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Buy Stock Economic Moats in Telecom
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Long-distance carriers have extremely small or, in most cases, no economic moats. There are numerous long-distance networks connecting most major cities, and competition remains fierce. Companies "with strong reputations—notably AT&T—enjoy a small competitive advantage as business customers look for carriers with financial strength. And because switching long-distance service can be a hassle for a large business, companies with large customer bases often have the upper hand. But the threat of competition has made it tough for long-distance carriers to raise prices. A rebound in demand could bring some pricing power, but given the industry's state, we doubt long-distance firms will earn returns on invested capital equal to their cost of capital, which makes it unlikely that they'll be worthwhile investments.

Compared with the long-distance carriers, local phone companies enjoy stronger competitive advantages, though we'd still put them in the narrow- moat category. These firms still control the majority of the local phone market and are able to earn very healthy margins on this service and generate enormous cash flows. As customers' demands on the local network grow, the ability to keep networks up to snuff should increasingly offer an advantage. Regional Companies that take on massive debt in the hopes of building a large business are extremely risky. Mature firms that take on massive debt to expand their businesses are similarly asking for trouble. AT&T borrowed heavily to fund its push into the cable TV business. Left with a huge debt load and large capital spending needs to upgrade its networks, the firm ended up selling the cable business for far less than the purchase price. The regional Bells, particularly SBC, have been selling assets to pay down debt and reduce the risk that declining revenues could cause financial distress. A measure of indebtedness commonly used in the telecom industry is debt divided by EBITDA; a ratio much higherthan 3 should be approached with caution.

Bells might upgrade their networks to offer a whole host of services, including TV, numerous phone lines, and high-speed Internet access, over a single con­nection. However, the Bells have traditionally moved very slowly into new technologies, and basing an investment decision on the basis of the Bells' po­tential for new product offerings requires a large margin of safety.

Rural carriers (sometimes called rural local exchange carriers [RLECs]) benefit from a relative dearth of competition. The RLEC advantage can be seen in the number of phone lines lost—about I percent on average during 2OO2 versus about 5 percent at the Bells. Moreover, most of the decline in phone lines caused by a weak economy has been offset by an increase in broadband Internet-access services. Rural firms have also maintained even stronger margins than their Bell brethren, "with operating margins exceeding 30 percent in many cases, which is roughly 10 percentage points higher than the Bells.

Wireless, meanwhile, is almost a textbook case of perfect competition, with near-zero pricing power and easily substituted services. Only Nextel has been able to meaningfully differentiate itself with its unique Direct Connect feature, and even that competitive advantage will likely be eroded away in the future as competing carriers promote similar push-to-talk capabilities. With that small—and likely temporary—exception, no wireless carrier has a sustainable competitive advantage. To most consumers, the carriers look identical from the outside, which forces them to compete almost solely on price. Like the long-distance industry, wireless providers offer calling plans that are nearly Indistinguishable: a finite number of minutes during peak calling hours and plenty of cheap—or free—airtime on nights and weekends.

Without economic moats, investment opportunities are few and far between in the wireless industry. The six national carriers continue to scratch and claw for new subscribers, hoping to benefit from better economies of scale. But subscriber growth is weakening as the industry rapidly matures, intensifying cutthroat price competition.

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