The Telecom Phoenix has Risen?Will it Burn Out???

“Profiting from the Telecom Phoenix” was a Special Report created by Bill Martin and Matt Ragas, editors of FindProfit , last year. The contrarian investors based their strategy around the central thesis that IT capital expenditures would resume in 2003 after a couple of years of intense, deep cost-cutting. The telecommunications sector was one of the most battered during the downturn. The companies that achieved such meteoric valuations throughout the end of the ‘90’s suffered a virtual ‘perfect storm’ of overcapacity on the part of their customers, huge debt loads due to acquisition-driven growth strategies, and a slowing economy exacerbated by 9/11. Now they’re back, with growing revenues and profits and the Experts highlight trends and cherry-pick top-performing companies.

Telecom Profits

Martin and Ragas had four central tenets to their big bet on telecom in 2003; i) Follow the Smart Money; ii) Broken Telecom spending logjam; iii) Riding the Telecom Theme; and iv) Profiting from Negative Sentiment. The editors of FindProfit are close followers of legendary investor, Warren Buffett’s every public investing move. Buffett purchased a significant share of telecom networking company, Level 3 Communications (NASDAQ: LVLT - Snapshot Report ). Combined with the purchase of bankrupt company, XO Communications by financier Carl Icahn, and a couple of other moves by successful and well-respected investors, Martin & Ragas felt they identified a pattern that would lead more money into the sector.

Martin & Ragas were also utterly convinced that 2003 would bring an upgrade cycle of companies’ telecom infrastructures. The advances in bandwidth and new data products that arose from corporate travel budget cutbacks required upgrading for many American companies. Companies, once again, began spending money with many newly restructured telecommunications companies that were leaner and meaner. Martin & Ragas had very little doubt that telecom would reemerge, and did not represent a dot com-trend that would fade like so many defunct companies of that era. A globalized economy demands global connections, and they knew it was merely a matter of time.

At present, the industry continues to strengthen as the winners gobble up assets of bankrupt companies at fire-sale prices. This sort of evolution reflects the maturation of the industry, and is a welcome sign. The discounted prices receive now punctuates the last prong of Martin & Ragas’ investment thesis last year. Telecom companies were trading at incredible bargains because of Wall Street’s frustrations with their previous ability to turn around their businesses and deliver even a little earnings growth.

Investing in Icahn’s

Carl Icahn bought a majority stake in bankrupt telecommunications company XO Communications (NASDAQ: XOCM ) some time back. Between Icahn and Geoffrey Raynor, 110 of the 137 million outstanding shares are held. Icahn is working toward completion of a restructuring and turnaround of the company with a substantially stronger balance sheet. When Singapore Telecom’s and Hutchinson Whampoa’s bids for the assets of Global Crossing (NYSE:GX) were held up due to national security concerns, Icahn made a big move to purchase the assets for XO.

The Raynor investment was welcome as it helped stop the dilution associated with a recent $200 million rights offering by XO Communications. While Icahn was unsuccessful in his bid for Global Crossing, XOCM did net $33.5 million on the sale of their stake in the bankrupt company. However, that does not mean that Icahn was totally unsuccessful in his discount telecom shopping spree. Allegiance Telecom, another bankrupt telecom concern, announced this morning that XOCM was the winner in a bid for the bankrupt company’s assets. Under the terms of the deal, XOCM will pay $311 million in cash and 45.4 million shares of common stock.

Martin & Ragas estimate that the assets acquired in the $650 million payout for Allegiance will reap $530-550 million in revenues annually. Allegiance operates in 36 major metro markets providing data, local and long distance phone service. Allegiance was on a $77 million EBITDA run rate, and was free cash flow positive. The editors of FindProfit expect the combined company to realize substantial network cost savings and to produce $1.6 billion in revenues this year.

XOCM will be a $1.365 billion market capitalization company, meaning that it trades at an enterprise valuation of under 1x revenues. It has $200 million in cash on hand and $400 million in debt. This compares with 2.3x for Time Warner Telecom (NASDAQ:TWTC - Analyst Report). Martin and Ragas expect the company to move to around 2-3x enterprise valuation over 2004, which would put it in the $15-$22.50 price range. Further, as consolidation in the space continues, XOCM should benefit as a buyer or seller of smaller assets, according to FindProfit.

Martin and Ragas concede that a NASDAQ listing will be a key catalyst, but its growing list of institutional investors and recently initiated analyst coverage will continue to represent positive catalysts to help the company build momentum. It is a top-rated stock in their higher risk Babe Ruth portfolio that was up 67.11% in 2003. Look for their updated telecom report to be out in late February.

Ghosts of Bubbles Past

The editors of FindProfit are nothing if not savvy investors. They pay careful mind to what they are paying for and learned plenty of lessons throughout the bubble burst. As such, Martin and Ragas take issue with Juniper Networks (NASDAQ: JNPR - Analyst Report ) recent bid for Netscreen Technologies (NASDAQ: NSCN ). Juniper is to issue 135 million shares of stock to purchase NSCN, which will give the company a $12.2 billion market capitalization. That’s equal to 9x sales and 74x earnings in 2004 for the combined companies.

It is not that Martin & Ragas don’t feel that the deal won’t be accretive to earnings or enhance Juniper’s product lines. Also, they understand that the sky high valuation of Juniper’s shares makes it tempting to use them as currency to acquire companies. However, their feeling is that Juniper’s current stock price is based on momentum associated with the turnaround, and that there are few backstops if demand were to slacken. Essentially, there is little upside, and a great deal of downside potential should Wall Street become more risk averse or the bull market hit a few bumps in the road.

Equally disconcerting was Sonus Network’s (NASDAQ: SONS - Snapshot Report ) announcement of accounting problems. The company announced revenue recognition problems and fired some officers in its accounting department. Martin and Ragas attribute the problem to unrealistic revenue and earnings projections and cutthroat competition to meet or beat those expectations. SONS merely provided one more caveat emptor for investors picking through the telecom space, and should be taken heed of.

Dirt Cheap Shares

Ian Wyatt, editor of the Growth Report also has a decent sized stake in the telecommunications arena and seeks companies that are taking advantage of the improving environment in the sector. One company in his portfolio that is on the upswing is j2 Global Communications (NASDAQ:JCOM - Analyst Report), which grew revenues 49% in 2003 on 136% earnings growth on a GAAP basis. The company has 5.6 million telephone numbers, of which 400,000 are paid on a fee basis.

Management guided for another 40% revenue growth on 51-74% earnings growth in 2004. Shares currently trade on a forward earnings valuation of 19-21x and a PEG (P/E/Earnings Growth) of .3, which makes shares extremely cheap. The discrepancy is that the company will begin paying taxes and index its 2003 earnings for taxation, when it didn’t pay taxes. Essentially, its valuation reflects flat earnings growth, when really there will be substantial improvement. Wyatt has a $33 12-month price target, which is 30x his EPS valuation.

Caveat Emptor

Nothing is to say that all telecommunications companies, or even all industries within the sector, will charge forth. However, the shifting dynamics reveal undervalued assets for investors and companies alike. This is an area where it is critically important to do more than look under the hood and kick the tires. Be sure to look at balance sheets, growth prospects, valuations and earnings statements. The Experts above can certainly provide some guidance.

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Trace Johnson is an analyst and writer for Zacks.com and the Zacks Advisor. He has appeared dozens of times on WebFN, First Business and CNBC-Europe. He can be reached at tjohnson@zacks.com.