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Do telecom insiders know something you don't?
Executives are scooping up shares of their own stock, which could signal an opportunity for investors. But the industry's crosscurrents make it a tricky proposition.
By Michael Brush
Insiders at telecom companies have been snapping up their own stock at an impressive rate over the past several months.
Should you follow them?
After all, many other investors are already doing just that. As a group, telecom shares have outperformed broader market indices since early last fall.
Put these two signs together -- insider buying plus relative strength -- and you have a signal that something positive is afoot in the sector, says Michael Painchaud of Seattle-based Market Profile Theorems, an independent stock research group.
Painchaud has been advising clients to buy shares in telecom companies where insiders have been the most active. These include SBC Communications (SBC, news, msgs), a former Baby Bell, Sprint PCS Group (PCS, news, msgs), AT&T Wireless Services (AWE, news, msgs), Corning (GLW, news, msgs) and especially ADC Telecommunications (ADCT, news, msgs), an equipment maker.
Top executives and directors rarely talk about why they buy shares in their own companies, but heres what telecom analysts who invest in the group have to say: This insider-buying trend does point to some interesting investment opportunities, but its not nearly as straightforward as seems.
Regulatory changes afoot
Unfortunately, to get a handle on the outlook for business, you have to delve into the details of regulatory reform getting kicked around Washington, D.C.
This is bad news for two reasons.
First, regulatory matters are complex, though weve boiled them down to the essentials. Second, any time a companys outlook hinges on whats going on in Washington, it makes for a much tougher call, because politics are so unpredictable.
That said, what may be shaping up in Washington is no less than a major rethink of Federal Communications Commission (FCC) rules that were meant to produce competition and better service in the phone sector.
At the heart of the matter are FCC rules forcing local phone companies such as SBC, Verizon Communications (VZ, news, msgs) and BellSouth (BLS, news, msgs) to share equipment and networks on the cheap with long-distance companies such as AT&T (T, news, msgs) and MCI WorldCom Group (WCOEQ, news, msgs). The idea was to open up the local networks so that long-distance companies could offer local service as well.
While the FCC rules were supposed to encourage decent profits as well as investment in telecom infrastructure, theyve really done neither. The current rules have led to unsustainable price competition, says Bill Rouhana, the former chief of a national fixed wireless company. This leaves scant investment capital from business to plow back into infrastructure.
Whats more, the long-distance companies have difficulty raising money on Wall Street to fund a buildout of their own local systems. Meanwhile, local phone companies question why they should upgrade their own networks only to be forced to share them at a loss with competitors, the long-distance companies. This is not a smart way to create a long-term, viable, competitive industry, says Rouhana. So something has to give.
What may give is how much local phone companies are forced to share equipment, known as unbundled network elements (UNEs) in regulatory jargon, with long-distance companies.
Many analysts and industry insiders believe ultimately the FCC will scale back dramatically the range of equipment the Baby Bells have to share with long-distance providers at heavily discounted prices, because the current system simply doesn't work.
As this thinking goes, the Bells still will have to share local networks, the so-called last mile. But a relaxation of rules on Bell-owned switches and high-speed DSL Internet connections could essentially return to the Bells a monopoly on local service. And that, of course, is exactly what they want, says Cody Willard of CL Willard Capital Partners.
If this camp is correct -- or even if the FCC moves moderately in this direction -- it could have the following impact on the telecom sector.
The Baby Bells and long-distance providers
The regional Bell companies would benefit the most from a softening stance by the FCC. Among them, SBC has the biggest base of local phone customers in urban areas, the kind being cherry-picked the most by long-distance competitors getting cheap access to Baby Bell equipment.
This may explain why SBC insiders were buying so heavily during the late fall, just ahead of the start of the FCCs triennial review of its rules, which is getting under way this month. The FCC has totally telegraphed the changes they are about to make, and the guys at SBC are looking at this as hugely positive for them, says Willard. Operations chief Stanley Sigman, Chairman Edward Whitacre and several board members were big buyers in the summer and fall. Whitacre, for instance, bought more than 170,000 shares over a three-month period from August through November 2002. (No one is suggesting this activity was improper.)
Regional bells lose about $20 per month for each line they have to share with long-distance companies. At the end of 2002, they were sharing about 11 million lines, notes UBS Warburg analyst Nikos Theodosopoulos, for an annual loss of $2.64 billion per year. More favorable FCC rules would help Baby Bells get some of that revenue back.
