July 24, 2002

Time to buy telecom?

Now that the dust has settled from the telecom bust, a good argument can be made for buying stocks like Nortel and Lucent at their current prices

Wynn Quon

What's the difference between a telecom stock and the Grand Canyon? If you jump into the Grand Canyon, you eventually hit bottom. To telecom investors, the events of the past year have been nothing but a bad joke. Instead of getting rich on bandwidth, we've been treated to a series of stink bombs and exploding cigars. How bad has it been? According to FORTUNE magazine's Geoffrey Colvin, the telecom bust has wreaked immeasurably more havoc than the more well-known dot-com fiasco of a few years back. The collapse in the stock prices of Nortel, Lucent, Worldcom, Global Crossing and dozens of others have destroyed US$2 trillion of market value, twice that vaporized by the dot-coms. Layoffs in telecom totalled 500,000 last year alone.

But despite the bad news, is it time to look past our soot-covered faces and start buying? As every good contrarian investor knows, the best opportunities come up when things often appear bleakest.

On balance a good argument can be made for buying stocks like Nortel and Lucent at their current prices. This isn't based upon the long-hoped for turnaround in capital spending by the carriers. Although there seems to be a consensus out there that a recovery will come in 2003, this is nothing more than the latest in a half-a-dozen missives of failed optimism. Teams of analysts have been combing the capital budgets of the giant telephone carriers in search of the elusive uptick, but unfortunately they're missing the bigger picture. The biggest threat to telecom recovery is the economy at large. The number to keep in mind: five of the past seven recession since 1957 have been double dips. To make things more dicey, this time around we're also struggling with the afttermath of a speculative bubble. If the economy does take a turn for the worst, it will mean a slowing or even a decline in the telecom carriers' most fast-growing markets: business data services, high-speed residential Internet access. Investors got a hint of how unpleasant this could be with the earnings release on Monday of Bell South, the third largest local telephone carrier in the U.S. Even with the relatively mild economic climate earlier this year, the company announced an earnings shortfall and cut its profit estimate for the upcoming year. The markets put an immediate 20% crimp in Bell South's stock price.

So if the turnaround is uncertain why consider buying now? Put it down to that old chestnut "traditional valuations". Two years ago, when telecom was red-hot, Nortel sold at a price-to-sales ratio of over 8, while Lucent sold at a price-to-sales of more than 5. Today Nortel sells at a PSR of 0.3 and Lucent at 0.4. What does this mean in everyday language? In 2000, investors were shelling out $8 for every dollar of sales that Nortel had. Now, they are only willing to fork over a mere 30 cents for that same dollar of sales. Of course, even though the shares are marked cheap, further markdowns aren't out of the question. In the same way that traditional valuations flashed red in the late 90s and stock prices continued rising, the green light that's flashing now doesn't rule out more panic selling on the downside. As value investors know, there's no trumpet blast signaling the market bottom. This is where the appetite for bargains must be tempered with an appreciation of risk.

For those who believe that the market often overreacts, one good sign for telecom stocks is the short interest. By short selling a stock investors are betting that it will fall in price. Investors are so sure that Nortel's stock will fall for example, that they've sold short 330 million shares as of last month. This short interest has tripled in two months. One of out every ten Nortel shares has now been sold short. The same is true for Lucent. The implication is that if good news does come, both stocks will get strong price boosts from short sellers closing their positions.

Other positive signs include the burst of insider buying at Nortel and a slowing of selling at Lucent. In June nineteen insiders bought two million shares at Nortel. At Lucent, insiders sold 70,000 shares in the past four months which is significantly down from the 2.6 million shares that were sold in the previous four months.

The ultimate risk in the case of Nortel and Lucent is their ability to survive a prolonged drought. A much-commented-on issue is the debt load that both of these companies have taken on. Nortel's debt-to-equity ratio, is a middling 1.2 while Lucent's is better at 0.33. But one overlooked point is when the debt needs to be paid back. Seventy-five percent of Nortel's long-term debt doesn't come due until after 2006 and the same is true for virtually all of Lucent's debt. In the meantime, the good news is that both companies are loaded with cash: Lucent has a tidy US$4.8 billion, while Nortel has US$3 billion. The key challenge for their management teams is to make it last until the recovery arrives.

Although it's not certain that they'll be able to pull it off, the chances are good, and certainly worth a prudent bet. But even as we ante up, you can't help but wonder. Will these former telecom stars pull the rug from under us once again? Are we being set up for the last punchline in the telecom shaggy dog story? Maybe so but at least this time, the odds are just a little more in our favour.

Wynn Quon is chief investment analyst at Legado Associates (e-mail: wynn_quon@hotmail.com; website: www.legadoassociates.com). Disclosure: the author may hold shares in some of the companies mentioned.