$18 billion boondoggle?

Investors will be a while sorting out VERIZON COMMUNICATIONS’ (NYSE:

VZ) plans to build the most advanced wireline communications network in the world: a fiber optic system slated to pass 18 million homes by 2010.

Verizon can certainly afford the projected cost, $22.9 billion less an estimated $4.9 billion that would have otherwise been spent on its traditional copper wireline network. The company’s profits from its wireless network--now the nation’s largest for retail customers--continue to grow as margins expand through efficiencies and new services. And despite growing competition from cable television companies, its copper network continues to throw off a mountain of cash, as the company cuts costs and upsells customers to high speed Internet service.

Management projects cash flow from ongoing operations will cover the buildout costs with ample room to continue cutting debt. Then there are the potential proceeds from a slew of saleable assets. These include the nationwide yellow pages directory service, millions of rural phone line connections and interests in foreign telecoms such as Venezuela’s CANTV (NYSE: VNT), which it’s attempting to sell to Mexican billionaire Carlos Slim. The company has even been able to hold its credit rating steady in the A range, despite raters’

general skepticism about the telecom industry overall.

When Verizon first announced plans to build its FiOS network in late 2004, many critics predicted it would be unable to get regulatory approvals in a timely manner. The biggest sticking point was winning local franchises to offer cable television service, which is counted on to supply a sizeable chunk of FiOS’ revenue. Others forecasted the company would be unable to win market share even if it gained entry, due to competitors’ supposedly better marketing. And still others were concerned costs would be much higher than anticipated.

The company’s progress report released this week goes a long way toward addressing at least the first two concerns. In a clear demonstration of the now combined local and long distance phone industries’ lobbying might, the US House of Representatives voted

321 to 101 to grant de facto “national franchises” for Verizon, AT&T

(NYSE: T) and others seeking to offer cable television service.

The bill probably won’t come up for a vote in the US Senate until after the upcoming November elections. But even if the Democrats do take control, the measure’s chances of passage are better than even, thanks to considerable bipartisan support. Meanwhile, Verizon itself maintains that nationwide relief isn’t necessary to its effort, as it has moved quickly to pass legislation in a half-dozen states for statewide cable TV franchising--including California--and has secured local deals where needed. Some 300 new markets are currently being targeted for entry.

In areas where the company has gained entry, results are impressive.

At the end of the second quarter, the FiOS system had achieved a 12 percent share of the high-speed Internet market where it’s operational. That figure is well on track to reach 15 percent by the end of this year, with the overall customer count doubling. Customer turnover, or churn, is only 1.5 percent, barely one-tenth of annual wireline churn nationally.

As for the FiOS television offering, Verizon has introduced a unique concept of product convergence by integrating contents from devices like personal computers and cell phones into television screens. The service had about 100,000 users by the end of June, also with a churn rate of just 1.5 percent. The current target is 175,000 users by year’s end, for a penetration rate of 10 percent. FiOS TV was available to about 1 million users at the end of the second quarter.

The entire buildout is on target to pass 6 million homes by the end of 2006, with about 3 million more slated for each successive year.

The company’s current goal is 6 million to 7 million FiOS Internet customers by 2010, a 35 percent to 40 percent penetration rate of then-available homes. That’s an increase from an earlier target of 30 percent. The goal is 3 million to 4 million FiOS TV customers by 2010, for a penetration rate of 20 to 25 percent. Both goals are based on penetration rates that have averaged 12 percent for the first nine months operating in test areas and 15 percent after the first year. Roughly 80 percent of FiOS customers are now buying a bundle of voice, data and TV service.

Whether these testing rates will hold up over time--enabling the company to reach these goals--is a matter for intense debate.

Obviously, cable giants like COMCAST (NSDQ: CMCSA) will battle fiercely if enough of their revenue is threatened. Verizon, however, has already shown it can take customers from rivals: 70 percent of FiOS Internet users are new Verizon broadband customers, rather than switchers from the company’s DSL service.

In any case, the FiOS network has a huge technology advantage over rivals, including Big Cable, in both speed and capacity. Early trials show the ability to deliver speeds of 2.4 gigabytes per second on downloads and 1.2 gigabytes per second on uploads.

As for the cost issue, it’s a little less rosy. The average cost to connect a home to the network was $933 in August, up sharply from the prior forecast of just $715. That’s prompted the company to boost its full-year estimate to $880 per home, and ratchet up its overall costs of the FiOS buildout.

On the plus side, there will presumably be some reduction in hookup costs as the FiOS network gains scale. On the minus side, hookup costs per area reached appear to vary widely. Consequently, final costs could be far different from those currently projected.

Those costs, however, are balanced against future projected savings of about $1 billion a year in operating costs, as running a fiber network is far less expensive than a traditional copper one. The company also expects to begin generating positive cash flow from FiOS by 2008 and positive operating income by 2009.

The big picture on the FiOS buildout is so far, so good. But there are many more hurdles to overcome before the final verdict is in on how profitable it will be.

