Can telecom giants weather the perfect storm?

Benj Gallander and Ben Stadelmann
Saturday, May 18, 2002

We get a lot of email (thank you faithful readers) and one of the more frequent refrains goes something like: “You guys are supposed to be contrarians, so how come you aren’t buying — insert name of favourite broken blue-chip telecom stock — at $X a share?”

This is a fair question, as there is no doubt that the entire sector is out of favour, a factor that would normally perk our interest, and indeed does. The trouble is — and this normally happens when the high fliers are en route to a crash landing — this refrain started when these stocks were much, much higher, and has continued all the way down. Bottom-fishing in these waters has been a dangerous exercise.

The overcapacity, obsolete inventory, goodwill writedowns, and debt downgrades that contribute to awful “weather” conditions for telecom firms have all been well covered. What is less understood are three other “climatic” factors that threaten many of the stalwarts of the industry.

First, these stocks are trading at low values, not just relative to their lofty highs, but also in absolute terms. For example, it is said that Nortel Networks Corp. currently trades at 1993 prices. This statement is not precisely accurate. In July 1993, Nortel shares actually traded at $22.80 (US), compared with $2.85 today. The difference by a factor of eight reflects the cumulative effect of three two-for-one stock splits that took place along the way. It is often pointed out that stock splits and stock consolidations are purely cosmetic because they do not alter the value of the firm. That’s true, but as we all know, appearances matter.

That’s because many institutions require a minimum share price of $5. Penny stocks are for rank speculators, not prudent retirement funds; a company valued at 30 bucks sounds more like a blue chip worth buying. Consequently, once a stock slips below that $5 benchmark, it has a tendency to keep falling.

One influential group that seems to have a particular aversion for low-priced stocks are the folks at McGraw-Hill who shepherd the S&P 500 index. The sway these gnomes hold over a $1 trillion industry constitutes the second potent threat to telecoms.

The lexicon of The Street contains many euphemisms like “restated earnings” and “repriced options” that make investors wince. But nothing is as terrifying to shareholders than the seemingly innocuous phrase from the index keepers: “Company to be removed due to lack of representation.” On Tuesday WorldCom Inc. heard those awful words and saw its shares plunge to a low of $1.08. More than 670 million shares were traded, shattering the previous Nasdaq record of 308.7 million. Other telecom stocks that are at risk of getting expelled from the S&P 500 are Qwest Communications, Lucent Technologies Inc., JDS Uniphase Corp. and old faithful Nortel.

The final indignity that menaces these companies is the possibility of a stock consolidation. AT&T Corp. is proposing a one-for-five stock consolidation, to take effect after the close of the sale of their cable operations to Comcast Corp. Considering that most of these firms had stock splits over the past few years, a reverse split may be the only way to get their stock back up to snuff.

Most firms that undergo a consolidation fare poorly for at least a year, but that’s likely to be the case anyway. Although the clock can’t be turned back, it is possible to “reset” investors’s expectations, setting the stage for the next round of appreciation.

One rule of thumb of investing in a shell-shocked sector is to go with a robust player with a high chance of survival. Another option is to grab a few players with the knowledge that one might become a casualty, but another should give at least a five-bagger.

Right now, there are lots of wounded elephants running about, and in the melee of the stampede it is hard to assess who will likely succumb to their injuries and who will recover. Until the dust settles a bit, at the behest of caution, we’ll watch and wait while patiently biding our time.