Running with the Herd
by Roger Conrad, Editor, Utility Forecaster. January 25, 2008
Running with the herd certainly beats trying to run against it �and getting trampled in the process. But it comes with a cost: surrendering your own common sense for �group think� that often makes no real sense at all.
As I pointed out last week, the character of the Wall Street herd has changed remarkably over the past two decades. Back in the 1980s, individual investors still accounted for the majority of stock ownership. Today, trading is squarely in the hands of big institutions and those who run them.
On the face of it, the result should be a more rational market, because money managers are pros trained and educated to navigate investment markets. In practice, however, the result is far more volatility and a lot less focus on what ultimately determines stock values, the worth of underlying businesses.
The bottom line is big institutions can't afford to sit with losing positions for long, when the herd is running the other way. To do so is to risk digging a deep hole, making it ever-more difficult to meet the all-important goal of outperforming the market. The fear level has been doubly high this year with worries about a US recession, leaving money managers extremely averse to risk despite the fact that the year has barely begun.
In the Jan. 11 Utility & Income, �Panic, Politics and Profits,� I cited the early year selloff in telecommunications stocks as a classic example of herd irrationality. The catalyst for the decline was a seemingly benign comment from newly ascendant AT&T CEO Randall Stephenson at an industry conference, in which he stated his company had seen some increase in cancellations of broadband service, presumably because of the slowing US economy.
With recession fears already reaching a boiling point, a number of well-known commentators took that statement as a tip off that AT&T was getting ready to warn of a shortfall in fourth quarter earnings and very likely for all of 2008 as well. The result was the sharpest selloff in AT&T shares in several years.
Since then, the Wall Street herd has continued to ignore management�s assurances that there would be no earnings warning coming and that business remained robust. Shares even failed to register much of a bounce when one of the commentators actually retracted his forecast of a warning.
With AT&T taking hits, the herd turned on other communications stocks as well, particularly rural-based fare. And today, the consensus has reached deafening volume that telecommunications companies were headed for big trouble as a US recession took hold.
On Thursday of this week, AT&T got its chance to answer back, not only for itself but for its entire industry with its fourth quarter earnings announcement. As management had indicated, there was a slight uptick in broadband turnover�to 0.6 percent from 0.5 percent a year ago. But there were also no surprises in the report.
The bottom line fourth quarter profit number was right in line with prior Street forecasts, as well as the company�s own. Adjusted earnings�excluding accounting effects associated with acquisitions�rose 16.4 percent for the quarter to 71 cents a share. Moreover, management affirmed its previous estimates for 2008 earnings, stating it expected another year of double-digit growth after factoring out one-time accounting items.
The numbers behind those numbers were even more impressive. Fourth quarter operating margin surged to 24 percent of revenue, up from 18.2 percent in the year-earlier quarter. Savings from the BellSouth and old AT&T mergers continued to run well ahead of original estimates, hitting $4 billion for the full-year 2007.
Cash from operations nearly doubled for the quarter and more than doubled for the year. Meanwhile, free cash flow after dividends�or cash flow less capital expenditures and dividends�came in at $7.6 billion, well above management�s prior estimate of $5 billion to $6 billion. That was despite an ambitious capital-spending program totaling $17.7 billion, as the company continued to widen its technology advantage over all of its rivals except Verizon Communications.
Going deeper into the numbers, AT&T gained 2.7 million new wireless subscribers, a pace 13.5 percent ahead of last year�s additions and well beyond Wall Street expectations. The end-year wireless customer base reached 70.1 million, providing a bigger pool than ever for the company to which it could sell its advanced data services.
Total customer turnover, or �churn,� sank 10 basis points to 1.7 percent. Post-paid subscribers�who accounted for the lion�s share of the company�s growth�had a churn rate of just 1.2 percent, down 30 basis points from year-earlier totals.
Average revenue per customer rose 1.9 percent overall and 5 percent for post-paid customers, as wireless data revenue surged 57.5 percent. That added up to a 16.3 percent jump in overall wireless revenue and a 58.2 percent increase in operating income, not including acquisition costs.
