Telecom Stocks: On the Rebound

Beaten-down shares such as AT&T and Citizens look attractive, says S&P's Todd Rosenbluth. A big plus: Their dividends are safe

Telecom stocks have gotten battered this year—only financial stocks have fared worse. The S&P Telecommunication Services index has fallen 14.6% so far this year (through June 13), vs. a 7.4% loss for the Standard & Poor's 500-stock index.

Why are investors so sour on telecom? "We think there are concerns about a slowing U.S. economy and increased competition," says Todd Rosenbluth, who follows the telecom sector for Standard & Poor's Equity Research. "However, we think that some of the concerns are overdone and believe selective stocks are attractively valued."

Rosenbluth notes that telecom stocks have recovered some ground in recent weeks because of mergers-and-acquisitions news and excitement around the launch of new handsets. It's also worth noting that investors had enjoyed a strong performance in telecom stocks last year, when integrated telecom services stocks jumped 13.8%, beating the 3.5% gain in the S&P 500.

The analyst's current favorite integrated telecom services stocks are AT&T (T) and Citizens Communications (CZN).'s Karyn McCormack spoke to Rosenbluth on June 19 about recent trends and his outlook. Edited excerpts follow:

How do you think Apple's new iPhone will affect AT&T and other smartphone providers?

We think the pending launch of the new 3G iPhone from Apple (AAPL) this summer will spur demand for smartphones, particularly in North America. We think the ongoing exclusivity of the iPhone with one carrier per country creates opportunities for other handset makers to ride the iPhone wave as wireless customers look to stay loyal to their carrier. For example, Verizon Communications (VZ) customers who are happy with their network will look to buy a smartphone carried by Research in Motion (RIMM) or others. But we think that the price tag of $199 supported by an AT&T subsidy could pressure smaller players such as Palm (PALM). Palm, in our view, has an older, narrower lineup than others.

We think the new product launch is a positive for AT&T, with wireless data as a key driver for AT&T, and the ability to retain all ongoing revenues will be a plus. Despite the negative impact to subsidize the phone, we think the iPhone will improve customer loyalty and help drive AT&T's stock. However, we think the subsidy will put pressure on other phone companies to match or beat the iPhone price. It could result in pricing pressure on the handset side, which could limit wireless operating margin expansion.

The other big news in the industry is merger activity. How will Verizon's proposed acquisition of Alltel change the landscape?

Alltel, the fifth-largest wireless carrier in the U.S., agreed to be acquired by Verizon Wireless, the second-largest carrier. Despite the size of the deal, what's most interesting to us is that Alltel was recently taken private in late 2007, and we were unaware of Verizon's efforts to increase its scale.

However, we see benefits for Verizon if the deal closes as expected—through reduced roaming charges and consolidation of back-office costs. If completed, the deal would make Verizon the largest U.S. carrier, which could result in premium pricing and handset allocation.

Do you see more deals down the road?

We don't think anything of size will be completed in 2008 beyond the Alltel-Verizon deal because of differing wireless technologies, regulatory pressure, and corporate governance matters at individual players.

How are telecom services providers faring against cable operators in providing voice, data, and video services?

Overall, telecom service providers continue to face challenges from wireless substitution and cable competition, which has pressured their total access line counts, or traditional phone subscriber base. While we think pressure will continue throughout 2008, we think the large telecom companies such as AT&T and Verizon will offset this with gains in broadband and video.

What are your strong buy stocks in the group?

We have two strong buy recommendations in integrated telecom services: AT&T and Citizens Communications. In addition to wireless growth at AT&T, we think cost synergy opportunities and an above-average dividend yield are positives.

For Citizens, we see continued room for DSL growth, its strong operating margins, and a 9% dividend yield adding to its investment appeal.

In our view, telecom stocks such as AT&T and Citizens have strong cash flow to support their dividend payments—a characteristic other high-yielding sectors may not offer.

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