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9/6/2002
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Taking Stock: Bargain-Hunting Amid The Rubble Of The Telecom Collapse

Regional phone companies may soon be worth buying.

That the telecommunications sector has suffered a severe meltdown isn't news anymore. Telecom switches and bundles of optical fiber fall by the wayside, unused, as the industry attempts to come to terms with overcapacity.

Numerous companies whose futures once looked promising have gone bankrupt, though a couple have emerged from bankruptcy. At this point, I'm more interested in discovering if there are any real bargains to be had from this pile of rubble.

As the tech and telecom boom got under way in the late '90s, new telecom companies undertook a massive buildout of fiber-optic networks worldwide. The optimistic assumption was that demand for bandwidth was growing so fast that it could absorb any capacity as it became available.

Unfortunately, demand turned out to be limited, and prices soon were falling at a precipitous pace. Falling prices combined with lower-than-expected demand soon led to a number of telecom companies being crushed under the weight of their debt.

You might think that bankruptcies in an industry suffering from overcapacity would be a good thing, but in this case, the bankruptcies might not help much. During bankruptcy, most of a company's debt is eliminated, thus freeing it from incurring interest expenses. As a result, companies emerge from bankruptcy with virtually no debt, a lower cost structure, and the same amount of capacity -- something that's now viewed as a cost that can't be reversed. The incentive is to sell capacity at the lowest-possible price. Eliminating the overcapacity might take longer than expected, and prices for long-distance voice and data services might continue to fall at a relatively rapid rate.

You'd think that the elimination of a number of telecom companies would leave the former Bell companies feeling good, but they're suffering, too. These regional phone companies are experiencing shrinking revenue and a decline in the number of installed lines, the first time since the Depression that the number of lines installed has declined.

This is partly because of the weak economy, in which businesses are either closing offices or disconnecting unused lines. On the residential side, many secondary lines are being replaced with cable modems or DSL service. In addition, increased competition in the local loop is taking its toll on the number of access lines installed. The competition comes from alternative telecom carriers as well as cable companies that are rolling out cable telephone service.

BellSouth recently warned that its earnings weren't going to meet targets. It's the fourth time this has happened in a relatively short period, indicating that it and the other regional phone companies aren't doing too well. BellSouth blames the poor results on a number of problems: faster decline in the number of access lines installed, an increase in bad debt, and lower revenue from Cingular, BellSouth's wireless joint venture with SBC Communications. Many investors had considered the regional companies relatively immune to an economic downturn, but that appears not to be the case. The earnings warning was specific to BellSouth, but Qwest Communications, SBC, and Verizon face the same trend.

Despite the doom and gloom surrounding the industry, the valuations are approaching levels where they're starting to interest me. (Notice that I said approaching. It's not quite there yet). BellSouth is trading at five times enterprise value (what a potential buyer might pay for a company, less cash) to EBITDA (a rough measure of cash flow), while the dividend yield is a healthy 3.7%, Verizon is trading at 4.8 times EV to EBITDA and has a dividend yield of 5.2%, while SBC is trading at 5.3 times EV to EBITDA with a dividend yield of 4.7%. A slightly lower price coupled with some improvements in the fundamentals and it might be time to buy one of the regional phone companies.

Most other telcos are best avoided as they struggle with debt and restructuring, although what's left of AT&T after the sale of the broadband business to Comcast looks interesting. But that's a story for another time.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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