If the FCC does cut back on the discounts that long-distance companies enjoy on the use of equipment owned by the regional phone companies, long-distance providers like AT&T, MCI WorldCom and Sprint would lose out, of course.
A couple of potential problems stand in the way of any gains for the Baby Bells. First, state regulators and the long-distance companies likely will challenge any FCC changes that favor the Bells dramatically. The battle could drag out for months.
Meanwhile, the Baby Bells are still losing customers to wireless providers and Internet-based phone service, says John Maxwell, a telecom analyst with Waddell & Reed. They also face problems with underfunded pension plans.
I would argue they have had their run, and I dont know what the next event is that will drive them higher, says Peter DeCaprio, an analyst with the Evergreen High Yield Bond Fund (EKHAX).
The equipment makers
On paper, it doesnt look like a favorable action by the FCC would increase Baby Bell spending much on the equipment made by the likes of Corning, Lucent Technologies (LU, news, msgs), Nortel Networks (NT, news, msgs) and ADC. At most, FCC actions could theoretically let the Baby Bells get back all of the roughly $2.64 billion they lose per year by sharing equipment at a discount with long distance providers.
But since the Baby Bells only spend about 15% of revenue on capital projects, that would translate to $400 million more for equipment makers. Thats not much in a $17 billion market.
Gartmore Total Return fund (GTISX) analyst Kent Madden, however, points out that the Baby Bells are at maintenance levels on capital spending. In other words, there may be nowhere else to go but up. He thinks capital spending will bottom in 2003 and rise in 2004. If hes right, that kind of reversal could spark a new interest in equipment makers by investors.
John LaForge of Phoenix-Hollister fund company thinks an FCC restoration of the Baby Bell monopoly position would spur capital spending for another reason. There will be a lot of resistance from states and consumer groups because they dont want monopolies. So the first thing they would have to do is start upgrading to make their service impeccable. Besides, he says, one reason Baby Bells are holding back is they dont see the point in making upgrades only to share improved networks with long-distance companies at reduced rates. Remove that disincentive and Baby Bell spending on equipment could increase.
Despite these potential positive trends, many investors are steering clear of telecom equipment companies such as Lucent, Nortel and Corning because they have weak financials. But with conditions improving in the credit markets recently, credit risks are less troubling, says Gartmore Total Return fund manager Bill Miller, who recently took positions in the debt of Lucent, Nortel and Corning. The going-out-of-business risk has diminished as the capital markets start to improve.
One that looks like it has debt trouble -- because it trades for less than $5 -- but which actually has a solid balance sheet is ADC. The company sells equipment and customer care software used in telecom and cable transmission. It is taking business from major players like Cisco Systems (CSCO, news, msgs) and Motorola (MOT, news, msgs). ADC is a pretty darn good way to play any rebound in telecom, says Willard. The insiders that are buying there are the type of insiders I respect because they handled this downturn very well. Chief Financial Officer Robert Switz and Chairman Richard Roscitt bought more than a million shares between them at the end of November, for example.
To be sure, equipment makers still face lots of troubles, too. Chief among them: Too much capacity and too much second-hand equipment on the market from failed phone companies. They also face declining cash levels and the need for tough cost-cutting ahead. It is kind of a high-wire act, says Evergreens DeCaprio. It is not easy to mange a downturn when your cash is declining.
Entry points
If all of the crosscurrents are hard to keep up with, heres a simpler way to look at it. Telecom insiders scooped up shares in their own companies recently partly because they simply got so cheap.
I think a lot of the people in the business looked at the industry and said, When was the last time business just went away for three years in a row? says LaForge. They saw their stocks at cheap levels and they said, Hey, I will take a shot.
So one approach might be to stake out an entry price a little above where insiders bought and wait it out. SBC saw steady buying in the $20 to $25 range during the summer and fall. Insiders bought Sprint at around $3 in late October. At AT&T Wireless and Western Wireless (WWCA, news, msgs), they moved in at around the $3.50 range. ADC saw significant insider buying in the $2-to-$2.20 range during November, while insiders went for Corning shares in the $3-to-$3.40 range in the same months. Last summer, insiders bought Lucent and Nortel at around $1.75 and $1.
What might send telecom shares back down near these levels? An ugly turn of events on the international front would do it. Meantime, the turnaround in telecom will likely be slower than investors now think. And investors may have to come face-to-face with that pace when telecom providers offer details about revenue and spending during quarterly conference calls over the next few weeks. When we start focusing on the first quarter, the numbers will be down significantly, and we will see people get scared again, says Evergreens DeCaprio.
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