Tenth Anniversary of the Disintegration of the AT&T Empire in the United States

The article takes us back to the US telecom era in 1994, the tenth anniversary of the collapse of the Bell system and two years before the new telecom law came into effect (1996). Based on this point in time, Peter Lynch analyzes how the telecom industry was perceived by different types of investors in the market, and gives his own view at the end of the article. We can use this article to look at this period of history a posteriori. All the uncertainties of technological change, policy shifts and corporate strategic deployment seem to define the future landscape of telecommunications.

Tenth Anniversary of the Disintegration of the AT&T Empire in the United States

The U.S. is obsessed with all things telephone-related, but the investment market lacks enthusiasm for telecom companies. That being the case, can telecom stocks still provide retail investors with sustainable and substantial returns in the future?

In 1984, the U.S. Department of Justice required AT&T to split into eight companies – the new AT&T Corporation (focused on business long distance), which inherited the name of the parent company, and the The Bell Seven Brothers, which focused on local telephone companies in their respective regions.

Before the split, AT&T resembled the former Soviet Union, large and often criticized for being unwieldy and outdated. In its heyday, 1 in 1,000 American workers were employed by AT&T; almost all phones and phone lines were controlled by it. Don’t rely on Big Mama Bell to make your calls? Then you might just have to try using easy-access cans and string.

Having 3 million holders makes AT&T the most loved stock in the nation. In contrast to the lukewarm reception of institutional investors, retail investors have been extraordinarily keen on it, and the split has not dampened their investment. For every 10 shares of Bell Dame held, investors would receive one share each of the seven Bell brothers. Today, the top four most widely held companies in the U.S. come from the Bell guys, and all Bell companies are in the top 15.

However, AT&T remains out of favor with institutional investors, consistently at the bottom of institutional holdings rankings – an unusual phenomenon for large-cap growth companies. Institutional investors treated the seven Bell brothers the same way, knocking the Bell family into the cold. This approach allowed them to miss out on the five-fold increase in earnings that the Bells still experienced after the split – the S&P 500 only tripled during the same period. Since most fund managers have not outperformed the S&P 500, we can probably conclude that retail investors who are non-professional but obsessed with investing in the Bells have beaten the investment experts.

Compared to the stagnation of the Bell mothers, the emerging telecom operators flourished. This situation continued until 1990, when the situation changed and the Bells held their ground in the face of stiff competition, with investors competing to buy shares and the stock price soaring. Because the Little Bells were treated as electrical facilities by regulators and were required to pay huge dividends like the electric companies, the Seven Brothers’ stock price failed to rise in tandem with Big Mama Bell. Even in the recent massive sell-off of electric utilities, the Seven Brothers were divided into this camp.

Where the Bells will go from here is our main concern. Regardless of the short-term sentiment of the market, the future of the Bells still lies in who gets to grasp more phone lines and which telecom companies are allowed to provide telecom services to whom. Therefore, it is more important to examine where to charge than who to charge. Likewise, considering their future revenue levels is an important dimension in determining whether they are a good investment.

Those who are long on telecom stocks argue that telecom companies cannot be equated with electric companies and remove them from the investment list together. Unlike electric companies, which are being dragged down by climbing costs and zero revenue growth, telecom companies still have a lot of potential, and its business is slowly penetrating the lives of the masses, and telephone communication is becoming a way of life. In the future, a family may have five telephone lines: a fax line, one dedicated to teenagers at home, a family daily telephone line, a home office telephone line, and one for cell phone service. There are so many scenarios for telephone use, telephone shopping, teleconferencing and so on. It is possible that in the near future, telephones will become so popular that restaurants will have to set up no-phone dining areas.

From the cost side, operators who need health insurance and salaries are replaced by machines and intelligent voice systems. Switches are more compact and easier to manage than ever before. In the last 10 years, nationwide call volume has increased by 30 percent, but telecom companies’ payroll has shrunk by half. in 1985, for Seven Brothers, 70 operators were employed for every 10,000 phone lines; by 1994, that number had shrunk to 35.

Rising demand and falling costs are two important factors in being bullish on Bell Seven Brothers. Based on the current stock price, the Little Bells are earning slightly more than 5% per share, and 5% is the highest dividend rate the Bells have paid to date, with the current S&P 500 dividend rate at 2.8%. In addition, the Bells hold some value assets, such as the franchise for the mobile business.

Cell phones were initially considered a fad, a special radio station created for yuppies. In each region, there would be two mobile franchises – one awarded to the local Bell Jr. and the other to one lucky winner chosen from among many providers. As of 1994, the country already had 16 million mobile subscribers, or 6 percent of the population, and the remaining 94 percent of potential subscribers heralded the enormous potential of this business.

Recently, our research found tremendous value in the mobile business. Pacific Telesis, a small California-based company, decided to spin off its mobile business as AirTouchCommunications, and as a way to give back to its shareholders, investors will be given one free share of AirTouch for every share of Pac Tel after the spin-off. Post-spin-off Pac Tel is about $30 per share – the market sees the mobile business as almost equal in value to other telecom businesses.

