Is it time to get your clients back into telecom? If the very word still gives you the jitters, that's understandable. No sector has caused so much pain to so many investors. Some $2 trillion in market capitalization has been lost over the last two years as upstart phone companies, their equipment suppliers and finally, the No. 2 U.S. long distance company sought bankruptcy protection. Their shares have descended to penny-stock status.
The implosion has been spectacular. But so was the frenzy on the way up. In 1999, a record 308 telecom companies went public, raising $31.9 billion, according to Thomson Financial. In 2000, another 162 telecoms were eaten up by investors, raising $28 billion more. These companies proceeded to borrow heavily to compete in local phone service, data and long distance. AT&T, once the stock your grandmother owned and swore by, took on a whopping $65 billion in debt to build up cable assets it said would beat the newcomers in local service. Now, those assets are being sold for 50 cents on the dollar.
At least AT&T could afford the gamble. Scores of companies, including those that had little or no track record, made huge bets on new fiber optic networks and other expensive gear — all aimed at demand for communications service that never materialized. It was no surprise then that newer, weaker players, such as McLeod, would suffer; many such players were shaken out a year ago. But this year brought the shocking news of more widespread problems in telecom that have hurt all players. The capper, of course, was what the SEC calls “accounting improprieties of unprecedented magnitude” at WorldCom. Once a must-hold position in any growth portfolio, the long distance giant now appears to have been a house of cards. The company has admitted inflating earnings by improperly booking more than $4 billion in costs as capital expenses.
So, who's ready to take the telecom plunge now? We are seeing increasing talk of investors who are identifying companies that could be winners in the next up-cycle, whenever that may be. The companies they are buying have the staying power to survive the slump and are in a position to snap up assets and customers on the cheap as the shake-out continues. It should be noted that many professional money managers are buying the ailing firms' debt (including preferred shares), where bonds can be had for pennies on the dollar. Warren Buffett joined an investment group that recently plowed more than $500 million into Level 3 Communications, an ambitious fiber optic network operator. Naturally, the move sparked a lot of interest on the Street, and Level 3 stock quickly doubled. His $100 million investment in Level 3 convertible bonds can be exchanged for Level 3 common at $3.41 per share, subject to certain conditions. Level 3 is still struggling with its debt and was downgraded in August, but investors who follow the Sage of Omaha are circling over the sector, analyzing the bonds of many such industry companies.
And what about AT&T? The telecom giant still has substantial resources, but it has had its share of trouble. It spun out its equipment-making and wireless units in the 1990s in an effort to increase shareholder value by moving into faster-growing businesses. But it was caught in a withering long distance price war and saw its market cap sink by $100 billion as the stock tumbled from a high of $63 to around $10. Its $100 billion bet in cable TV has been a bust, and the company has agreed to sell the unit to Comcast, where CEO C. Michael Armstrong will become chairman.
On his way out, Armstrong says there is a good case for AT&T now. He told me recently that the collapse of WorldCom will directly benefit AT&T. “To say that this is an opportunity is probably putting it mildly,” Armstrong says. “It's the chance of a lifetime for us. We invested $40 billion in networking and services and product and global infrastructure to serve businesses around the world, and they have been our primary competitor in that space.”
AT&T isn't interested in WorldCom's assets — just its customers, says Armstrong. And he may be getting them. AT&T has been gaining market share among corporate enterprise customers. The company lost $3.49 per share in the second quarter, but did better than analysts expected. “The current market environment has placed additional pressure on AT&T stock, but we expect an improved revenue mix and strong cash flows to drive improved stability and valuation,” says Bank of America analyst David Barden, who has a buy rating and a target of $12.50.
In addition, AT&T may see more positive catalysts over the next three months. A sale of its Time Warner Entertainment stake to AOL Time Warner was being negotiated in late August and could bring AT&T $2 billion in cash and $1.5 billion in AOL common stock.
It will spin off its AT&T Broadband, its cable TV business to Comcast in November. Armstrong, who paid $100 billion for Media One and TCI, is now selling those assets at half the price. Armstrong says the reason for the retreat from cable was mostly financial. “It was in the fall of 2000 when we recognized that the capital structure to fund these businesses going forward was really going to be stressed and strained,” he says. “And by capital structure, I mean access to the credit markets, to debt, to bank lines, to commercial paper as well as to equity. It was a tough decision, but we knew that if we were going to realize the potential of all of that we have put into it, we have got to have a capital structure to afford the future.”
So, if AT&T is in such a good position, why is Armstrong jumping to Comcast? Armstrong simply says he is leaving because he will be 65 years old and he is forced to retire.
If you believe that the worst drops in pricing are behind the industry, AT&T is well positioned to profit from a stronger business environment. In addition to its conventional phone business, it has large enterprise customers who need long distance, data and Internet services. Many analysts say there is value in AT&T shares today. Says Jeff Burnside of Sanford C. Bernstein, “From an investment perspective, the company generates $2 billion a year in free cash flow and the market is discounting free cash flow growth. You have businesses that are very valuable. I would argue that these businesses will not decline as much as people think.”
Adds Blake Bath of Lehman Brothers: “The balance is actually looking a lot better today than it has in the past. The business services business is in good shape.” We are now approaching that time of the year when corporate America begins to set its 2003 spending budgets. Expectations for spending remain depressed and any growth at all from 2002 levels will likely come as an upside surprise for the industry. “The cable part of the business is still the drag,” says Bath.
The one risk people talk about now is the possibility of Comcast walking away from the deal with AT&T, but few people believe that will happen. If they were to walk, AT&T gets a $1.5 billion break-up fee, Armstrong points out. “That would be just the beginning.”
As for AT&T, post-spinoff, some people have talked about a whole new crop of deals among the major players. FCC Chairman Michael Powell suggested recently that the commission may allow the Regional Bell Operating Companies to acquire some assets of WorldCom. Many people expect AT&T in fact to eventually get back together with a Baby Bell at some point.
I asked Armstrong if he thought AT&T would be acquired by a Baby Bell. His response: “I think from an AT&T standpoint, independent of any Bell company trying to buy us, we have a growth future, and we are going to accumulate a lot of value for our shareholders. Now, if a company wants to come along and pay all of that value upfront, and I don't know what that number might be, but I know it's a hell of a lot more than the $10 [a share] that it is right now.”
Maria Bartiromo is the markets reporter for CNBC and host of Closing Bell.