Baby Bells' Silver Lining

We're dueling over the telecom industry on Fool.com. Ben McClure says the Baby Bells still have lots of life left, while Bill Mann disagrees. Read both articles, and then vote for which argument you think is better.

I like rain, Bill. The harder it falls, the better. Storms clear the street and send folks ducking for cover. In other words, the best opportunities emerge when investors get so worried about the clouds hanging over stocks that they miss what follows.

So, while these might be gloomy days for telecommunications stocks, it is a good time to highlight the silver lining offered by the Baby Bells. Verizon (NYSE: VZ  ) , BellSouth (NYSE: BLS  ) , and SBC Communications (NYSE: SBC  ) face a tough fight, but given their resilience, it's far too early to count them out.

Sure, the Bells are slow to move. But that slowness served them well. In the late 1990s, it was hard to hear past analysts, journalists, and other influence peddlers proclaiming that the Bells' days were numbered because of their hesitancy to roll out broadband digital subscriber lines (DSL). Instead, the now-defunct competitive local exchange carriers, or CLECs, taught everyone about broadband, and by the time the Bells got serious about DSL, the technology was fully developed and the cost had come to make it richly profitable.

Once again, Wall Street is swept up in the latest frenzy, viewing the march of Voice over Internet Protocol (VoIP) as the stake in the heart of the Bells. VoIP expansion plans at big cable companies such as Comcast (Nasdaq: CMCSA  ) , Cox Communications (NYSE: COX  ) , and Time Warner (NYSE: TWX  ) , plus AT&T (NYSE: T  ) and VoIP service specialist Vonage, are unmistakably aimed at the markets dominated by the Bells.

VoIP and wireless, not so scary
But on closer inspection, it looks like the VoIP threat is some way off. For starters, the number of VoIP users is minuscule -- don't expect the technology to put a big dent in the old telephone business anytime soon. Then there's the quality issue: While high-speed Internet connections have boosted performance of VoIP, it still falls short of regular phone service quality. And don't forget that the cost advantage could be short-lived if cash-strapped U.S. states impose new tax measures on VoIP calls.

Besides, regional Bells are getting ready to offer their own VoIP offerings. This makes business sense. In order to make Internet phone calls, people need a broadband connection such as DSL. So, by offering VoIP phone services, the Bells can guarantee that they capture $40 a month for DSL charges. That compares with about $25 a month that they collect for unlimited calling on the old voice network. VoIP doesn't look quite so scary now, does it?

If it's not VoIP that's hoisted up as the bogeyman, it's wireless services. Sure, consumers' flight to cell-phone services has dented the Bells' local phone businesses. But remember, the industry's biggest operators, Cingular Wireless and Verizon Wireless, are controlled by Verizon, Bell South, and SBC. In other words, with Bells pulling in much of the wireless market's revenues, these investments are paying off handsomely.

Good day, sunshine
That's not all. For the first time, the Bells have sold more high-speed Internet connections than cable providers. Verizon, SBC, BellSouth, and Qwest Communications added more than a million DSL lines in the first quarter of this year. Thanks to rising demand for high-speed Internet service, DSL has become the glue that is keeping the Bells in many households.

Plus, new FCC rulings are a huge win for the Bells. Next year the Bells will be able to stop providing long-distance companies and others deep-discount access to their local networks. Facing higher wholesale charges, MCI and AT&T are pondering a retreat from the local consumer business entirely. That means the Bells can win back millions of the lines that they lost, which translates into billions more in revenue in the coming years. Even better, the Bells get to keep the business of bundling long-distance and local services.

Free cash and dividends
It's the Bells' free cash flow numbers that really shine through. Despite fierce competition, which has resulted in price discounting, heightened marketing spend, and flat earnings, the Bells continue to generate very healthy free cash flow.

As a result, their shares sport very attractive dividend yields. In fact, both Verizon and SBC now produce more income than an equivalent 10-year T-bill offered up by Uncle Sam. For its part, it offers a sweet yield of 5.1 percent. That's almost twice the payout of the typical S&P 500 stock.

The Bells aren't about to cut their dividends anytime soon. Just look at their payout ratios -- the percentage of cash flow paid out as a dividend. The lower the payout, the more room the company has to boost the dividend, even if cash flow growth stays flat. For the three biggest Bells, the payout ratio is well below historical average levels.

Not all created equal
Admittedly, not all Bells are created equally. The best bets are Verizon and SBC. BellSouth looks riskier. Steer clear of Qwest Communications.

Verizon's aggressive shift to high-growth wireless, long-distance and Internet services appears to be offsetting losses in its core local phone business. Using fiber-to-the-premises (FTTP) and 3G wireless technology, Verizon is set to be the first U.S. carrier to deploy true end-to-end broadband networks capable of offering services that cut into the cable guys' turf, including digital TV and video on demand. Sure, these new networks won't be cheap to build, but they ought to help retain old and attract new customers, generating higher revenues per user. Thanks to more than $22 billion in free cash flow this year, Verizon will be able to substantially pare down its debt, even while rolling out next-generation networks.

Tom and Dave Gardner have picked one telecom company for Motley Fool Stock Advisor: SBC Communications. The recommendation makes sense. Like Verizon, SBC generates hefty free cash flow and shrinking debt levels. It is firmly positioned, as the second-largest U.S. broadband provider, with 3.9 million lines in service, behind Comcast's 5.7 million. My one big concern with SBC: the excessively high price paid for AT&T Wireless (NYSE: AWE  ) by Cingular Wireless, its joint venture with BellSouth.

Compared with Verizon and SBC, Qwest looks downright off course. The runt of the Bell litter, Qwest has far fewer customers than its bigger Bell brethren, and it is the only one that doesn't own a wireless business. Qwest is also behind in the scramble to sell high-speed Internet connections. With the company bogged down by $16 billion in debt, Qwest's dividend, now zero, is likely to stay there.

Remember, Bill, Qwest is the exception, not the rule. At first glance, the clouds hanging over the Bells look ominous. But don't bother with an umbrella. It'll keep you from spotting where the clouds break.

Fool contributor Ben McClure hails from the Great White North. Ben doesn't own any shares mentioned here. The Motley Fool has a disclosure policy.


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