Touting Telecom

Large integrated services providers will generate free cash flow near term, even with big acquisitions and battles with competitors

From Standard & Poor's Equity Research

Two recent additions to the are integrated telecom services and tobacco. Heads says I talk tobacco, tails tells me to reach out to telecom. Tails won.

The S&P 1500 Integrated Telecom Services index consists of 10 large-, mid-, and small-cap companies, with AT&T Corp. (T; ranked 4 STARS, buy) being the largest by market value and General Communication (GNCMA; not ranked) the smallest.

Year-to-date through Aug. 11, this subindustry index advanced 24.1%, vs. a 1.2% rise in the S&P Composite 1500 index. During 2005, this group fell 8.9%, vs. a 3.8% advance for the 1500 index.


  S&P's Equity Strategy Group recommends an overweighting of the telecom sector (the subindustries in this sector are Integrated Telecom Services and Wireless Telecom Services), due to its high dividend yield, defensive characteristics, and strong cash flow from wireless operations. But what about the fundamental investment outlook for the sector's largest subindustry?

Analyst Todd Rosenbluth says the investment outlook for the Integrated Telecommunications Services (wireline) subindustry is neutral, as he believes 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.

He says the telecom landscape was significantly altered with the formation of AT&T Inc. (T; 4 STARS, buy) via the merger of SBC Communications and AT&T Corp. in November, 2005 and the combination of Verizon Communications (VZ; 3 STARS, hold) and MCI in January, 2006. Further shaking up the industry, in his view, will be the recently proposed merger of AT&T and BellSouth (BLS; 3 STARS, hold), subject to necessary approvals.

He sees AT&T and Verizon causing imbalance in 2006 as they begin to compete for share of consumer spending and have power over their suppliers. Furthermore, he believes that the second half of 2006 will begin to see some of the synergies of the already completed deals, adding to free cash flow. The number of large telecom carriers has grown as Sprint Nextel (S; 4 STARS, buy) spun out its local operations as Embarq (EQ; 3 STARS, hold) and Alltel (AT; 3 STARS, hold) merged its wireline segment with Valor, forming Windstream (WIN; not ranked).

For those companies having already reported second-quarter results, total access lines and revenues for the wireline companies were restricted by competition from cable companies and wireless substitution, Rosenbluth says. DSL customer growth has been strong, in part because of pricing cuts. In his view, growth in wireless units should be the driver for 2006 results for the major telecom providers. The overall driver of results has been operating cost savings, which he expects to continue.

Rosenbluth expects telecom providers to further roll out fiber-based broadband and video services in 2006 to combat cable competition. He sees Verizon deploying the fiber services to an additional three million households in 2006; AT&T launched its own service in the latter half of the year. He expects smaller telecom providers to wait until equipment pricing for such services declines before rolling out faster speeds of broadband.


  However, even with an increased focus on capital spending for fiber initiatives, he believes telecom providers will generate sufficient cash flow to support share buybacks and modest dividend increases, some of which were already announced in the first half 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," he says.

So there you have it. This group's fundamental turnaround as a result of a return to improved free cash flows, in our view, may already be reflected in the share prices of many of this subindustry's constituents.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500).

  High Momentum Industries
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