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THE BIG TEL BANDWAGON
by Roger Conrad
Editor, Utility &
Income
June 16, 2006
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It’s been quite a rocky few weeks for stock markets around the world. And if you think things have been rough in the US and Canada,try looking at South America and Asia. Even energy stocks--the most reliable cash machines of the past couple years--have taken it on the chin, despite continuing strength of the raw commodities themselves. One group, however, has shown surprising strength throughout the market slide: Big Tel. The world’s biggest communications companies have been among the absolute weakest equities for the better part of this decade. But the turn they started just a few months ago has continued. And even during this selloff we’ve seen gains. Big Tel has been strong for several reasons. First, they were starting from a very low point: An unprecedented, five-year-long industry depression that’s seen record bankruptcies and repeatedly dragged even the sector’s best names through the mud. Wall Street expectations could scarcely be any lower for the group, which has made it very easy to beat them. Second, Big Tel’s numbers are definitely improving here in mid-2006. Wireless profits are growing rapidly, as the major networks are still adding customers at a record pace even as they’ve established economies of scale and are rolling out a massive pipeline of new products and services. And on the wireline side, additions of broadband and other new services--along with cost cutting--are starting to far outpace the impact of losing local phone customers. The result is surging revenues for the major players, who are using their increasing cash flows to pay big dividends as well as invest in growth. VERIZON COMMUNICATIONS (NYSE: VZ), for example, continues to spend billions on a rapid build out of its massive FIOS fiber optic network, even as its credit rating outlook remains “stable” according to both Fitch and Moody’s. The biggest reason Big Tel has stayed strong, however, is government. A year and a half ago, regional giants SBC COMMUNICATIONS--which became the “new” AT&T (NYSE: T)--and Verizon announced marriages to long distance giants AT&T and MCI, respectively. At the time, the Wall Street consensus was these deals were defensive-- almost desperate--moves on the part of dinosaurs trying to fend off their extinction at the hands of disruptive technologies like Voice over Internet Protocol communications (VoIP). Analysts who supposedly spent all their time looking at company financials and big trends pronounced the mergers as negative for the acquirers’ earnings and financial strength. And the institutions that followed their advice punished the stocks of both SBC/AT&T and Verizon. Of course, in the months since they were completed, both deals have repeatedly beaten expectations for both creating new business and cost cutting. But their greatest advantage--and the real reason both mergers truly made sense when they were inked--continues to be ignored by Wall Street, the financial media and many intelligent investors: the unprecedented merger of lobbying clout in our nation’s capital. IN THE BLIND SPOT Wall Street is ultimately very good at divining the worth of a business, discounting a trend in the economy or finding out a fraud, though it sometimes takes a while for enough investors to cut through the usual clouds of hype and fear. But there’s one place where even the most savvy and experienced analysts seem to have a severe blind spot: Washington, DC. Simply put, the rules of the road in our nation’s political capital are fundamentally different from those in our financial capital, New York City. The latter operates at a furious pace, and skill, luck and experience are constantly rewarded on a minute-by-minute basis, while the opposite qualities are punished. In contrast, Washington operates to its own rhythm, and woe to those who fail to move to its beat. The pace is considerably slower, but perhaps even more inexorable and definitely far less forgiving of failure. That’s a lesson even presidents have learned, if they’ve fallen afoul of Lady Luck or simply started to believe in their own infallibility. My colleagues and I have the serendipity to operate in the nation’s capital. And while none of us are operators in any sense of the word, it’s hard not for some of Washington to rub off, even as our primary business is the investment market. Aside from whom you meet--the parents of your children’s schoolmates, for example--our newspaper is the nation’s foremost source on what’s going on in America’s policy and politics, with the best stories always what’s between the lines. When the Big Tel mergers were announced last year, Washington knew what was really going on: a union of two of the greatest armies of lobbyists the US had ever seen in what is still a heavily regulated industry, and the sky was the limit. For two decades after the breakup of the old Ma Bell in 1984, the local phone offspring, or Baby Bells, had been at war with their former parent, who had joined forces with other long distance phone giants. The local phone versus long distance company rivalry became increasingly venomous with