Are Big Government and Big Communications about to butt heads for real? That looks more likely after the Federal Communications Commission’s (FCC) recent 360 pages worth of proposals to boost broadband usage in the US.
Since the Telecommunications Act of 1996 went on the books, the history of the communications industry has been one of rapid technological advancement coupled with consolidation of market power. The first was well anticipated by Wall Street and Washington bureaucrats. The other has been an almost complete surprise to all but a handful of observers, though it was arguably an inevitable consequence of the first.
Keeping up with technological change is expensive. For every innovation sweeping the communications space in the past 15 years–from digital cable to smart phones–billions of dollars have had to be spent on equipment, software and spectrum, as well as to pay personnel.
The giants of the 1990s have seen what were once their core businesses continue to diminish, from what used to be long-distance telephone service to basic cable television. But revenues from new modes of communications such as broadband and wireless have grown even faster. In fact, we’ve now reached the point where these so-called advanced services are actually a larger part of the pie than the traditional services, which become less important by the year.
The key to any company being able to stay on top decade after decade is the ability to tack successfully with the changes in the economy and society. When the telecommunications industry was deregulated in 1995, I was among a very few advisors who gave the Baby Bells and nascent cable television companies a chance of being able to ultimately compete with the likes of old AT&T, WorldCom and others. But it was two Bells that wound up taking over AT&T and WorldCom at pennies on the dollar as they grew to become America’s two telecom leaders AT&T (NYSE: T), which rose again from SBC Communications, and Verizon Communications (NYSE: VZ), the old Bell Atlantic.
AT&T and Verizon today dominate US communications in a way even pre-1984 breakup Ma Bell could scarcely have dreamed of. And as the only companies in their industry that can spend $18 billion to $20 billion a year on networks, they’re widening the gap with rivals every day.
The advent of 4G LTE (Long-Term Evolution) networks for both companies later this year could prove a bridge too far for most or even all of their competitors. That includes Sprint Nextel (NYSE: S), which is rolling out its own 4G network using WiMax technology in a partnership with cable companies. Still losing millions of customers and millions of dollars every year, Sprint has literally no choice but to get its system to market now. Outside of Texas, however, coverage will be sparse, and the needed expenditures will be a heavy burden for America’s No. 3 wireless company.
Even Sprint’s five-year bonds, for example, have a yield to maturity of close to 9 percent, 700 basis points above Treasuries. In contrast AT&T’s five-year paper has a yield to maturity of barely 3 percent, scarcely more than Treasuries. That’s good news for its ability to raise capital, though bad news for anyone hoping to scrape out a decent return by buying AT&T bonds. Sprint debt, meanwhile, is more likely than ever to be downgraded by major raters, further boosting its cost of capital just when it most needs to invest.
All this is 180 degrees opposite from what Reed Hundt, the FCC chairman in 1996, envisioned. And it seemed to baffle his successor, William Kennard. The Bush administration FCC, under Kevin Martin, took a more hands-off approach, generally approving mergers and allowing the emerging giants to expand by buying wireless spectrum on favorable terms.
But year in and year out, this industry has continued to evolve on its own terms. The range of services and products has expanded exponentially, and costs and rates have continued to drop. Best of all, the advances are far from done.
Enter the Obama administration, a new Democrat majority on the FCC and a new chairman, Julius Genachowski. Call me a cynic, but item No.1 on the agenda should be to become relevant again.
Citing statistics asserting the US is falling behind the rest of the world in broadband network speeds and penetration, the Genachowski has proposed what he calls an aggressive plan to expand high-speed Internet service. Key proposals include a redirection of Universal Service Fund subsidies from basic phone to broadband networks in rural areas. The FCC will also ask broadcasters to “voluntarily” give up unused spectrum for a share of the proceeds in a spectrum auction. And it’s proposed spending $16 billion to create and operate a new network to be used by public safety responders.