Much of the strong performance in 2007 came from the growing success of the iPhone and the demise of the No. 3 US wireless company Sprint Nextel, which has provided a wealth of new customers for rivals in recent months amid growing service and financial woes. Both of these trends may taper off a bit in coming months, as rival devices to the iPhone hit the market and Sprint presumably gets its act together enough to stop the bleeding.
But AT&T�s ability to control its wireless costs, upsell customers and hold down churn in the fourth quarter�supposedly a time when the US economy has been slowing down sharply�is a very good sign for 2008 and beyond. iPhone users are now at 2 million and still accelerating. And the larger the company is able to get, the better its economies of scale will get. For example, wireless operating income margin expanded to 25.7 percent�not including acquisition costs�from 18.9 percent a year earlier.
AT&T and sometime ally/sometime rival Verizon are now expected to dominate the ongoing Federal Communications Commission auction of wireless frequency. That's in sharp contrast to earlier expectations that Google and a handful of smaller companies would use the auction to launch competing networks. And it's very good news for both companies� longevity.
Winning in Wireline
Since the announcement, critics have chosen to ignore the wireless results. And we've actually seen one analyst downgrade the stock on supposed weakness on the wireline side.
Different opinions are what make the market, and everyone is entitled to his or her opinion. To date, however, the numbers just don't support the thesis that this side of the business is breaking down, not by a long shot.
To be sure, America is slowly but surely migrating off the old copper phone line network that's dominated communications for more than a century. AT&T�s results continue to reflect the move, with its basic copper phone line connections dropping 5.6 percent over the last 12 months.
However, the key for AT&T�as it is for every wireline company�is to ensure it remains dominant on the network that replaces copper. That's definitely the case in wireless, where Verizon is the only real competitor of consequence now. But as the fourth quarter numbers reflect, it's also the case for wireline.
Namely, despite fears of the negative impact of overall US economic weakness, AT&T continued its relentless, successful upselling of new advanced broadband services. For one thing, raw connection growth far offset the continuing attrition of the old copper wireline connections. And just as important, the profit margins on the new network�with its lower operating costs and ability to sell advanced services�are far greater than the old.
In other words, AT&T�s profitability rises as it replaces basic copper connections with broadband customers. And that's a trend set to continue for years to come.
Pay television service is one area from which new growth has only begun to be tapped. AT&T has accelerated its weekly installment rate for its U-verse television service to 12,000, from a prior goal of 10,000. By the end of the fourth quarter, total subscribers reached 231,000, nearly twice levels at the end of the third quarter. The company has now resolved the glitches that originally plagued this offering and signed on 7.6 percent of its primary consumer lines to a video solution, up from 4.6 percent a year ago.
Belying the bogus forecasts of some that broadband growth was falling victim to recession, AT&T�s total broadband revenue surged 13.7 percent to a record $1.4 billion. Total high-speed Internet connections reached 14.2 million, up 16.3 percent over the past year. The upshot was total consumer wireline connections rose 1.2 percent, as new services more than offset copper line losses.
Moreover, the company is on track for U-verse users to reach 1 million by the end of the year, more than four times current levels, which should ensure it continues to gain more in far-more-profitable broadband than it loses in copper.
As I pointed out in the January issue of Utility Forecaster, business-to-business operations have considerable upside for many utilities, particularly dominant telecoms. This has been a generally dormant business for both AT&T and Verizon in recent years. Now both are starting in earnest to roll out advanced offerings on a global basis to US businesses, and initial results are very promising.
Recurring enterprise service revenue�excluding items and newly acquired assets�rose 1.8 percent. That's a sharp increase sequentially from the third quarter�s 0.3 percent gain and a quantum leap ahead of the 3.5 percent decline in fourth quarter 2006 figures.
Ultimately, the market looks ahead and never behind. So arguably the most important portion of AT&T�s release was the forecast section. And at least for now, the outlook is still very bullish.