the passage of the Telecom Act of 1996, which broke up the Baby Bell local phone service monopoly. And for the next decade, the advocates of both sides were locked in a ferocious battle in the US Congress, at the Federal Communications Commission (FCC) and in the states to gain even a small advantage in what became increasingly cutthroat competition. To the surprise of most on Wall Street, the ultimate victors in the battle turned out to the be the local phone giants, who built leading franchises in wireless communications and wound up taking over the long distance phone market. By the time the merger agreements were inked, AT&T and MCI were losing sales at double-digit rates and locked in a game of continual downsizing to maintain cash flow, as their basic businesses entered a death spiral. One aspect of their operations remained extremely healthy: lobbying clout. The Bells were fresh from a major victory in the courts,notably the rejection of FCC rules that forced them to sell network access to long distance companies at discounted rates, the UNE-P (unbundled network elements pricing platform). But the lobbying arms of AT&T and MCI were still ready to fight and their reach in the halls of power was undiminished. Overnight, the mergers turned old enemies into staunch allies. And by the time they were completed roughly a year later, the lobbying machine was ready to rollover the opposition. PRIMARY OBJECTIVES As far as Big Tel is concerned, its ascendancy as a unified force couldn’t have come at a better time. The Bush administration and Congress have tried to limit regulation on the industry for five years. But with local and long distance companies ever battling for advantage, all changes were viewed within the prism of whom they benefited. And with both groups contributing heavily to the Republican majority, action was often simply stymied. With the mergers, however, Big Tel now has a common objective: to limit regulation over how they run their networks, including the services they offer and what they must provide to competitors and others who use their wires. And armed with unprecedented lobbying clout and with a willing Washington, they’re on the verge of several major victories that will all but cement their industry power. There are three major venues where communications battles are fought. The FCC is the administrative body that sets regulatory policy. Now that Chairman Kevin Martin at last has a 3-2 Republican majority, he’s a major force for approving mergers with a minimum of conditions--with BELLSOUTH (NYSE: BLS)/AT&T the biggest current beneficiary--and enacting new measures such as tolls charged by owners of networks to major users. Much of what the FCC does is well out of the public eye and can be accomplished literally by fiat. Congress can theoretically override decisions, but not without passing legislation, which can often by blocked by the White House or its allies on Capitol Hill. What it can’t get at the FCC, Big Tel is going to Congress for. Specifically, a bill has now passed the House of Representatives that will allow Big Tel to offer pay television service nationwide, without having to get franchises from every locality as traditional Big Cable companies have had to do. If the bill passes the Senate and is signed into law by the president this year as expected, Big Tel will be able to quickly roll out product bundles including cable service nationally. Meanwhile, Verizon and others are already on the brink of winning statewide franchising ability in several major markets, including California. Big Tel’s real agenda in offering cable service has been endlessly debated on Wall Street. In my view--coupled with fiber optic cable that’s superior to the coaxial cable used by Big Cable--it will become a valuable tool for increasing Big Tel’s broadband customer base, which according to industry surveys is already grabbing the lion’s share of new broadband users. But whatever the case, it appears on the verge of becoming reality, and far more quickly that myopic Wall Street expected. Big Tel’s biggest victory in the new legislation may be what it managed to exclude: tough provisions for network neutrality that would put into law certain guarantees of cheap and open access to networks, specifically the high-speed broadband networks Big Tel and Big Cable are now building. The network neutrality debate has been particularly contentious. On one side are Google, Amazon, eBay and other companies that have grown rapidly in recent years by providing content and services over the Internet. These are the companies that have been driving users to the Internet, and hence its rapid growth. Their ability to grow or even survive depends on being able to access the network at an economic rate. I should mention at this point that KCI Communications, my publisher, falls into this camp. Were someone to force us to pay heavily to access the Internet to sell our products and services, it would be very difficult for us to grow. And the same is true of the literally hundreds of thousands of businesses that operate on the web. Some network neutrality advocates--including a range of consumer advocacy groups--go so far as to equate the debate with the operation of roads in pre-industrial