from: DSL Prime [1]

Note: The NYT reports [2] 1/24/08 that AT&T profits are up for this quarter.

DSL Prime: Wall Street Falls
DSL Prime examines the future of the Bells as Wall Street slowly passes its own flawed judgment.

by Dave Burstein
of DSL Prime and Future of TV and the Web Video Summit
[January 23, 2008]

"I'll take Manhattan, the Bronx, and Staten Island too, I'll turn Manhattan into an isle of joy."
—FiOS is coming to New York

Friday, January 18, 2008, 1:30 local time, working a few miles from the New York Stock Exchange. U.S. telcos have lost over $20 billion on the market today, an amount changing by billions every few minutes. 3:15 They've dropped another $5 billion. This is a big story, likely to have worldwide repercussions, so I've dedicated most of this issue.

If I had sent out the headline AT&T, Verizon: Up So High They Look Down Very Far yesterday when I wrote it, I'd be acclaimed a prophet. It would have been an accident; I didn't expect today's drop. There's a real possibility that the U.S. telco market drop will spread around the world, although my best guess is things will ease up.

Wish I could spend the week at DLD, Hubert Burda and Yossi Varda's worldclass Munich event. Marc Mangold has assembled remarkable speakers. I'll haven't sold enough ads lately, so I'll have to watch the webcasts at http://www.dld-conference.com/.

Apologies to readers outside the U.S. for the local focus. I have stories coming from Viviane Reding of the EU, Hanaro, and Sri Lanka that I'm holding over to another issue because this is so long.

AT&T, Verizon: Up So High They Look Down Very Far
The $20 billion AT&T price drop wasn't irrational
Be very, very cautious. I wrote the headline above on Thursday January 17, although I had no idea the telcos would implode on Friday. DSL Prime is not an investment report, but covers the market because of the impact. A great classical economist explained that a crisis in the financial markets has enormous repercussions in the real world. (Originally put as "a crisis in the realm of circulation" affects "the realm of production." Details in volume two.)

On January 17th, the price earnings ratio (GAAP, not "normalized") of AT&T was 19.50 and Verizon was 21.71. A recent p/e for the Standard and Poor's 500 was 15.79 and the Dow Jones 15.96. That only makes sense if the telcos were likely to grow earnings significantly faster than the average company. That's unlikely.

Three years ago, most of us expected hard times for telcos and problematic earnings. VoIP and cable were coming, and many governments were promoting competition. So many people had purchased wireless, future growth was limited. That's not how it has played out in the U.S. so far, with strong earnings and cashflow lately. It may revert.

The current tendency of the market is to overemphasize cash flow, dividends, and buybacks—compared to long term earnings. The effect in the real world is dire, with many companies (Qwest, AT&T) cutting capex to below depreciation. This is the primary reason most of the U.S. and the U.K. are getting a second rate Internet. Cuts raise cashflow and the stock price, but take a high price in the long run. Pricing is clearly irrational on fundamentals, although to pick stocks, you have to go with the mad crowd. Then you pray you catch the turn before it wipes you out.

Some thoughts on AT&T: AT&T has had strong earnings for several years and some very good results. Until recently, almost all analysts expected very good earnings in 2008 as well. Don't forget that as you read on. The iPhone is the finest small computer ever designed, and will be even more of a killer in the 3G model. In addition, Randall is proving a much more effective manager than I expected.

One of the very best analysts on the street, John Hodulik, told me telco investors are very fearful. Another strong analyst suggests the market was counting on wireless to drive AT&T's earnings sharply higher. Sprint's problems suggest wireless may be in trouble.

January 8th Randall Stephenson made a comment about customers not paying their bills, and AT&T shares were briefly down $20 billion, ending the day about $12 billion lower. That was an over-reaction that convinced me investors were very scared, and inspired this item.

From July 2006 to July 2007, AT&T shares rose a remarkable 48 percent despite having essentially no significant major news. That was too much.

I have no reason to believe there has been any fraud or breach of accounting rules, but AT&T has reported a remarkably consistent pattern of increases in earnings and dividends. Especially in the face of industry problems, this is unlikely without careful "control" of earnings.

Several times in the last few years, I've spotted anomalies in SBC's financial reports, including literally billions in "special charges." I've several times asked for details and been refused answers. For example, I've asked several times for an explanation of the accounting treatment of the investment of over $1B in Prodigy, which became essentially worthless. They wouldn't tell me either the current book value or when/whether they took a writedown. I'd like to repeat I have no evidence of any financial impropriety. I believe this was large enough to be material and should have been disclosed.

