DSL

DSL Prime News Weekly: The Inside Source —Continued

 

Explanation #2 DSL cutbacks raise 2001 EPS 4-7 cents

I've found no evidence of impropriety in SBC's accounting, or reason not to invest in the stock. But I've taken a look at SBC and telco financials in general, to understand the decision.

DSL, year one, is always cashflow negative
BellSouth, pulling down earnings forecasts, recently gave us the best public information about first year net cost. They emphasized DSL was essential to their future, but costly the first year. Dan Reingold of CSFB was the first to make the calculations, and our subsequent working of BellSouth numbers showed a $1,100 first year loss, nominally not including the DSLAM and other capital expenditures. I think this will change going forward, as self-install, reduced marketing, and more efficient provisioning bring costs down. Michael Grasso of SBC pointed out these costs include the sales center, provisioning, help desk support, and customer service, although he could not give us a total. We are assuming a net cost to SBC of $400-800 the first year. That can be quickly recouped, with gross profits likely to be upwards of $300 per year thereafter. If our assumption that SBC is choosing to slow DSL deployment by 500,000 lines in 2001 is accurate, that represents $200-400M. The price rise itself increases revenue by $60-120M. Aftertax, that's 4-7 cents for each of the 340M + shares of SBC. The revenue foregone (not all of which is profit, of course) is probably $1B over three years—more, if some customers switch their phone service to competitors, or if SBC will succeeds increasing revenue with added value services.

Earnings shortfall previously cost SBC $20B on the market
In December, SBC made a small reduction in 2001 predictions, which they attributed primarily to one time expenses. The street punished them by forcing down the stock price more than ten times the projected earnings shortfall. "Managing earnings" may make analysis harder, but is good strategy.

Small fluctuations in EPS can be costly
Verizon lost over $1B in stock value earlier this month when downgraded by one of the top wall street analysts. Key to his analysis was an earnings disappointment after he made an adjustment for a tax change. Wall Street is obsessed with numbers, particularly those they know how to measure like earnings per share. Smart longterm strategies—like rapid DSL growth —are harder for the street to value.

Quarterly earnings from SBC almost impossible to interpret
We present three headlines, all derived from the same SBC announcement:

"SBC 4th-Quarter Earnings Sink 39%" Deborah Solomon's headline in the WSJ

"SBC Reports 9 Percent Gain"—AP

"SBC Rings Up a Solid Q4"—Motley Fool

The contradictory headlines cannot all be accurately capturing the essence of SBC performance last quarter. The WSJ, as we would, emphasizes the reported earnings per share; the others, different numbers after adjustments, which were the emphasis of the press release. SBC is playing by the rules, but the rules have become so fuzzy that the actual results, quarter to quarter and year to year, are throughly obscured.

Any accountant will tell you corporations have many legitimate ways to alter earnings. Reducing purchases temporarily is a traditional dodge, and AT&T's drastic cutback in equipment purchases late in 2000 was clear in sales of key suppliers. In DSL, Efficient and Westell had late quarter customer cancellations recently.

Financial transactions can be timed; SBC, for example, has much flexibility in when to write down the losses in the Prodigy, NAS, and Covad deals. Half-owned Prodigy lost $300M this quarter, much of it on expenses for SBC DSL customers; how much of that is (or should be) reflected on SBC's own statement is unclear. Any large corporation is likely to have undervalued real estate, and can time its sale, and move dollars to current earnings through structuring a leaseback.

Depreciation calculations, virtually impossible to untangle, and other asset and reserve calculations, dwarf the reported quarterly and annual variation in earnings.

Yale's Ivo Welch made this point in another context. "Management of earnings by IPO companies is pretty drastic" he told the Journal. "After about a year, it catches up with them." A large, profitable company with massive investments and capital spending has even more capacity to "manage" earnings.

Long term profits under pressure
As I wrote in August "The major telcos in the United States have made unreasonable projections of income going forward, and will have to struggle to meet the numbers and eventually hit crisis. At some point, probably not immediately, the street will be stunned and disappointed, as recently happened at Verizon. Local service prices will go down with competition, LD rates are plummeting, and basic growth is unlikely to continue at three and four times the growth in the economy. We have seen this reflected in consistent underinvestment which will ultimately catch up with them."

In January, DSL Prime reported "Look for telcos to use all their political power to raise local rates. Telephony is a declining business, where demand is flat, costs going down and if there were competition prices dramatically going down. DSL, wireless, and data services should be competitive, without monopoly returns. So sales & profit growth, longterm, should be in the range of economic growth (2-6%) plus at most a small premium. Instead, seeking double-digit growth, AT&T blew tens of billions overpaying for cable companies, while the baby bells have allowed service to deteriorate so badly their reputation—and long run competitive position—is at risk."

Again, we emphasize this is not a stock prediction (in fact, we suspect current emphasis on earnings quality gives telco stocks an advantage). Rather, we use financial data to explain industry trends.

$Multibillion issue in typical telco accounting
Jim Crowe of Level 3 sounds a warning about the business consequence of inadequate depreciation, telling the street "Carriers can't compete with us, because they are carrying obsolete fiber at high values on their books." The essential data on depreciation is for practical purposes unavailable, and it would take months (and skills beyond ours) to come up with specifics.

But I can extrapolate from the TELRIC debate to establish there are $B's involved. TELRIC sets pricing on telco resale on current and future costs, as they would be set in a competititve market. Bill Kennard in his last month asserted the TELRIC is the only accurate way to price services, which we agree with, but the telcos have been claiming that will cost $B's, compared to pricing by the costs they are carrying on their books.

That implies their accounting systems, even if they have followed all regulations scrupulously, do not reach the ultimate goal of accounting, to accurately measure corporate reality. Many factors are involved, but we believe the largest is historic costs that have not been depreciated to true current value. Some portion of this has been required by regulation aimed seeking to hold down rates, less of a factor since deregulation. Ultimately, these true costs affect profitability. We have no way to estimate that impact on SBC's longterm finances—large in ordinary terms, but presumably small compared to a $170B market value.

No reason to suspect fraud or anticipate a stock decline
Many, on and off Wall Street, read DSL Prime to understand stock prices, although we know, empirically, we do not move markets, unlike some of the analysts we regularly quote. In particular, many on Wall Street have been bearish on the telcos already, for many reasons—any conclusions you might draw from this article have probably already been anticipated by the market. Lucent is under investigation by the SEC for misstating $hundreds of millions of revenue; Covad is currently restating earnings for the second time. We have no reason to suspect anything similar with SBC, or any impropriety. Rather, we believe following legitimate procedures has made them very hard to analyze, or for anyone to project.

Copyright 2001 Dave Burstein.
The DSL Prime Newsletter is reprinted with permission.

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1. News

2. DSL Prime News Briefs

3. SBC Justifies DSL Price Hike

4. Analyzing Perplexing Telco Financials

>5. Consequences of the DSL Price Hike