times. They charge that allowing tolling of service providers on the network would literally force a feudal system on the Internet, where every lord of bandwidth is able to impose a fee, with the end result of restricting commerce for all. On the other side, Big Tel and Big Cable argue that their networks were paid for by their shareholders and should therefore be operated for their benefit. They argue that there is competition among networks--not only between Big Tel and Big Cable but also with wireless systems--and that it would be against network owners’ interest (in fact suicidal) to exclude or discriminate against traffic. All they want, they say, is to be able to bill those who benefit most from a reliable, high-speed broadband network. This, they maintain, is necessary, since Google and others will be increasing their traffic exponentially in coming years mandating more investment for network owners to avoid clogging up the pipes. Whether you subscribe to that view or the more nefarious perspective that Big Tel/Big Cable wants nothing more than total domination on the Internet by being able to favor its products over those of rivals, Congress is now unlikely to act. The House soundly rejected a measure that would have prescribed tough punishments for any network owner found to “discriminate” against the Googles of the world. And with more than a few Democrats joining virtually all of the Republicans, the Senate looks set to drop the issue as well. Big Tel and Big Cable will more than likely move slowly on this issue, to avoid setting off alarm bells with the public. Should they overplay their hand, I don’t think Congress will have any compunction whatsoever about revisiting the issue. And Google and others may decide to tilt the odds further in their favor by contributing heavily to Democrats in the upcoming Congressional elections. But for now, at least, it does appear we’ll see some kind of system in which network owners are allowed to bill big users for premium services such as extremely high speed. That’s a huge plus for Big Tel and Big Cable, and a major minus for recently IPO’d VoIP provider VONAGE (NYSE: VG), which has now sunk below $10 a share and seems to encounter more bad news daily. The company’s lavish advertising--including sponsorship of US coverage of the 2006 World Cup--had better pay off in spades, or bankruptcy won’t be far behind. Small VoIP providers now appear headed for another major and potentially crippling burden: contributing to the universal service fund. Almost ignored in the media was a huge victory won by Big Tel last month, the end of the 108-year-old excise tax on conventional long distance telephone calls. The Bush administration is also refunding $13 billion in taxes paid for the past three years, and it’s pushing for the abolition of similar taxes on local phone service as well. That may well slow down Big Tel’s local phone line losses, since taxes are the biggest reason VoIP is cheaper. The third venue in the communications war is in the courts. Here, too, Big Tel and Big Cable are scoring big. Today, for example, the US Court of Appeals for District of Columbia upheld the FCC’s decision to loosen regulation on the owners of networks, turning back an appeal by network users led by COVAD (NYSE: DVW). TOWARD DOMINANCE One of the more difficult things about forecasting in a regulated industry is politics can change things in the wink of an eye. A November Democratic victory in one of the houses of Congress, for example, could make things a lot tougher for Big Tel and Big Cable. On the other hand, congressmen of both parties need money more desperately than at any time in American history. And almost no one in American industry today is better positioned to pony up than Big Tel and Big Cable. The pair will lock horns fighting for customers for virtually every communications product or service. Even as Big Tel is entering the pay television industry nationwide, for example, Big Cable is on the verge of a major rollout of wireless services as part of its product bundle, in alliance with now all-wireless SPRINT (NYSE: S). Their battle, however, is being fought on a playing field of increasing scale and falling costs and prices that will eventually crush their smaller competitors, and probably sooner than most now think. Most important, their industry is growing, as the world becomes ever more closely linked. Maybe there’s a Utility & Income reader who can name a sector where sales are growing and where there’s not enough room for two competitors to thrive. But with sales and cash flow surging for everyone from Comcast (NSDQ: CMCSA) to Verizon, this doesn’t appear to be one of them. Advisors who trumpet the same theme over and over again run the risk of ridicule. And granted, I’ve been on this one for some time, including in my 2001 book Power Hungry: Strategic Investing in Telecommunications, Utilities and Other Essential Services (still available at http://www.amazon.com/). But sometimes in the markets, you’ve just got to be patient enough to let the stars align in your favor. And I’m increasingly convinced, even in the midst of a very rocky and uncertain market, that’s where we are today.
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