2HRS2GO: Nothing safe about AT&T

COMMENTARY -- Last year's market turmoil supposedly represented a return to rational investing, but AT&T (NYSE: T) is proving otherwise today.

Morgan Stanley Dean Witter analyst Simon Flannery jolted AT&T investors into action this morning. Shares of Ma Bell gained more than 10 percent after Flannery called the stock a "strong buy" after years of Morgan Stanley's bearishness on the telecom giant.

But nothing has changed about AT&T. Flannery's upgrade amounts to re-evaluation of existing data.

The Morgan Stanley analyst points to three factors:

• Valuation.
  
• Break-up potential.
  
• Wireless and cable strength.

Flannery notes that the big risks to AT&T remain its bad credit rating and its flagging voice units. AT&T Wireless (NYSE: AWE) currently trades around $20 a share, so the market has already put a value of zero on Ma Bell's traditional business, effectively pricing the risk into the stock, the analyst believes.

As for that credit -- lowered bond ratings and $60+ billion in debt are hard to ignore -- Flannery believes AT&T is fine with cash, given that the company just got billions from NTT DoCoMo, received a $25 billion loan and cut the dividend to just 17 percent of its former payout.

AT&T's remaining business carries a conservative value of $35 a share, Flannery argues. That price target rests on a valuation of 9.5 times 2001 earnings before interest, taxes, depreciation and amortization.

The analyst also sees a value of $39 per share if you value AT&T's units separately.

Assuming multiples of five times Morgan Stanley's estimated 2001 EBITDA for the company's business long distance and three times estimated EBITDA for consumer voice yields values of $48.3 billion and $15.7 billion respectively.

Morgan Stanley's wireless analyst puts a value of $66.3 billion on AWE.

On AT&T broadband, Flannery's discounted cash flow analysis for the cable services unit and IP telephony, combined with current market values for related investments, produces a value of $66.3 billion.

AT&T's equity stakes and joint ventures combine for $14.2 billion, Flannery says.

Add it all together produces a value of $210.8 billion for AT&T's operations. Subtract Morgan Stanley's 2001 debt estimates for AT&T (not including the wireless unit's debt) and you have a price of more than $151 billion for Ma Bell. Divide that by a 2001 estimate of 3.86 billion shares outstanding gets you to $39 per share.

The other legs of Flannery's AT&T triangle are easier to see. AT&T plans to spin off three major business units this year, creating a trio of catalysts for the main stock. Wireless looks as strong as it ever has. And cable is improving.

All that was apparently enough to convince Wall Street.

That's assuming people bothered reading the report. More likely, people simply saw a major research firm reversing a long-time bearish stance.

Apparently few folks are considering the possibility of Morgan Stanley the investment bank angling for a piece of AT&T's scheduled IPOs. At the very least, the timing of Morgan Stanley's upgrade is curious.

Curious also is the reasoning. Flannery tries to lend weight to his conservatism by pointing out that his 2001 earnings estimate of 58 cents per share for AT&T is far below Wall Street consensus of 85 cents. He cautions that AT&T stock could feel some short-term pain if the company, as he expects, cuts its 2001 guidance.

But a value of $35 or $39 still seems to be a stretch.

Much of that valuation rests on his estimation of the company's parts. Yet even Flannery notes that approach has rarely worked in his field. "We are well aware of the difficult track record that sum of the parts analysis has in the telecom sector, and for AT&T," he writes.

He asserts that the upcoming break-up will provide the value realization. Could be, but until you get closer to the actual IPOs, no one can say what kind of price Wall Street is willing to assign to each unit.

I wonder if investors and fund managers be willing to pay any multiple at all for a declining voice business. And AT&T's lousy track record with cable so far ought to give anyone pause before proclaiming that it will gain traction this year; Flannery says AT&T has finished most of the measures that had to be taken to fix cable, but the company still has to prove it can not only run the system well, but sell enough services to make it worthwhile.

The only concrete part of Flannery's AT&T look is wireless, which is strong by any measure. But there's already an existing AWE tracking stock to catch that portion.

All told, the Morgan Stanley analysis is thorough, but it asks investors for a leap of faith. It asks for more tolerance than AT&T investors historically have been willing to endure.

You have to believe Ma Bell's IPOs will do well in a market that has seen initial public offerings shrivel up over the last several months. You have to believe AT&T will execute well on its cable business despite failure so far. You have to believe wireless will remain strong this year, although there are some signs that it could be stalling for awhile -- see the latest report of Nokia (NYSE: NOK) for details.

Flannery admits AT&T has become a more dangerous stock.

"AT&T today is far removed from the Ma Bell of previous years," he writes. "Investors should buy the stock with the understanding that the risk reward is favorable, but the risks remain substantial, particularly with long distance and credit quality."

And everything else. 22GO>