The Bush administration's decision to not challenge a U.S. Court of Appeals ruling against the Federal Communications Commission will block "network unbundling" rules previously scheduled to go into effect on June 15. Briefly, network unbundling mandated that incumbent local exchange carriers (ILECs) -- the old guard -- provide the network elements and pricing necessary for competitive local exchange carriers (CLECs) -- the upstarts -- to compete without having to lay network infrastructure themselves.
Forced to share their networks at government-mandated prices, ILECs like Verizon (NYSE: VZ), David Gardner's Motley Fool Stock Advisor recommendation SBCCommunications (NYSE: SBC), and BellSouth (NYSE: BLS) faced some serious competition. Yesterday's decision allows these companies to lease their infrastructure at "fair and reasonable" prices. The ILECs contend that the higher income will encourage them to invest for long-term, low-cost operations. We shall see.
As for the CLECs, this latest news is troubling. Upstart Talk America (Nasdaq: TALK), for example, looked like a bargain when it traded at five times free cash flow in February and an even bigger bargain in May, when it traded at an enterprise value of just four times free cash flow. But looks can deceive.
Clearly, pricing uncertainty exists for Talk America, AT&T (NYSE: T), and others until new contracts can be negotiated. Rich Smith provided an early glimpse into this dynamic when Qwest Communications (NYSE: Q) negotiated a new access agreement with the renamed MCI (Nasdaq: MCIA). The contract has "MCI agreeing to start paying gradually higher rates to lease local lines from Qwest, starting in 2005." In only two years' time, MCI will already be paying $5 more per month, per line, than it does now. Ouch!
Granted, Talk America delivers a return on equity (ROE) in the hundreds. And the company, at least, thinks its stock is cheap and is buying back $50 million of its shares. For investors, though, the question is: When you compete on price, and your costs are rising, what will your future operating margins be? Already, for Talk America, they languish at a less than stellar 12.9%.
Uncertainty will continue to loom until new contracts are negotiated. Until then, investors would be wise to ignore valuation metrics that appear historically cheap. Sometimes stocks look cheap for a reason. Given Talk America's uncertain future, the screaming value is a mirage.
Spend some time talking to other investors about Talk America or SBC Communications on our discussion boards.
Fool contributor W.D. Crotty
owns stock in Verizon.
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