Meeting the projections outlined this week will obviously depend greatly on whether the company is able to meet its sales targets.

Verizon will have to keep doing the job of building out FiOS and selling services well and the rapid growth of the Internet will have to continue.

Regulation remains a wildcard, particularly the issue of so-called net neutrality. This year, the Republican-controlled US Congress beat back attempts by GOOGLE (NSDQ: GOOG), MICROSOFT (NSDQ: MSFT), YAHOO (NSDQ: YHOO) and others to codify rules that would essentially prevent Verizon and other broadband network owners from controlling their access or imposing fees for usage. A change in control could resurrect this issue, though it should be noted that a number of Democrats opposed the measure as well.

In addition, the Republican-controlled Federal Communications Commission (FCC) has initiated a study of the concept of net neutrality. The Republicans will control the FCC for at least two years after the election and, given their past actions, are unlikely to impose anything severe. But we could well see action after 2008 that would have a more dramatic effect, possibly postponing the day of FiOS’ profitability.

There’s also the risk that a competitor could develop an even faster system--either wireless or wireline--that will undermine FIOS’

superiority even before the network reaches critical scale. The company’s main advantage here is virtually none of the competitors it now faces have the financial power to build such a network, but rather are trying to piggyback services off of existing networks.

That’s the case with the voice over Internet protocol or VoIP companies like VONAGE (NYSE: VG), which are currently taking its copper phone network customers at a rate of roughly 5 percent a year.

Cable television’s big two companies--Comcast and TIME WARNER (NYSE:

TWX), however, do have the financial power to make dramatic upgrades to their systems. And they no doubt will when they perceive the competitive threat from FiOS too great to ignore.

Every growing industry in economic history has been able to support at least two strong competitors. And the greater the competition grows between Big Tel and Big Cable, the more impossible it will become for other rivals to keep up. But again, a massive buildout by cable could slow FiOS’ growth and delay its day of profitability.

IS IT WORTH IT?

Unfortunately, anytime a company makes such a long-term bet as FiOS, it has to face these risks. Verizon is far better equipped than any player in its industry, thanks to unmatched financial power and a firm franchise in wireless. Further, its projections appear to be based on relatively conservative assumptions.

But even Verizon, in the words of that famous Bard, is not wholly immune from the slings and arrows of outrageous fortune. In my view, the odds favor a big payoff from this aggressive buildout, particularly in view of the initial results.

In fact, it could wind up greatly exceeding expectations if the company can successfully integrate its wireless network--widely regarded as the best in the country--with the new FiOS build in coming years. That looks likely, given the rapid development of such convergence technology and it would give Verizon an overwhelming advantage in many markets.

On the other hand, it’s entirely possible that FiOS could flounder in a sea of rising costs or unsatisfactory sales. That raises the question, Is this aggressive move worth the cost, or would the money have been better spent reducing debt and helping to jack up near-term earnings?

Verizon shareholders are certainly entitled to ask. Since the mid-1990s, the company has continually expanded it business from its original base as the former Bell Atlantic, acquiring successively NYNEX, GTE and MCI, in addition to numerous wireless properties after combining with the US operations of VODAFONE (NYSE: VOD).

Today Verizon, along with AT&T (itself forged from combining Southwestern Bell, Pacific Telesis, Ameritech, New England Telephone and the old AT&T), dominates the phone industry and appears on course to continue getting stronger.

Shareholders’ benefits thus far, however, have been mediocre, aside from the steady accumulation of the company’s hefty dividend. In fact, despite a solid showing this year, the stock is only slightly above where it traded in 1995 and is little more than half its late

1999 peak in the mid-60s per share.

In recent years, it’s become obvious that Verizon’s bets have been paying off, particularly in the wireless arena. But every time the share price has started to reflect the company’s improving fortunes, management has announced another dramatic deal, arousing the skeptics and sending the shares slipping again.

The announcement that the company was buying MCI, for example, sent the stock plummeting from around $40 a share back to the high $20s.

After it became clear the MCI deal would be even more profitable than management had forecast, the shares rebounded, only to be sunk by the announcement of the FiOS buildout.

This year, Verizon shares have actually underperformed AT&T, despite the latter’s aggressive bid to acquire BELLSOUTH (NYSE: BLS). That’s largely because AT&T is offering its version of television service without building an extensive FiOS-like network.

Verizon would survive if FiOS should fizzle, or at least not measure up to expectations. If FiOS does pan out, it will be the best-placed communications company in the country, head and shoulders above the competition. And in any case, market expectations for success are

low: The stock actually sold off in the wake of the FiOS progress report. That adds up to a pretty good long-term risk/reward tradeoff and it should eventually translate into a sizeable shareholder return.

It’s fair to say that a bigger dividend or share buyback would have done more for Verizon’s share price in the near-term. And there’s no guarantee that even if FiOS does pay off richly that the company won’t make some other dramatic move that depresses its share price.

