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Baby Bells may provide investors a storm shelter

As economic growth falls flat and technology bellwethers blame macroeconomic trends for their earnings misses, there may be a species immune to economic downturns: Baby Bells.

    As economic growth falls flat and technology bellwethers blame macroeconomic trends for their earnings misses, more analysts are pointing to a possible recession. But there may be a species immune to economic downturns, one that proved itself in the tough times of 1990-91.

    The "Baby Bell"--also known as an RBOC (regional bell operating company) or an ILEC (incumbent local exchange carrier)--is the closest thing investors will find to a recession-proof technology stock, and the best line of defense investors can have in a portfolio during a downturn.

    Consolidation has narrowed seven Baby Bells to three and one hybrid RBOC/long-distance company: Qwest. All are stronger and more diversified. Their impending entry into the long-distance business should be a boon to them; and they now have new high-growth areas--data and high-speed access.

    Here's what's left of the Baby Bells: BellSouth, Qwest, a former upstart that became a hybrid Baby Bell with its purchase of US West, SBC Communications and Verizon, a company formed by the merger of Bell Atlantic and GTE.

    Qwest and BellSouth are seen as a "strong buy" by most analysts. Qwest is one of the highest-growth telecom companies, and it announced in its fourth-quarter report that it is on track to meet estimates for upcoming quarters. There is some conjecture by analysts that BellSouth could get gobbled up by Verizon or SBC, as the companies try to push into international markets.

    "I don't know if I would call them recession proof, but they are resistant," said Deutsche Banc Alex Brown analyst Gary Jacobi, who cited the company's diversified revenue streams and diversified customer base as strengths.

    The resilience of the business comes from its dependence on essential utilities. People aren't going to stop making telephone calls just because of a recession. On an aggregate basis, the four companies derive 37 percent of revenue from local phone services, 19 percent from network access, 18 percent from wireless services and 6 percent from directory services, according to figures from Morgan Stanley.

    While an economic slump could impact access line growth and long-distance calling, local services should be resilient, and wireless services should also prove a solid revenue generator since it "has morphed from a luxury into a necessity," Morgan Stanley analyst Simon Flannery wrote in a research note.

    Fixed-prices used in most calling plans also limit the link between usage and price, making it less likely that average revenue per user will dwindle during a recession.

    Historical evidence
    The performance of some Baby Bells--also known as RBOCs (regional bell operating company)--or ILECs (incumbent local exchange carrier) during the 1990-91 economic downturn makes a strong case for their reputation as a defensive investment. Local revenue and access line growth showed only minor slowdowns, though operating revenue on an aggregate basis declined. Categories hardest hit were network access and regional long distance. As for the stocks, the Baby Bells were down 10 percent in aggregate for 1990, but they gained ground in 1991 and 1992, peaking with gains of 11 percent in 1993.

    Those returns aren't spectacular, but it sure beats watching former high-fliers fall almost 100 percent from their 1999 highs.

    Wireless, a business many analysts assume more likely to be considered discretionary, was dented during 1990-91, but it still showed overall growth, thanks in part to the fact that the industry was in such an early stage--something that would be different this time around.

    Even if wireless does suffer this year, the RBOCs are now a much different animal and have plenty of assets to offset any decline.

    Consolidation has narrowed seven Baby Bells to three and has left one hybrid RBOC/long-distance company: Qwest. All are stronger and more diversified. Their impending entry into the long-distance business should be a boon to them; and they now have new high-growth areas--data and high-speed access--that should be in a similar situation as wireless was in 1990-91.

    "My bet is there's enough demand for high-speed and wireless to sustain them," Davenport & Co. analyst Drake Johnstone said. "Penetration of high-speed services is still less than 50 percent...we're still in the game in terms of high-growth."

    Given a renaissance of "value investing"--looking for stocks at a reasonable price--and the fact that Baby Bells are selling below a 15-year price-to-earnings ratio, there is a good chance the stocks will appreciate, Flannery said.

    Historical trends also show that these stocks were undervalued in 1998 through 2000, he said. It was the inevitable outcome of a bull market and the shift away from value investing, Flannery said.

    Don't overstay your welcome
    Although Baby Bells may look like a safe bet in an economic downturn, timing is everything. If evidence that ties the value of their stocks to interest rate cuts is to be believed, it might be time for short-term investors to consider dropping the stocks by mid-year.

    While economists quibble over whether the United States has indeed entered a recession--especially since the Federal Reserve's two rate cuts in January--Flannery said a recession has indeed arrived; and based on historical evidence, he said, investors should consider getting rid of RBOC shares as soon as the economy picks up again.

    According to Flannery's report, titled "RBOCs Can Rally in Recession," their stocks appreciate following the first series of rate cuts, but "following the last cut and 12 months thereafter, ILECs tend to underperform." The performance of the stocks in 1995 and 1998 back up his claim.

    Economists widely believe Fed cuts are likely to continue, with a 4.5 percent Federal funds target rate by the middle of the year. At that point, recovery is expected, and investors will move in on the more aggressive stocks in telecommunications and across the board.

    It may even be too late to buy based on a timing call. "I'm not interested in buying something that's defensive at this point. The market is usually looking three to six months in advance, its more focused on a recovery in the second half of the year," said Russell Wayne, president and chief investment officer of Sound Asset Management.

    Analyst Jacobi discounted theories that the RBOCs could lose popularity as the economy rebounds. Any downward turn would be offset by growth in data and what Jacobi calls the "271 effect"--regulation 271 is the result of recent legislation to allow local calling companies entry into the long-distance market.

    That said, Jacobi acknowledged that if the economy rebounds strongly, some smaller CLECs (competitive local exchange carriers) could be the stocks to watch. These include Metro Media Fiber, Allegiance Telecom, XO Communications and Time Warner Telecom. More aggressive communications stocks like Williams Communications, Level 3 and 360 Networks could also outperform the Baby Bells.

    But for most analysts, the call isn't about timing. The growth opportunities in these companies' data and high-speed businesses are enough to recommend them. Jacobi said that a recession is not factored into his current ratings and estimates for the RBOCs, and he wouldn't say the economy is in a recession, yet. "That said, RBOCs are a good place to be regardless of the environment," he said.