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Monday, January 11, 1999

An Investment Opinion
by Alex Schay

Pacific Gateway "Exchanging" Shares

As everyone knows, the present shape of the telecommunications landscape is in large part due to the court-directed divestiture of the "Bell System" in 1984. In connection with the divestiture, a monopoly was broken and the U.S. was divided into 194 local regions known as Local Access Transport Areas (LATAs). The Bell System was separated into a long-distance carrier, AT&T Corp. (NYSE: T), which divested itself of the Bell Operating Companies (BOCs), transferring them to seven holding companies, or Regional Bell Operating Companies (RBOCs).

Increasingly, deregulation has become the international way as well -- and all these global networks getting interconnected has meant growth for the global network operators. In a similar fashion to the interconnection "rules" that govern local and long-distance practices in the U.S. market, global interconnection is facilitated by gateway providers.

Here's how a typical international telephone call might move. Assuming the call originates in the U.S., it must first travel through the local carrier's switched network to the caller's domestic long-distance carrier. The long-distance operator then carries the call to an "international gateway switch." An international carrier picks up the call at its gateway switch and then routes it to the corresponding international gateway switch operated by an international carrier in the country of destination (usually by means of a digital undersea fiber optic cable or satellite circuit). The long-distance carrier in that country then routes the call to its customer through the domestic telephone network. Foreign-originated traffic is routed back to the U.S. along similar lines (pun intended).

Today, Pacific Gateway Exchange (Nasdaq: PGEX), a facilities-based provider of international telecommunications services, was dropped by the market $14 11/16 to $31 after releasing a profit warning this morning. The firm reported that earnings per share for the fourth quarter will be $0.06 to $0.08 below expectations -- which were at $0.32. As well, Pacific Gateway reported that present 1999 earnings estimates of $1.57 per share will be "impacted by less than 20%."

The firm has attempted to market some of its services directly to retail customers that generate a lot of overseas traffic in areas where Pacific can offer a competitive price and service package. In addition, Pacific has tried to boost its overall operating margins by making a foray into the "value-added services" arena, which includes 800 service, international directory assistance, and travel card services as well as videoconferencing and Internet access.

Today, the firm reported that "slower than expected growth in our retail, value added and offshore operations, most notably in Japan, France and Germany, were particular issues this quarter. In addition, we experienced higher fixed costs in both the U.S. and in our newer offshore markets where the revenue is beginning to ramp up." In the company's third quarter, offshore revenues grew to account for 11% of the total base, while wholesale revenues declined, coming in at 85%. Meanwhile, retail remained somewhat of a disappointment, accounting for only 4% of revenues (and less than 10% in operating profits).

While Pacific still derives roughly 95% of its revenues from the increasingly competitive wholesale business, and many of the largest carriers will continue to develop their own switching facilities overseas -- like AT&T's Internet Protocol Switch in Mexico -- the firm is still set for some strong growth in its offshore markets and in the nascent "customer services" area. Pacific is going to pre-sell its two cable undersea fiber optic circuits in 1999 in anticipation of the system's completion in the first quarter of 2000. (When it can also recognize the revenues.) Even with numbers coming down rather dramatically today, year 2000 estimates will probably still be in the range between $3.00 and $3.50 per share, putting Pacific at 10 times these numbers.

Trading at 17 times trailing cash from operations with a 17% unleveraged return on equity (as in zero debt with ROIC of 25%) and diminished but not dashed prospects for 1999, the patient investor might want to take a closer look at Pacific. (Note: the firm's lack of debt has given it some flexibility in its capital structure, accordingly it has been working to secure a $200-300 million bank debt facility to support its expansion plans.)

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