Those proposals have already won widespread bipartisan support in the US Congress as well as with the communications industry. Particularly popular are plans to effectively double spectrum available in the US, which would alleviate what some executives are calling a “spectrum crunch” triggered by the growing popularity of smart phones like the Google’s (NSDQ: GOOG) Andriod, RIM’s (TSX: RIM, NSDQ: RIMM) Blackberrys and Apple’s (NSDQ: AAPL) iPhone.
The broadcasters’ lobby is putting up some opposition, as the spectrum would come from them. These objections are likely to be muted by money, as the FCC has promised them a share of the profits from an auction that’s likely to fetch many billions of dollars.
So much for the carrots; on to the sticks. The biggest of these is a proposal to reclassify broadband as a telecom service and therefore subject it to FCC regulation, as basic phone service is. This would instantly make the FCC one of the most important regulatory bodies in the country, overseeing what’s arguably now America’s most dynamic and fast-growing industry, one that continued to expand even during the recession.
Should it gain this new power, the FCC would then be empowered to impose numerous new regulations on industry, in particular Genachowski’s apparent Holy Grail of “net neutrality.” What this means exactly would depend on what the FCC decided. But at its core, it’s basically a philosophy that holds broadband networks should be treated as public domain as far as content is concerned. In an extreme form, owners and operators would not be entitled to favor their own content over that of other companies, including rivals. And the definition of content could also be extended to include services, including basic phone and cable service.
Such a decision would arguably make the building and operation of communications networks much less profitable for companies like AT&T and Verizon, as well as for cable companies like Comcast (NSDQ: CMCSA). Comcast is currently battling the FCC in the US Court of Appeals over potential new rules on its broadband network, and appears likely to win setting up a possible appeal to the US Supreme Court–with FCC authority and relevancy squarely on the line.
In a speech delivered March 2, Genachowski stated the FCC’s proposals would set broad policy rather than impose new regulations immediately. Rather, these will be hammered out of a period of months, with all players given an opportunity to weigh in.
Given the current environment in Washington, it looks unlikely anything dramatic will happen. For one thing, the FCC is relying on Congress to back its proposals, and there’s far from unanimous support for new regulations on broadband, including among Democrats. Meanwhile, ranking Republicans have already vowed to battle any proposals that veer from the task of connecting people who don’t have broadband. And they’re certain to view the issue as tailor-made for bashing Democrats as supporters of new regulation on an industry that doesn’t need it.
Unfortunately for investors, Genachowski’s proposals bring uncertainty, which is always depressing for stock prices. America is far from being another New Zealand, where regulatory intervention has severely depressed private-sector investment in telecom and forced government to pick up the slack. But the FCC’s attempt to grab power is a major factor behind low telecom stock prices, even though the underlying companies continue to post strong growth as the global connectivity revolution accelerates.
Fortunately, we can squeeze some pretty good lemonade from these lemons. FCC uncertainty means expectations are low, even as the businesses continue to perform.
As long as the FCC is a threat to impose heavy new regulations, share prices will remain depressed. But risks will also remain low, thanks to low expectations. Even if they do something drastic, it’s arguably priced in already. Meanwhile, underlying profitability will remain sound and–as the industry’s resiliency even during the Reed Hundt era testifies, it’s certainly capable of handling whatever the FCC throws at it.
Finally, once the FCC threat goes away–which could happen as soon as November elections if moderates and conservatives win seats in Congress–we can look forward to some hefty gains in these stocks, in addition to growing yields that currently range from 6 to 10 percent. That’s a nice combination to have in a market where some investments are getting ahead of themselves and real economic risks remain.
Question of the Week
Here’s a question I fielded from readers this week. Send your queries to utilityandincome@kci-com.com.
- Why do stocks and master limited partnerships (MLP) always sell off when companies issue shares? How can I find out about equity issues in advance so I can avoid losses?
Unless you have a seat on a company’s board, you’re not going to find out about equity issues in advance. You can make some pretty good guesses about which companies are going to sell more of their stock and when, those that have a lot of capital spending or debt refinancing in their future, for example. Ultimately it’s at management’s discretion, and not even they can trade on that knowledge legally.
It’s absolutely true that investors are selling off stocks practically every time they issue new shares. We’ve noticed this particularly in MLP universe. In fact, it’s not been uncommon in early 2010 to see an MLP plunge as much as 5 percent on the day it announces a new share issue.
