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The telecom sector is filled with the kinds of companies we love to hate: They earn mediocre (and declining) returns on capital, economic moats are nonexistent or deteriorating, their future depends on the whims of regulators, and they constantly spend boatloads of money just to stay in place. Even companies that once boasted wide moats, such as those that control the local phone network, face increasing competition from newer players, such as cable and wireless networks. Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

Before 19S4, AT&T was one of the world's most reliable companies. Ma Bell essentially ruled the U.S. telecom world, owning the vast majority of networks needed to provide local and long-distance phone service. The majority of households and businesses had little choice but to send cash monthly, making AT&T shares the proverbial safe haven stock for a generation of investors.

But following years of legal challenges, the industry was split in two and divided between those that connect cities to one another and those that provide network access to customers. AT&T retained the intercity, or long­distance, business, which has been increasingly competitive ever since.

The access, or local, side of the business maintained its virtual monopoly for several years because regulators decided this business was too capital- intensive for competitors to have much influence and, thus, still in need of strict oversight. AT&T's local phone networks were divided among seven companies, now known as the regional Bells. These firms have consolidated over the years, leaving the majority of the nation's local phone network in the hands of four companies: Verizon, SBC, BellSouth, and Qwest.

Local phone companies, by virtue of their control of a major access point to the phone network, retain some remnant of the old Ma Bell moat because most customers have access to only one or two fixed-line networks. But even this area of the industry has come under increasing attack as changing regulations and improving technology have fostered tremendous growth in the number of ways people connect with one another. The local phone companies are being threatened by wireless carriers and cable com­panies on the technological front and by their fixed-line peers on the regulatory front.

Unfortunately, the firms trying to dethrone traditional phone companies are no more attractive as investments. The wireless industry, for example, is excruciatingly competitive, with little opportunity to develop a moat. Wireless phone service is a commodity—a minute of airtime on one carrier's network is virtually identical to that on another's. There are six nationwide carriers slugging it out, while several smaller regional players carve up areas not reached by more than one or two of the majors. The presence of several large carriers has resulted in near-ubiquitous network coverage. Roughly 95 percent of the total U.S. population has access to three or more different wireless carriers, and 80 percent has access to at least five carriers. With little opportunity to differenti­ate their services, the wireless carriers have resorted to cutthroat pricing: The price per minute of wireless airtime has fallen more than So percent over the past decade.

Wireless isn't the only threat to the Baby Bells' fixed-line business. Twelve years after the breakup of AT&T, the federal government decided the time was ripe to deregulate the local business and open it up to competition. Congress passed the Telecom Act of 1996, forcing the regional Bells to lease access to their networks to competitors at discounted rates. Would-be local phone com­petitors, known as competitive local exchange carriers (CLECs), can build a "virtual" network to service their customers. AT&T and WorldCom/MCI have been the biggest users of this regulation, adding local service options to their traditional long-distance phone services. The result has been a loss of revenue for the Bells and greater control of customers for their competitors.

As a result of this regulatory framework, the Bells and the competitors endlessly debate which elements should be made available and how prices should be determined. State regulators individually set line-lease rates under the direction of the FCC, which directly impacts the attractiveness of each state to competitors.

However, there has been one consolation for the Bells in all this regulatory upheaval: Once a state is deemed open to competition, the local phone giants are allowed to enter the long-distance business. This isn't a huge moneymaklng proposition for the Bells, but it can help them hold on to customers.

The desire of lawmakers and regulators to push fixed-line phone service to a more competitive model has further eroded the competitive advantage of the local phone companies. For example, the number of phone lines in service declined in 2OOI and 2002 for the first time since the Great Depression. With local phone service generating the vast majority of the regional Bells' cash flow, declining lines in service threatens to diminish their ability to invest in net­work upgrades and pay out dividends.

