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Telecoms

Big Telecom Scores Again

By Roger S. Conrad, on Nov. 1, 2013

We’ve yet to see third quarter results for most of the US communications industry. But it’s not too soon to ask what happened to the assertion the Big Two US Telecoms — AT&T (NYSE: T) and Verizon Communications (NYSE: VZ) — would be skewered by rivals’ cut rate pricing and a cheaper iPhone.

Last week, Verizon poked a huge hole in that argument by posting a 20 percent boost in its bottom line, largely on the strength of adding new high-end iPhone customers to its 4G wireless network. It also did a good job not losing current users, posting an industry-low “churn” rate of just 0.97 percent.

America’s largest wireless company now serves 101.2 million total accounts, adding 5.5 percent to its rolls over the past year. And despite the supposed increase in competition, it also raised profit margins by increasing revenue per customer 7.1 percent. “Smart phones” now account for 67 percent of Verizon’s retail wireless base, a figure set to rise now that its 4G network is essentially built out.

Verizon’s results should make its investors feel a lot better about buying out Vodafone Plc’s (London: VOD, NYSE: VOD) 45 percent interest in Verizon Wireless. That deal must still secure some regulatory approvals. But despite a $130 billion price tag, there’s little to worry about on the financial side after the company’s record $49 billion bond sale at favorable rates.

Verizon also has plenty of cash, with $16.6 billion in free cash flow projected for 2013, even after $16.6 billion in network capital expenditures. The hefty CAPEX is the single biggest reason Verizon continues to grow market share, even as smaller rivals like Sprint (NYSE: S) and T-Mobile USA (NSDQ: TMUS) sacrifice margins and roll up debt to hold business.

This week, it was AT&T’s turn to demolish the bear case. The company added nearly a million wireless customers in the third quarter, a sequential improvement from second quarter tallies. It also boosted service margins from the year ago period, and reported that 75 percent of its contract customers now use a smartphone, adding 6.7 million users in the quarter. Post-paid churn was barely above Verizon’s at 1.07 percent.

AT&T’s bottom line was up 6.5 percent from last year, excluding a one-time gain. Quarterly free cash flow after $5.97 billion in capital expenditures was a robust $3.2 billion. That was enough to fund dividends comfortably and buy back $1.9 billion in stock.

Meanwhile, year-to-date CAPEX of $15.6 billion continued to widen the company’s network capability advantage over all rivals except its fellow Big Two Verizon.

No one should expect critics of either company to soften their tone, or for theories of their imminent demise to disappear. One reason is simply that old views die very hard.

And more than a few industry observers have been convinced for years that the US communications market will inevitably go the way of Europe’s under-invested, overly populated industry—though there’s nothing in these numbers to even remotely indicate that possibility.

Both companies were more heavily shorted than usual coming into reporting season. And while some traders are no doubt trying to cover their positions on better-than-expected results, these giants are so big and complex there’s always something to point a finger at and justify a bearish view.

In addition, speculation remains that AT&T may be on the verge of a major acquisition in Europe, possibly Vodafone once the Verizon Wireless sale is closed and the proceeds are distributed. Should that happen, it would certainly increase uncertainty for future earnings, as the company would have to deal with the Continent’s troubles.

On the other hand, AT&T stock has lagged Verizon this year, as well as the under-performing S&P 500 Telecom Service Index. That’s a pretty clear sign this stock is already pricing in at least some of that risk.

For long-term investors, however, the numbers from AT&T and Verizon are clear confirmation that US communications is more than ever a game of scale. And the more these companies outspend their rivals on networks, the more their share of the most profitable customers will grow.

That in turn means robust margins and strong cash flows for both companies. And from that they can finance more capital spending to widen their advantage over rivals, as well as fund dividend growth, stock buybacks and stronger balance sheets.

Over-Ripe Apple

Ironically, the same can’t be said for the company whose revolutionary devices have accelerated the rise of AT&T and Verizon to dominance — Apple (NSDQ: AAPL).

Following up on my piece last month on this subject, the company’s high-end iPhones were once again big sellers for the Big Two in the third quarter. Considerably less clear, however, is how the lower-end offerings fared.

Apple guided last month to revenue “near the high end” of its previous forecast of $34 to $37 billion for 2013. But the success of AT&T and Verizon in the third quarter holding and gaining new customers suggests the low-end offerings may have had a lot less impact than was initially hyped.

In addition, the hire of the former CEO of luxury goods maker Burberry as retail marketing chief is writing on the wall that management sees the future as higher-end customers. The company announced this week that it’s rolling out a new line of higher definition and thinner iPads in time for the holiday season.

The primary cache of all these new products, however, is clearly scarcity. And so far as prices go, the devices are unlikely to fit into the typical consumer budget. Meanwhile, the company is still losing market share to global industry leader Samsung Electronics (Korea: 005930, NSDQ: SMSN), as well as a host of much smaller competitors.

The lesson here is device makers—no matter how ingenious their product—are always at risk to losing out to a better mousetrap. Unlike service providers, there is no natural advantage of scale, other than potentially superior access to capital and marketing reach.

To be sure, those can be formidable advantages. And as the history of other large technology companies demonstrates, once a company rises as far and fast as Apple has, the decline and fall can take a very long time.

I fully expect third quarter results to be released October 28 to be quite solid. The problem is—in contrast to earlier this year—that appears to be the Street consensus.

Bullish activity in options has apparently risen to a six-year high following the iPad announcement, according to data compiled by Bloomberg. And of the whopping 65 analysts Bloomberg tracks that cover the stock, 47 rate it buy, versus just 14 holds and 4 sells.

This is an extraordinary level of bullishness for a stock that’s underperformed the average S&P 500 company by 24 percentage points thus far in 2013. And it’s in spite of the shiny quarterly dividend of $3.05 per share. The insiders appear on the surface to be positive as well, adding 29 percent to holdings over the past six months—though there have been several sizable sales recently.

Street bullishness may be due to activist investor Carl Icahn’s mounting pressure on Apple CEO Tim Cook to use the company’s considerable cash position to buy back $150 billion of stock. Or it may be the lingering belief that Apple’s share price “belongs” closer to its September 2012 high of $700 plus—a level it reached as a smaller and less profitable business.

My view: Apple simply doesn’t command the same level of market dominance as the pair that’s arguably its two most important customers, AT&T and Verizon. Its heavily traded stock can be a good contrary bet when investor pessimism builds, as it did up until mid-year.

But with even daily fluctuations in the stock greater than the quarterly dividend, it’s no place for conservative income seekers. That distinction belongs to the far less loved but infinitely more essential Big Two of Telecom. And with the consensus hyper-bullish, Apple looks a bit over-ripe for now.

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