Since at least 2002, analysts have been pointing out issues with telco accounting for capital spending, etc. that the companies have never provided enough information to analyze.

Most significant, AT&T's capital spending since 2002 has been cut in half to 20 to 30 percent less than their depreciation. Over five years, their depreciation was $42B and their capex $31B. Unless they have a major discrepancy in their balance sheet, that implies they are not maintaining their network. This has raised their cash flow and stock price significantly, but presumably will bite them eventually.

Ed Whitacre planned to retire in 2007, which gave him enormous incentive to maximize the stock price and hence his options in 2006-2007. In fact, his options made him over $100 million in 2006. This is consistent with a pattern of operating in the short term the last few years and having problems thereafter.

AT&T's earning the last few years have been propped up by efficient operations, numerous price rises as states deregulate, and a turnaround in wireless when Nextel and the old AT&T Wireless were taken over. There are many reasons to think those trends are playing out.

While people are holding on to their wireless phones, many can sharply reduce their bill by switching from a $50 postpaid plan to a $15 prepaid plan, which is what I have. Many people can keep their calls short enough to stay within 100 minutes on cheap prepaid.

Sprint

The 26 percent/$8 billion drop is wildly disproportionate to the actual change in earnings the problems suggest, especially as the stock has already fallen sharply.

That does not mean the stock price now is too low, however. An alternate explanation is that Sprint (and others) were valued much too high six months ago, and it's now catching up.

Sprint's market cap is $24 billion as I write. Their long term debt is $21billion. Their property plant and equipment is $25 billion. Even assuming a 25 percent overstatement in ppe, that values the company at a total of about $25 billion, ignoring goodwill, intangibles, and other soft items.

That is less than the value of their approximately 50 MHz of spectrum across the U.S., priced according to previous auctions. That gives no value to the existing operation, customer relationships, etc. On fundamentals, if you don't think the U.S. wireless market will collapse, it's a buy. I do not expect the market price to reflect fundamentals in the short term, of course.

The mobile WiMAX is likely to work fairly well in short order, based on experience with the equipment around the world. That will be a substantial asset.

Verizon

Verizon, unlike AT&T, has invested significantly in their network. FIOS works wonderfully, and I'm separately reporting they are in line to get a New York City video franchise. Their wireless network is terrible, but not as bad as the others in the U.S. Opinions differ on whether the $20 billion FIOS investment will pay off in full (I think so), but there definitely is significant value there and half the cost is already sunk. The more advanced Verizon network should be more valuable than AT&T's and much more resistant to cable erosion. For several years, the market has gone the other way.

The other issues are similar to AT&T: competition and technology worries that make it hard to justify a multiple higher than the market.

International telcos BT, DT, FT, NTT, Telfonica, and Telecom Italia did not move in parallel with the U.S. companies. Many investors will be expecting problems there on Monday if things don't rally. Hard to call. Both Vivianne Reding and Mathias Kurth have told me they intend to further reduce mobile fees and encourage competition; they will face many of the same issues. Every country is different, of course, and I don't have the depth to support opinions here.

Level 3 and Qwest may well suffer if a tough economy leads important corporate customers to choose AT&T or Verizon for security. Qwest's investment ratio is deplorable and their network is on borrowed time.

Regional U.S. telcos were clobbered, although they are unlikely to hit the same problems as the bells. They are highly leveraged, so falling interest rates are good for them. However, they have been investing even less than AT&T, which should start to hurt. Jessica Zufolo at Medley broke the important news that the Bells are in position to drastically increase their share of the universal service fund, at the expense of the regionals. Virtually all U.S. regionals are dependent upon wildly inappropriate USF and Intercarrier Compensation, and have borrowed far more than assets are worth. One CEO told me that if USF were cut, his dividend was in trouble; if ICC were rationalized, he'd default on his bonds. Fortunately for the companies, D.C. Doesn't look to be cutting so much this year or next.

Suppliers are likely in even more trouble than previously, as many companies will cut capital spending to pump up the stock prices. ADC, Adtran, Tellabs, and Westell are particularly concentrated on the U.S. market.

I do not pick stocks or time the market. Todd Rosenbluth of S & P remains optimistic that the problems will be confined to Sprint, and the other companies will continue to do well. In particular, he sees room for more upside at AT&T. Other informed opinions think it's more likely than not telco stocks will rebound; two top analysts haven't changed their ratings, and I expect some others to suggest to "buy on weakness." In the longer run, however, telco stock prices are higher than the market and their growth slower. Competition remains weak, but not as weak as previously. Danger, Will Robinson.