Truth be told, I’ve been spot-on about Verizon as a company, since I first started tracking it as Bell Atlantic in the early ’90s. Almost alone among analysts, I forecast in the mid-’90s that it would come to dominate the communications industry, by virtue of scale, skill and financial power. I predicted it would beat out the long distance giants--AT&T, MCI and SPRINT (NYSE: S)--as well as the myriad competitive local exchange carriers that sprouted up in the late ’90s as Wall Street favorites.

I haven’t been dead wrong on the stock: It’s given a total return of around 160 percent since I added it to the Utility Forecaster Portfolio in November 1991, thanks largely to a policy of paying out generous dividends. But it’s routinely lagged the market and my biggest sector winners like ALLTEL (NYSE: AT), which I held as Lincoln Telecom before it was taken over. Also, for those who took my Bell Atlantic buy recommendation in the late ’90s, Verizon remains deep in the hole.

I still believe that the key to building real wealth in the stock market is to buy companies that are building increasingly valuable businesses. That’s the basis for my recommendations in every investment advisory I contribute to, from Utility Forecaster and Canadian Edge to the Income Portfolio of Personal Finance.

Verizon’s share price will ultimately reflect the growing strength of its underlying business, which could easily take it to a new high. Its valuation metrics--1.27 times sales and 14 times the lowest Wall Street estimate for 2007--are cheap. In the near term, the stock should easily cross into the $40 range, the high point for the past few years which it last saw in January 2005. And it continues to pay a big dividend.

I also believe, however, that Verizon shares are going to continue to tax my patience as I wait for them to finally reflect what I believe to be their true worth. Therefore, I suggest the following:

HOLD VERIZON SHARES AS A SAFETY IN YOUR PORTFOLIO, WITH THE EXPECTATION OF PICKING UP AN AVERAGE ANNUAL RETURN IN THE HIGH SINGLE-DIGITS. That’s a dividend yield of 4 percent to 4.5 percent, plus a roughly equal amount of share price appreciation. If you’ve held Verizon a long time and are in the red, consider selling some shares for a tax loss and enter anew once the wash rule expires.

In this way, you’ll be able to afford to be patient with the stock until it someday achieves a fair value. This is one of the best-capitalized and best-positioned companies in a market that continues to grow. It’s also the poster child for pessimism in a sector where the skeptics vastly outnumber the optimists.

Sooner or later, that combination will add up to outsized returns.

But as has been the case since the company began building its empire, playing with it will take a lot of patience.

MARKET WATCH

Interest rates and energy prices continue to be the keys to income investment performance. This week, we saw the benchmark 10-year Treasury note yield reverse a portion of its recent decline, reflecting investors’ growing concerns about the core inflation rate, which remains above the Federal Reserve’s targets.

At the same time, oil prices made a goal-line stand at $60 per barrel, actually shooting above $63 mid-week before cooling off.

Natural gas, meanwhile, continued to plunge, with futures prices falling for winter months as well as into next year on concerns about rising inventories. The fuel also continues to be hit by speculation that an El Nino weather system will keep winter 2006-07 mild, further exacerbating the current supply glut.

Overlaying the performance of both markets was more evidence that at least certain sectors of the economy are slowing fast, notably housing. The boom in housing has been credited with spurring consumer spending, as rising prices have made people at least feel wealthier. The stalling and possible reversal of the boom may be at least partly responsible for the 0.1 percent dip in consumer spending for August.

It’s still far too early to tell if these numbers indicate a stalling economy overall, or if they simply indicate more of the same thing we’ve seen for the past few years: an economy that doesn’t run hot or cold, but just keeps on chugging along.

If it’s the former, the energy sector is likely headed for more trouble. That’s a good reason to keep your picks conservative.

That’s big oils, utility producers and Canadian oil and gas trusts with a focus on sustainability. All will do well when energy inevitably turns back up again and in the meantime they’ll hold their ground.

A real slowdown in the economy would also be very good for the market’s safe havens. That means bonds and well managed bond funds, strong utilities, well-managed/low debt REITs, Canadian trusts outside the oil and gas business and other high quality yield-paying stocks backed by strong businesses.

If, on the other hand, the economy just keeps chugging along, energy is likely to bottom sooner than later and we’re going to see some huge profits once the November elections are out of the way. In that case, we could probably expect the Federal Reserve to return to focusing on controlling inflation, which would push up interest rates and very likely trigger at least some pullback in traditional income investments.

The upshot is income investors need to be prepared for both scenarios. That really gets back to remaining diversified over a broad range of sectors, sticking with high-quality companies--those with businesses that are becoming more valuable. This is no guarantee you’ll never have losses, particularly should the market weather get ugly. But you’ll keep getting a good stream of dividends with the virtual guarantee of ultimately rebounding. And if the market weather is good, you’ll score strong capital gains as well.

Roger Conrad is Editor of UTILITY & INCOME