Among the more important points was a forecast for a boost in wireless operating margins to the mid-40 percent range by the end of the year, with a �low 40s� average for the full year. That's based on cost controls and upselling as well as expected new customer additions, which the company has repeatedly forecasted conservatively in recent quarters. Overall adjusted operating margins are seen in the 25 to 26 percent range, continuing the improvement of recent years.
The company also expects little drop off in capital spending, even if the consumer segment proves to be weaker than expected. CFO Rick Lindner stated that only a small part of AT&T's capital budget varies depending on call volumes or data usage on its wireless and wireline networks.
Most positive was the company�s forecast of $16 billion to $17 billion in free cash flow. That's roughly in line with this year�s totals despite a projected record 2008 capital spending budget of $19 billion, or $1.3 billion more than last year�s total, as the company continues to upgrade wireless and wireline infrastructure. That's a massive cash hoard with which to pay off debt, buy back stock and pay dividends, and it should keep AT&T�s A rating in good stead.
The bottom line is it's hard to find much wrong with these earnings, which continue the trend of steady improvement in recent years. Moreover, they underscore management�s contention all along that its basic business�while not wholly recession proof�is at least quite resistant to downturns in the overall US economy and market. And this is before likely improvements because of targeted overseas expansion.
Judging from post-announcement market action, the herd hasn't changed direction yet. But with the stock trading with a yield of 4.4 percent and selling for barely 11 times consensus 2008 earnings, it's hard to see it going that way for long.
If AT&T shares have been treated less than fairly on Wall Street, that goes triple for the rest of the telecom sector. Most of these stocks fared poorly over the past year and sold off sharply last week following the phony AT&T profit warning rumors.
As with AT&T, the herd expectation is that other telecoms� numbers will be damaged by a slowing US economy and companies will be forced to guide lower in 2008. Consequently, it won't take a lot to beat expectations and ultimately turn the herd around.
The next big announcement we'll see is Verizon�s fourth quarter numbers, which are slated for Monday, Jan. 28. Company spokesmen last week stated unequivocally that fourth quarter results were not hit by US economic weakness and 2008 was projected to be a banner year. And again, despite herd expectations to the contrary, there's every indication they'll be vindicated, as growth in wireless, FiOS broadband and enterprise services continues to charge ahead.
Verizon shareholders will get an additional bonus in the next month or so, as the company completes the spinoff of rural phone lines in Maine, New Hampshire and Vermont and merges them with FairPoint Communications. The two companies have now reached agreements with regulators in all three states to approve the deal, which will result in Verizon shareholders receiving one share of the new FairPoint for every 55 Verizon shares they now own. Verizon shareholders will own most of the new company, which will serve 31 markets in 18 states.
Along with cable television companies, rural phone outfits were very poor performers last year, largely because of fears of recession and its potential impact on sales and distributions. FairPoint, for example, sank more than 20 percent in 2007, versus gains of 23.1 percent and 24.8 percent for AT&T and Verizon, respectively. Otelco�a staple share combining debt and equity�slipped 28.1 percent, even including its rich double-digit dividend.
In the rural wires space, Citizens Communications (-4.2 percent) and Windstream Corp (-3.2 percent) were relative outperformers, largely because of their greater size and stability. But they've been taken out and shot along with the others this year.
At its core, the rural wireline telephone business is rock steady. Citizens and Windstream, for example, have routinely signed on more broadband customers than they've lost in normal copper line attrition. Coupled with relatively few capital spending needs, that's translated into strong cash flows, which they've used to pay off debt, buy back stock and make acquisitions.
Acquisitions have increased their pool of basic connections from which to upsell to broadband service, further boosting economies of scale and overall business stability. And cash flow is augmented periodically by federal subsidies to ensure service to harder-to-access areas.
The rural phone story isn't about earnings or earnings growth, which is routinely minimized to reduce tax burdens. Rather, it's about cash flow, free cash flow in particular, which is the account from which the generous dividends are paid.
