in our view, is not a peer of rural telecom providers, which trade at similar premiums to the Bells and have similar capital spending programs.
In 2005, Qwest lowered its capital expenditures as a percentage of revenues to 11.6%, from 12.5% the year before, and further reduced spending to 11.2% in the first quarter of 2006. We are concerned that Qwest is investing less in newer technologies and services than its peers.
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