One niche of the industry hasn't been as affected by regulatory changes— rural carriers such as Citizens, Alltel, and CenturyTel, which primarily operate local phone networks in areas ignored by the old AT&T. These less densely populated areas don't attract the level of competition seen in urban markets. Moreover, the rural carriers actually benefit from regulations, receiving subsi­dies to help cover the relatively higher cost of serving these areas and in many cases guaranteeing a certain return on investment.

A favorable regulatory environment, combined with the natural benefits of owning the only local phone network in town, gives these companies the strongest competitive advantages in the industry. These companies will never earn huge excess returns on capital, though, so we still wouldn't consider the moats wide. In addition, their financial stability means that the shares of rural carriers rarely trade at cheap valuations.

Building and maintaining a telecom network, whether fixed line or wireless, is an extremely expensive endeavor that requires truckloads of upfront capital. This requirement provides a substantial barrier to entry and usually protects the established players. To raise capital, a new entrant must have a great story to tell investors. The emergence of the Internet, the opening of local networks to competition, and rapid "wireless growth during the 1990s gave numerous new players the yarns they needed, which is why the usual barrier provided by huge capital requirements came crumbling down as investors lined up to grab a piece of the action.

While the effects of this massive infusion of capital are still being felt in the industry, ongoing capital needs have sunk many new entrants. Even a mature telecom firm will need to invest significant capital to maintain its network, meet changing customer demands, and respond to competitive pressures. The Bells, for example, spent nearly 30 percent of their annual sales on new equipment during the late 1990s, though a spending rate of 20 percent of sales is more normal. Despite sluggish growth and sharp reductions in capital budgets in telecom, the Bells still spent a combined $30 billion on their networks in 2OO2.

TgIgcqiti companies can't expect to recoup the cost of a piece of equipment in any one year, so developing recurring revenue streams is important to earning a sustained return on investment. Sometimes firms seek out nonrecurring sources of revenue to boost growth and profits, but these sources of revenue can't be counted on to deliver future returns. Qwest, for example, spent billions building a long-distance network and reported fantastic revenue growth as the network was placed into service. Unfortunately, much of this growth came from one-time sales of basic network capacity, rather than ongoing service contracts. Revenue from these capacity sales, which generated high margins, was booked upfront, giving the appearance of rapid growth. Once demand for this type of capacity dried up, revenues began to fall and margins shrank. The firm was left with a business too small to support its debt load and was forced to sell off assets.

Because of the enormous cost to build a network, carriers typically have very low ratios of sales to assets (asset turnover ratios). Even a mature carrier typically generates only around Si per year in sales for each Si of assets invested. But building a business of ample size to support interest payments and ongoing capital needs is very important. Because fixed costs are so high, it's imperative for carriers to have enough customers over which to spread the costs.

Squeezing as much profit from the sale as possible is also crucial. While size again plays a role here, a telecom company must be able to send bills, provide customer service, maintain the network, and market services efficiently. A mature company, either fixed line or wireless, should expect to earn operat­ing margins between 20 percent and 30 percent. Short of this level, it is extremely difficult to earn an attractive return on invested capital, given the slow pace at which assets turn over.

With so many companies raising money and building networks in the late- 1990s, the volume of business needed to support all these huge investments never materialized. Nowhere was this more true than in the long-distance industry. New entrants such as Williams Communications and 360 Networks filed for bankruptcy despite rapid revenue growth because they were never able to generate the level of sales needed to justify the enormous expense of building the networks, nor were they able to boost margins anywhere near the levels needed to support their borrowing costs. Investors eventually refused to give

Telecom investors must pay particularly close attention to profitability. One measure commonly used in the industry is earnings before interest, taxes, depreciation, and amortization (EBITDA), which gives a sense of how well operations are generating cash to support capital spending needs and debt service. To calculate EBITDA, take operating income and add back depreciation and amortization expenses. Falling EBITDA margins may be an early indicator of competitive pressures or operating inef­ficiencies. EBITDA is a blunt tool, however, and should not be mistaken for operating cash flow, as reported on the cash flow statement. Focusing on EBITDA can obscure problems such as growing accounts receivable that would be readily apparent on the cash flow statement.

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