Why AT&T and Verizon Communications Should Not Be Rising Today

The Dow falls but its telecom members rise anyhow thanks to a glowing analyst note. But do this upgrade's assumptions really support the conclusion -- and market action?

Jul 25, 2014 at 1:45PM

The markets are having another bad day today, driven by lukewarm durable-goods orders this morning and a few disappointing earnings reports last night.

But nobody told the telecom sector to stay down today.

Verizon Communications (NYSE:VZ) is one of today's strongest performers with a 0.5% rise, and archrival AT&T's (NYSE:T) 0.2% gain also ranks it fairly high on this dour day of trading. Yesterday, AT&T fell while Verizon surged; today, the telecom giants are acting like the Wonder Twins as usual, moving in unison against the broader market trend.

Vz Sign Fool Flickr

The big catalyst here is a fresh research note on Verizon from analyst firm FBR Capital. Analyst David Dixon raised Verizon from a "neutral" rating to a "buy," painting a positive picture of the market for America's largest telecoms.

Dixon expects the merger of smaller rivals Sprint and T-Mobile to pass, while the Street overall sees a lower probability of final approval. So why isn't he downgrading Verizon and AT&T today?

Because he thinks the merger would actually be good for the two giants on top of the wireless heap. "Until the combined asset becomes an effective substitute to Verizon and AT&T in the high-end postpaid and enterprise segment, we would not expect substantial competitive pressure on the two larger incumbents in market segments where they currently enjoy an effective duopoly today," he wrote.

And that's not all. Dixon also expects Verizon and AT&T to continue building out fiber-based backbones across their wireless access networks, setting them up to leverage these investments with high-quality next-generation services.

This is where I have to respectfully disagree with Mr. Dixon's conclusions.

He may be right about AT&T and Verizon laying the groundwork for fantastic services several years down the road. But that would be a larger threat to today's small-scale rivals than to the proposed third meganetwork.

Given the economies of scale that would come with Sprint and T-Mobile's combined 104 million paying subscribers, Japanese billionaire and Sprint chairman Masayoshi Son would most certainly build a modern network to match what the big dogs can manage. The fragmented second-tier competitors we have today simply don't have the scale to get it done.

Going back to Dixon's first market-moving conclusion, the integration period that follows any major merger would only give AT&T and Verizon a short-lived respite. And then there's a determined attack coming. So if Dixon expects this merger to happen, he really should count that as a negative against the big telecoms' long-term valuations. What we have here is a case of short-term thinking draped in long-term language.

This market-moving catalyst makes no sense when you dig below the shiny surface. Dixon's assumptions don't point to his final conclusion at all, other than in a short-term perspective. And that myopic thinking will not help you beat the market in the long run.

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