Rural telecoms were hot earlier in the decade, as investors gravitated to those high yields. They�ve been hammered since last summer, starting with the spike in interest rates and carrying over to concerns about the economy.
The herd mentality now on the group is that economic weakness will slow broadband growth and speed up copper phone line attrition rates in rural areas. That, in turn, will hit cash flow hard and put the distributions at risk. Current dividend rates are more than 9 percent at even Citizens and Windstream. That's arguably already pricing in modest cuts, and rest of the group is pricing in more damage still.
To be sure, we've seen one rather large distribution cut in the group. As part of an agreement with Maine regulators to approve the Verizon deal, FairPoint Communications agreed a month ago to cut its payout by 35 percent.
That move, however, was dictated by unique circumstances�namely officials� insistence on more capital spending as the price of their approval. And it had little or nothing to do with FairPoint�s operations, which continue to generate solid cash flows. Meanwhile, this deal gives FairPoint solid economies of scale for the first time and leaves it a far-healthier company than before.
How likely are dividend cuts at other rural telecoms? From all indications thus far, the answer is not very.
According to Citizens� CEO Maggie Wilderotter, the company had a �very strong� fourth quarter, with disconnections for nonpayment actually lower sequentially from the third quarter. That's actually quite remarkable considering the normal adjustments that follow acquisitions such as those made by the company over the past year. For its part, Windstream has asserted that nonpayments spiked in July but have since leveled off.
As was the case with AT&T this week, actual earnings announcements should lay to rest a lot of the fears about either company. Unfortunately, neither of these companies is going to report fourth quarter earnings for a while.
Citizens� date is Feb. 26--more than a month from now. Windstream�s report date is sooner on Feb. 8. But even that's an eternity in a market that still seems wholly convinced things are coming apart at the seams.
The result: These stocks could still have more downside from percolating investor fears, despite the fact that they're likely to report solid fourth quarters and steady guidance for 2008. They're great bets for bargain hunters but only those who don't mind going against the herd for a while longer. And given the action in recent weeks, they're going to be vulnerable to bad news on the economic front, which we're almost certain to get even if the US does wind up avoiding a recession.
In my view, that doesn't disqualify them as great high-yielding pieces of balanced portfolios. But again, we're not running with the herd here, so it may take some fortitude to hang in there for the payoff.
That also applies to cable giant Comcast Corp. Despite the recent travails of its shares, the company remains at the top of the cable industry and�in my view anyway�one of the top three US communications companies along with AT&T and Verizon. The company�s fourth quarter earnings are slated for release Feb. 14 and will no doubt be subjected to incredible scrutiny, particularly regarding real or imagined exposure to US economic weakness.
For its part, management has yet to guide lower for 2007 or fourth quarter earnings from the downward revisions it made this past fall, and it's affirmed its expectations of strong growth going forward. The problem is management�s credibility has rarely been lower, evidenced by the attempt of at least one major shareholder to oust once-lionized CEO Brian Roberts. In effect, few trust the current guidance, and most are expecting to see disappointing numbers for the fourth quarter, as well as sharply lower guidance for 2008.
Only time will tell if the herd is right on this one. But one thing is for certain: It will take a lot more bad news than has already occurred for this company�which trades for just 1.27 times its growing book value�to justify the stock�s slide of recent months. That means anything hopeful or reassuring has the potential to shift the market psychology in a meaningful way to the positive.
To be sure, the best solution for this stock is for management to initiate a dividend, which it could easily do even under the most-pessimistic assumptions for ongoing cash flows. Given the tight control of the Roberts family�which is typical in cable companies�I'm not holding out a lot of hope. But the shares certainly look cheap, and it's not hard to imagine a strong rebound in 2008, even if the US economy does continue to weaken.
Not yet a Bargain
There is, of course, one major telecom that's become a full-scale washout: SprintNextel. The stock was a horrific performer last year, down 30 percent, and has picked up where it left off in 2008, crashing to less than $10 a share.