Because of two special attributes of Los Angeles – people like to make phone calls during long traffic jams and Hollywood people like to talk business while jogging – Pac Tel has the largest number of mobile subscribers and related operating income, making it the leading mobile business of Bell. Meanwhile, other Bell companies are also deploying mobile services in their regions. In addition, they also purchased franchises outside their own regions from that lucky non-Bell family provider. Not only that, but Bell companies have acquired businesses and ownership in Mexico, Russia and other regions for paging services, cable TV, real estate and parts of telecommunications companies.

According to an analysis of Southwestern Bell in the Bell family by S.G. Warburg telecom analyst Bill Deatherage, I learned that Southwestern’s mobile business is valued at $13.75 per share, with Mexican telephony taking a share ($5 per share) and various other assets ($3 per share). Deatherage sees the company’s net asset value at $55 (per share), while Southwestern’s actual share price is $43.

Currently, Deatherage likes US West best of the Bells, which has a share price of $42 per share — $5 from the mobile business, $6 from Time Warner, $3 from the international cable and mobile business, $4 from real estate and the remaining $4 from other fractional businesses and assets. And the company’s net assets are worth $58.75 (per share).

While the above are reasons to be bearish on the Bell family, let’s look at why analysts are bearish on these stocks. The key to the bearishness is that the little Bells are losing their grip on municipal services. Compared to their previous monopoly business model, the small Bells have had to face more and more competitors after the spinoff, especially in the long distance business (known in the industry as “handshake contact”).

Although they were not long-distance carriers, the Belles were able to charge a fee for each long-distance call, as long as they were in an area where either party was making or receiving the call. Typically, a long-distance call that charges 17 to 18 cents per minute can earn the Belles 3 to 4 cents on that. I live near Boston, where long distance refers to any call to any area other than an adjoining town, so it’s extra important for NYNEX, the Bell company in my area, to charge port charges for long distance calls.

Imagine the dramatic drop in communication costs for subscribers if the two ends of a long-distance call were no longer different local carriers. This is already happening in the business districts of some major cities – Competitive Intervention Providers (CAPs for short) are providing customers with direct access to long-distance communications providers by installing their own fiber optic lines for customers, skipping the local Bells. Fearing being squeezed out, the local Bells were forced to work with CAP, allowing CAP to install its switches in the Bells’ territory. This may change in the near future due to court involvement.

Although CAP won’t be serving every home right away, they’ve already taken a sizable cut of the Bells’ revenue. The Bells are also actively resisting the intrusion of outsiders. Just recently, Bell Atlantic, a member of the Bell family, won a case that prevented CAP from doing business in its heartland. The fact is that the seven small Bells are fighting for a license to start long-distance service while their monopoly on local calls is being opened up to more and more telecom companies.

Southwestern Bell recently applied for court approval to launch local communications services in a small Maryland town that is the territory of fellow Bell family Bell Atlantic. If the application is approved, it will be a case of each man for himself, not the Bell brothers.

Jack Grubman, a telecom analyst from Salomon Brothers, is bearish on Bell Jr. stock. While he recognizes the value of the telco’s mobile business, among other things, he believes the cost-cutting benefits of the bearish view are overstated – every penny Bell earns through layoffs could be lost in the downward price pressures of peer competition. In his view, the high dividend payments have led to a chronic cash flow shortage for the Bells. But one day, as technology iterates, the Bells may need to burn through all their cash to replace new wires and new equipment.

Grubman rates Bell stock as a hold and sees their earnings growth in the 5% to 7% range. He prefers AT&T, MCI and Sprint as long distance carriers (in order of preference), which he sees growing at double-digit rates in the future. He sees long distance telcos growing at a rate comparable to pharmaceutical companies, and their PEs are much smaller than those of pharmaceutical companies.

The future of the Bells and CAPs, and all the companies in the communications chain, depends heavily on regulators, politicians, courts and Wall Street market makers. Will communications companies get into the cable business? Or will cable providers get into the communications business, and what is the future of CAP? Will the small Bells be allowed to launch long-distance services, such as local outgoing or incoming long-distance calls? Will they be able to generate real profits from their various alliances with limited television companies and overseas telecommunications companies? Will they be allowed to do business on a large scale in non-jurisdictional areas?

Questions ensue and there are always more questions than answers. Taking all factors into account, I would not be bearish on the Bells. In fact, I own two of the companies, Southwestern Bell and NYNEX, whose shares did not rise in the 1991-1993 bull market and fell in the subsequent 1994 bear market. But their dividend yield, which was twice that of the S&P 500, refuted the market’s pessimistic expectations of them.

Wall Street thinks the Bells will be restrained by new legislation in Congress, but it seems to me they have enough lobbyists and influence in Washington. These influences will not be specific to corporate balance sheets, but in a regulated industry, these are the most valuable intangibles.

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