Investment Consult

Time to dial up telecom stocks?

The sector has been hammered, but for aggressive investors, it's chock full of bargains.

Lewis J. Altfest, CFP

Few sectors have been hit as hard as telecommunications. On average, mutual funds that invest in communications companies are down almost 44 percent in the past 12 months and 29 percent a year over the past three years, according to Morningstar.*

What a difference a few years has made. In the late 1990s, when the industry was hot and money was flooding in, many companies expanded into cable, wireless, and other services. Now they're suffering from overcapacity and increased competition. As I write this column, WorldCom has filed for bankruptcy; Lucent Technologies' stock is down 80 percent year-to-date; and Qwest Communications International, whose accounting practices are the subject of an SEC investigation, is restating its earnings for 2000 and 2001. The entire industry seems highly suspect.

But like every financial debacle, the telecom mess brings potential opportunity. Already, world-renowned investor Warren Buffett has purchased $100 million of debt issued by Level 3 Communications, a network provider that's purchasing small companies and gaining new business in its struggle for survival. When someone as respected as Buffett gets behind telecom, individual investors should take a closer look, too.

Which telecom companies will survive and be able to take advantage of what I consider a fundamentally bright future for the industry? Regional service providers, also known as the "Baby Bells." Why not the telecommunications giants such as AT&T, Sprint, and WorldCom? Because long-distance service, their mainstay, has become a commodity product, and competition for customers is fierce. These leading players are all suffering, now that people are increasingly using Internet messaging and cellular service instead of traditional landline connections.

In an amusing reversal, two of the four remaining Baby Bells have stock market capitalizations greater than that of AT&T. They've come out of this rough period in relatively good shape, thanks to two advantages. First, because of their strong infrastructure and lack of viable competition, they enjoy almost a monopoly position in their local markets. Unless the Federal Communications Commission steps in, they're likely to maintain the lion's share of the local phone exchange business.

Second, the Baby Bells have stronger balance sheets. (An exception is Qwest, which in 2000 acquired a regional Bell, US West, and now staggers under the weight of debts totaling $25 billion.) The most robust of the Baby Bells—BellSouth, SBC Communications, and Verizon Communications—will likely grow over the next three to five years by acquiring companies through stock or cash transactions. They all have forward price-earnings ratios that are well below the average forward P-E of the stocks in the S&P 500, which indicates that they may be currently undervalued. (A "forward P-E" is based on what analysts expect next year's earnings to be, whereas a "trailing P-E" looks at earnings from the latest year.)

You won't get rich on BellSouth, SBC, or Verizon overnight, but a 10 percent annual return from each is possible over the next few years. Moreover, if any of these companies pulls off a key acquisition, its annual returns could be even higher.

If you're willing to accept considerably greater risk, I'd recommend Lucent Technologies' corporate bonds. There are four issues available, which currently yield between 10.0 and 13.4 percent. Note the word "currently": If Lucent goes bankrupt, you may receive only modest payments, and maybe none at all. And, depending on how the company emerges from Chapter 11, you may not be allowed to write off all of your losses. The current high yields reflect the Lucent bonds' below-investment-grade status and, thus, the greater chance that they'll wind up in default. I think bankruptcy is possible but less likely than an eventual turnaround. For one thing, despite the beating its stock price has taken, Lucent (which, like the Baby Bells, was spun off from AT&T) has cash to cover its near-term liabilities, and it has very little debt due before 2005.

Also, although Lucent has been hit hard by reduced spending on telecommunications equipment, the Baby Bells have an interest in keeping the company around, because they use plenty of Lucent's products. In fact, with a market capitalization of nearly $6 billion, Lucent remains one of the world's largest suppliers of wireless equipment and services.

Finally, Lucent owns Bell Labs, which boasts some 40,000 inventions since its inception in 1925, including computers, laser technology, TVs, and VCRs. While it adds considerable value and a measure of stability to the parent company, it doesn't remove the specter of bankruptcy that hangs over Lucent. So invest in these bonds cautiously. And definitely don't if you're risk-averse and unwilling to be patient.

*Unless otherwise noted, all performance figures are through Sept. 25.

The author, a fee-only financial planner, is president of L.J. Altfest & Co. ( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

Lewis Altfest. Investment Consult: Time to dial up telecom stocks?.

Medical Economics

2002;20:19.