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Google and AT&T: Is bigger better?
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Phone numbers
Let's take the same kind of look at a very different company, AT&T, that's growing by acquisition, a very different model from Google's.
I've read all the Wall Street explanations for why AT&T's acquisition of BellSouth makes good business sense. It will increase the company's footprint in both conventional land-line and wireless phone services. It will enable the company to compete more effectively with the cable companies in offering new services such as TV and long-distance telephony over the Internet. And, of course, there's the conventional explanation for why the deal is so great: synergies. The newer, bigger AT&T will be able to cut costs by $2 billion annually in stage one and then increase the savings to $3 billion annually by 2010. Much of that will come from job cuts: 10,000 as a result of the acquisition of BellSouth and 13,000 as a result of November's deal combining SBC and AT&T.
I get the job-cut part, but I don't see why AT&T had to acquire BellSouth if all it wanted to do was reduce costs by paying fewer workers. The other stuff? It just doesn't hold up for me. AT&T owned 50 million access lines before the deal and had 7 million DSL (high-speed Internet) lines in place before the merger. BellSouth will bring 20 million access lines and 2 million DSL lines. That's a hefty chunk of customers, but not really to the point if you're talking about the ability to offer new services. And isn't a company with 50 million land-lines already so big that adding 20 million more isn't a significant change in scale?
The deal is especially puzzling when you look at the liabilities it brings to AT&T. The company already has one of the 10 largest unfunded pension obligations among the companies in the Standard & Poor's 500 ($INX). A shortfall of $12 billion puts the company just below General Motors (GM, news, msgs), Ford Motor (F, news, msgs) and Verizon Communications (VZ, news, msgs). In buying BellSouth, AT&T also acquires another $7 billion in unfunded pension liabilities. The total: $19 billion.
Besides pension costs, the other huge drag on phone-company profitability right now is capital spending, which is needed to deliver all the neat stuff that is supposed to win the battle against the cable companies. AT&T isn't as far along in its buildup as Verizon, the industry leader. But it's not far behind, and Wall Street projects that after climbing by another 4.1% in 2006 (after a 7% increase in 2005), AT&T's capital spending will level off in 2007 and then start to decline.
Land-line locked
BellSouth, on the other hand, has been spending most of its money on its legacy land-line network and on its wireless system, with relatively modest investments in the fiber optics necessary to deliver the brave new world of services to the home that the phone companies are betting on to beat back cable. So in buying BellSouth, AT&T is taking on a high-technology build-out that is less advanced than its own.
But if you ignore the high tech razzle-dazzle that Wall Street is using to sell this deal to investors and that AT&T is using to sell it to consumers and Congress, and look instead at the old land-line business, you will see how scale is important. The land-line business -- you know, your Mom and Dad's telephone -- isn't growing. Wireless and Internet telephony are taking their share. Prices are dropping. AT&T projects a 3% drop in wire-line revenue in 2006, followed by a 1% drop in 2007. Yep, in some ways, it's a terrible business.
On the other hand, it still generates huge cash flows. In 2005, $40 billion out of AT&T's $65 billion in total revenue came from the land-line segment. That's 62% of revenue. About 57% of earnings before interest, taxes, depreciation and amortization came from the land-line segment.
And you know what? Profit margins in this declining business are actually climbing. By cutting customer service and reducing work forces, the phone companies have been increasing the cash this cash cow yields.
Now think of the deal not as designed to improve AT&T's position in new technologies, but to defend the old legacy phone business and these climbing margins. If you can remove a competitor, as SBC did when it bought AT&T and AT&T did when it bought BellSouth, a company has more ability to cut costs by reducing customer service without the fear that some competitor, spending slightly more on this business, will poach your customer.
So in this one business -- the declining legacy business that no one really wants -- scale does matter, and bigger is better. Adding a percentage point or so to your profit margins adds up pretty quick when you're looking at $40 billion in revenue.
And, of course, if you know that you're going to be going head-to-head in an investment war with first the cable industry and then with new WiMax broadband wireless technologies, every extra dollar you can get from that cash cow counts.
Updates
Sell iShares MSCI Japan
I added the iShares MSCI Japan (EWJ, news, msgs) ETF to Jubak's Picks on Nov. 4 to get some exposure to Japan's big exporting companies. My thinking was that with the Japanese economy returning to growth, these companies would see a pickup in domestic sales in Japan, and that I'd get an extra foreign-exchange boost as the U.S. Federal Reserve stopped raising interest rates. That would lead to a weaker U.S. dollar and raise the value of Japanese stocks held by U.S. investors such as myself. Well, only part of that macroeconomic picture has worked out as I projected. The Japanese economy is growing even more strongly than I had estimated, with some economists now looking for 5% to 6% growth in 2006. But the U.S. Fed now looks like it will keep raising interest rates longer than expected. That will keep the dollar stronger than I anticipated against the yen, even if the Bank of Japan starts to raise Japanese interest rates later this year. In this environment, I'd rather hold domestic Japanese equities to pick up more of the country's internal economic growth. So with this column, I'm selling my position in iShares MSCI Japan for a 9% gain. In the weeks to come, I'll be looking to add another domestic Japanese stock but probably not before the Bank of Japan meets in April. (Full disclosure: I will sell my personal position in iShares MSCI Japan three days after this column is posted.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: iShares MSCI Japan and Microsoft. He does not own short positions in any stock mentioned in this column.
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