RealMoney Silver - Explaining the Jitters in VZ, T

Explaining the Jitters in VZ, T
By Tero Kuittinen
RealMoney.com Contributor
2/6/2008 12:13 PM EST

Each time we get particularly bad news on the U.S. macroeconomic front, AT&T (T) and Verizon (VZ) seem to respond particularly violently. Why are these two names so vulnerable to the threat of consumer recession -- shouldn't telecom spending be relatively stable? That's one of the most intriguing issues of 2008.

I see several reasons Wall Street has suddenly grown skittish about the two biggest mobile operators of the United States; they are particularly relevant during this specific recession.

First, average annual spending on mobile telephony services in America has soared well above what anyone expected half a decade ago. According to the Bureau of Labor Statistics' Consumer Expenditure Survey, American consumer spending on mobile phone services soared from $210 in 2001 to $524 in 2006. During the same period, spending on residential telephone services and payphones declined from $686 to $542.

The problem here is that the overall spending did not grow much -- it increased from $914 to $1097 over five years. Factor in inflation, and the growth in overall consumer telephony spending has not been that spectacular, even during a period that American consumer spending on things like video games and fashion soared. In 2007, U.S. spending on video games soared by more than 40% after years of double-digit revenue growth.

The telecom spending of American consumers is already at such a high level that finding any further growth above normal wage expansion is difficult. What I find interesting about the relative stagnation of U.S. consumer spending on phone services over the past half-decade is that this was a period of profound change -- mobile phone market penetration exploded from around 40% to 90%, Americans learned to embrace text-messaging, camera phones became an everyday item and sending photo messages emerged as part of daily routine for many younger consumers.

Yet the overall spending patterns did not shift. Most of the revenue growth that mobile telephony delivered was simply cannibalized from landline, and that seesaw effect creates the special dilemma of 2008.

The mobile telephony substitution has now reached the stage where Americans are spending more on mobile services than landlines. Much of the carcass of the century-old landline dinosaur has been devoured, and some consumers will not substitute. Families with small children or elderly members will not drop their landline service and go purely mobile. If the mobile/landline substitution starts slowing down as a result of easiest gains having already been made and consumers growing wary of any new spending in a recession environment, it is suddenly easy to see how the mobile growth numbers of 2008 might be deeply disappointing.

I know that AT&T and Verizon are diversified companies with several lines of business. But the core of the investor fascination in them has been the hot mobile growth of the past couple of years. And here is the heart of the story -- the mobile data growth of America's largest operators grew by more than 50% in 2007, creating more than $20 billion in value-added mobile service revenues in the last year. But the mobile voice spending per average consumer keeps sliding as operators roll out new family plans and cheaper voice buckets.

The AT&T and Verizon growth stories rest largely on their mobile service, and the mobile service growth hinges on mobile data, not voice. Investors are going to be deeply disappointed if Verizon's mobile data growth keeps cooling down from the still-torrid 53% pace of the fourth quarter of 2007. For Verizon, mobile data revenue still generates just $11 a month out of the overall $51 average revenue per user. The data growth has to continue to run hot, or the overall ARPU will start declining.

During the 2001-2002 period, American consumers barreled through an economic rough patch and kept spending growth surprisingly robust -- partly because of housing market strength. During the recession of early 1980s, the only mobile handset owners in America were Wall Street M&A sharks with five-pound car phones. We simply don't know how to model consumer spending on mobile services during a U.S. recession -- there are no prior templates.

But there are two warning signs here: the lack of overall telephony spending growth since 2001 and the likelihood that the low-hanging fruits from the mobile/landline substitution have been picked. The resulting uncertainty is toxic for investors -- until we see how a true consumer spending weakness affects mobile telephony spending, Wall Street is likely to expect the worst.

The pool of AT&T and Verizon owners who have seen their 2007 gains wiped out is wide and deep; I think these two names are exactly the kind of "old leaders" that get brutally mauled during bear markets.