If there's some solace here, it's that management at last isn't standing still and taking it. This week, newly installed CEO Daniel Hesse sacked the company�s chief financial officer, its chief marketing officer and its president of sales and distribution. It's also announced 4,000 in layoffs and will close 125 of its stores nationwide as part of an aggressive cost-cutting and retrenchment strategy.
Still unanswered are some basic questions about the company�s once-vaunted strategy of launching a nationwide data network based on Wi-Max technology�namely how aggressively it will be rolled out, what the company will spend and where it will concentrate its efforts. The technology is still highly regarded in some circles, though a shrunken Sprint will have a more difficult time rolling out anything significant.
Hesse has, at least for the moment, frozen new developments on WiMax in order to get the company to focus squarely on its basic wireless business. One possible step is a forced migration of customers of the former Nextel from its proprietary iDEN network to the CDMA network of the original Sprint, with a sale of the iDEN network to follow. This would be a wholesale admission of the failure of the Nextel merger, but it may be the only way to ensure enough network quality to engineer a turnaround.
Another would be to try aggressive price-cutting. But this strategy also has severe limitations. For one thing, AT&T and Verizon aren't really competing on price but rather on network and device quality factors. Cutting prices may slow customer flight, but it may also wind up merely slashing cash flow from the company�s best customers at a time when it's needed most.
As one analyst put it, Sprint has basically been a carcass from which other wireless companies have fed in recent quarters. The company is still experiencing unsustainable churn in large part because of network problems and a prior strategy that focused on less-profitable customers. The company lost 683,000 post-paid subscribers in the fourth quarter. That's up from a decline of 337,000 in the third quarter, and there's every sign the losses are continuing into 2008.
This week, Standard & Poor�s cut the company�s credit rating to BBB-, just one notch above junk. The rater also maintained a negative outlook, meaning that, unless Hesse succeeds in bringing down costs and shoring up cash flow this year, it will likely be cut to junk.
I've been strongly negative on Sprint for some time, both in U&I as well as my print advisory Utility Forecaster. But in my view, there's an end game here.
First, it's almost a sure thing that Sprint is going to keep losing customers in the near term. But it does still have 52 million users on its network. Once management can stabilize those numbers�probably at a lower level�that network is going to be worth something to a potential buyer.
A party change in the White House and the Federal Communications Commission would likely take the most-promising US suitor out of the mix, Verizon. But there are plenty of potential foreign buyers. South Korea Telecom, for example, has already made a $5 billion bid for partial control. And there are plenty of other cash-rich players that could be interested once there's some real visibility on the health of the company�s underlying business.
Second, the US wireless market�s penetration rate has increased markedly in recent years. But relative to other countries, wireless data is still in its infancy. And with device technology continuing to advance�and demand for a multitude of applications now demonstrated�it's poised to explode to the upside. That, in effect, was the most important factor behind AT&T�s strong wireless returns�rather than sheer customer adds�and it promises to accelerate in coming quarters.
In this kind of growth industry, there's always room for more than two very profitable players. And although Sprint looks fated to fall well behind AT&T and Verizon, it can still have a very profitable business if it focuses and stops trying to rule the world.
Finally, Sprint shares currently trade at just 61 percent of sales and 48 percent of their book value. And despite its current woes, it's still raking in billions of dollars in revenue and cash flow.
Coupled with management's aggressive steps to engineer a turnaround, that's a very strong argument that we're at least within a point or two of touching bottom. This is no asset-less Vonage that's only kept alive by trying to game the system. This is a substantial company with real assets.
It may be unloved and shunned now, particularly by those who rode it all the way down. But sooner or later, it's going to bottom and very likely head a lot higher.
The only problem with recommending its shares now is that there are so many other very cheap stocks in the communications sector, most of which have much higher yields than Sprint.
Income investors, for example, will find far more to like in the rural telecom space. Growth and income value players will want to focus on far-steadier, faster-growing Verizon and AT&T. Those who want to bet on a comeback will appreciate Comcast more.
Sprint is one, however, that I definitely have my eye on now. And I'll be even more interested if ongoing market turmoil takes it lower.
© 2008 Roger Conrad
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