Hold the Line on Telcos

The market has factored in the convergence benefits of the reinvigorated telecoms, says S&P's Todd Rosenbluth. But there are opportunities

Telecom stocks have been hot, driven by cash-flow growth and some high-profile deals. So far this year, the Standard & Poor's Telecommunication Services index has jumped 13.5% through June 29, vs. a 6% gain for the S&P 500 index.

The large telcos are generating strong cash flow, but the positive developments from cost synergies and wireless and broadband growth are largely factored into share prices, says Todd Rosenbluth, who follows telecom stocks for Standard & Poor's Equity Research. "Because of the merger activity, many of these stocks have rallied either on the terms of the deal or in anticipation that future mergers will occur," he adds.

The bottom line for investors: "We look at a 12-month time horizon as to what the stocks are worth, and many of them are fully or fairly valued."

Rosenbluth's favorite stock in the telecom-services group is Citizens Communications (CZN), a Stamford (Conn.)-based provider of wireline services to rural areas and small and midsize towns and cities in 24 states, including Arizona, California, New York, and Pennsylvania. He also likes a few communications gear makers, such as Amdocs (DOX) and Corning (GLW).

BusinessWeek.com's Karyn McCormack spoke with Rosenbluth on July 5 about the deal frenzy in the telecom sector and his favorite stocks. Edited excerpts from their conversation follow.

Note: Todd Rosenbluth is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

Deals in telecom are picking up, with the July 2 news that AT&T (T) will buy Dobson Communications (DCEL), and that BCE (BCE) will be taken private. Do you see more M&A coming? What's driving the dealmaking?

There has definitely been a lot of merger activity in the telecom space. Besides AT&T announcing it will acquire Dobson and BCE agreeing to go private, there was a smaller deal that same day: Consolidated Communications (CNSL) bought a small company called North Pittsburgh Systems (NPSI). These deals come on the heels of Alltel (AT) being acquired by private equity earlier in the year and the handful of small rural telecom deals.

We think that the reason why so many deals are happening in a short time period stems in part from the current stage in telecom where cash flows are stabilizing and many telecom companies are looking to benefit from scale (see BusinessWeek.com, 6/25/07, "Telecom: Back from the Dead"). The AT&T-Dobson deal involves AT&T buying a large roaming partner that's going to add about 3% to its customer base. There will be synergies in roaming costs. But if you're an AT&T shareholder, the price they paid to acquire Dobson, at more than nine times EBITDA (earnings before interest, taxes, depreciation, and amortization), is expensive, before one factors in the synergies that remain uncertain at this time.

So do you think the takeover and going-private prices are getting expensive?

Every deal that we're seeing—BCE, Dobson, Alltel—is valuing these assets at premiums to the industry as a whole and assume significant synergies to get the payback. While we recommend investors hold on to shares of AT&T and Consolidated Communications, we believe the prices these companies are paying for acquisitions are expensive.

As for why they're doing it, they believe there are synergies, and we believe there are a scarce number of properties that can help these companies. Because of the scarcity, we're seeing higher valuations than in the past. It's becoming a supply-demand issue. Both private equity companies that are looking to get into this space and existing companies looking for scale have had to pay up to do so.

Which area, wireline or wireless, is ripe for more M&A?

I can't speculate which company will be next to be bought. But the dominance of the four national wireless companies in the U.S.—AT&T Mobility (formerly Cingular Wireless), Verizon Wireless, Sprint Nextel (S), and T-Mobile USA—makes it harder for niche players to compete. So we think there are more opportunities in traditional wireline for merger activity.

On the wireline side, even though AT&T and Verizon (VZ) are the dominant phone carriers, there are many small and midsize phone companies operating in towns and cities around the country. Many of them are not public, and they could add scale and growth opportunities for public companies.

For example, Citizens Communications, which happens to be our top pick and ranked strong buy, announced a small $62 million acquisition on July 5 of a California phone provider. We think there are hundreds of these small phone companies that may make sense for larger rural companies to acquire.

Telecom stocks have had a nice run in the last 18 months. Do you see more gains? What are the main drivers?

We think the telecom sector is going to perform in line with the broader market throughout the rest of 2007. We think the cash-flow stories remain intact, where despite competitive pressure, the dominant phone companies are generating sufficient cash flow to reward shareholders through large share buybacks and large dividend yields. But we look for cable companies to make more inroads and pressure local phone operations.

For those companies that own their own wireless operations, namely Verizon and AT&T, we think this segment will continue to be a major driver of earnings (see BusinessWeek.com, 5/31/07, "Behind the Telecom Rebound").

Will the iPhone provide a boost to sales?

For AT&T, we think the iPhone will help to generate wireless store traffic. While we think iPhone customers will be a percentage of the overall story, we think it will help to increase data-service usage (some wireless plans include unlimited Internet usage). We figure AT&T will add 1.5 million net new customers in the third quarter—some of those will be iPhone customers. Some customers will buy other AT&T products. It's a positive for AT&T even if they don't sell a lot of phones.

What are your favorite stocks?

We don't have a lot of them. Because of the strong performance in the last 18 months, we believe most of the telecom-services stocks in our coverage are fairly valued or overvalued. Our top pick is Citizens Communications, which we believe has above-average EBITDA margins and is rewarding shareholders with a 6%-plus dividend yield.

We are positive on some companies that supply communications equipment. One of them is Amdocs—it's ranked strong buy and provides billing and customer-care support for AT&T, Bell Canada, and Sprint Nextel, to name a few.

Another equipment play is Corning—also ranked strong buy. The company is benefiting from increased fiber deployment by the telecom companies as well as growth in the flat-panel TV display market.