This is very much a “show me” world. When a company, MLP or whatever issues more equity, investors know it means dilution. In other words, whatever profit there is must be spread over more shares. All else equal, that means a higher payout ratio for a dividend-paying company and lower earnings per share for a company valued on growth prospects.
Potential dilution is the single biggest reason that stocks and MLPs sell off when companies issue equity. And the institutions that control the vast majority of trading in the markets are usually the fastest to react, which is why the down moves are often so violent.
Are these selloffs justified? The answer is never, provided the company’s underlying business is strong. Strong companies issue equity mainly to finance investments in their growth and sometimes to reduce debt. The new stock does technically dilute earnings. In reality, however, both investing in growth and cutting debt boost earnings power–the very opposite of dilution.
A weak company that’s forced to issue equity to raise survival cash is one thing. But strong companies only issue equity when it’s to their advantage–i.e., when it’s accretive and not dilutive to earnings. And that’s exactly what today’s issuers, particularly the MLP issuers, are experiencing. Equity issues boost the number of units outstanding. But the acquisition and construction of assets they finance boosts earnings power more.
In fact, in a business like energy pipelines, such bulking up actually reduces the company’s cost of capital even more, opening up still more opportunities for growth. Enterprise Products Partners LP’s (NYSE: EPD) takeover of sister company TEPPCO Partners LP, for example, made it the biggest energy infrastructure MLP in the US and has since opened up numerous opportunities for growth simply by making it larger.
Some investors didn’t like the TEPPCO deal when it was announced. But if they stuck around, odds are they like it a lot more now, with Enterprise’s unit price and distribution rate already markedly higher. The units needed to buy TEPPCO were clearly money well spent.
So why do stocks and MLPs sell off so sharply when new equity is issued? This is an “act first, ask questions later” market. Investors will only give a company raising money credit when the financing has been obviously put to good use. Until then, they’ll treat it as dilutive and take the units down.
Provided the underlying company’s management knows what it’s doing, the money will be put to good use. And as the market comes to believe, the company’s share price will not only recover whatever ground it’s lost, but will move onto higher highs. When good companies sell off after issuing equity, it’s a buying opportunity, not a time to bail out.
The key is to know what you own and how that business is doing. And if it’s still going well, there’s nothing to worry about. Not only is the distribution safe. But it’s more likely than ever to grow and take the share price higher along with it.
The tragedy is many investors are so afraid of this market that they’ve actually made themselves vulnerable to losing real money when equity is issued. I’m speaking primarily of dividend-seeking investors who set stops too closely.
Stops always take you out when a particular price is breached for whatever reason, even if the dip is short-lived. In fact, a large number of stops can exacerbate a decline, as the instructions go out to dump at any price. A particularly sharp intra-day low can take out even investors who have set stops well below the current price.
There are real reasons to sell dividend-paying stocks. When a company’s underlying business deteriorates is the most important one. I also think it’s a good idea to take a profit whenever a particular investment becomes too large a piece of your overall portfolio.
A temporary selloff in the wake of an equity issue, however, is never a good reason to sell a stock–particularly if the sale is automatic via a stop-loss. You can’t forecast an equity issue. But you can eliminate this risk to your portfolio by focusing on companies’ underlying health and staying away from simplistic and often disastrous strategies like attaching stops closely to dividend-paying stocks.
Reach the Summit
How best to ride this market? Join me and my colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado for the 2010 Wealth Society Member Summit.
You’ll have the extraordinary opportunity to meet one-on-one with me, Elliott Gue, Yiannis Mostrous, Benjamin Shepherd and GS Early and ask anything you want about how to keep and grow your nest egg.
We’ll give it to you straight: the brightest trends and our best recommendations, and anything else you might want to know about how to profit in 2010 and beyond.
Space and time limit us to 100 participants, so mark the date on your calendar: April 23-24, 2010, in San Diego, where they say it’s 72 and sunny every day of the year. You may find all details at www.InvestingSummit.com. Better yet, call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table.
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