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Don't kid yourself. The really bad news is yet to come for




For weeks, the Denver-based telco's plunging stock suggested investors expected an earnings warning. When the company duly supplied one Monday, the stock jumped 10%. If the bad news is out, investors reasoned, the worst is over, right?

Not so fast. Bears still see as much as a 40% drop for this stock, believing that even Qwest's reduced growth targets are unattainable and that the stock remains overvalued. After losing half its value over four months, Qwest rose $1.76 Monday to $19.90.

Big Turnaround

Qwest stock has long traded at a premium to its peers because the company combines a new telecommunications network with a cash-generating Baby Bell business. The company is a combination of the Baby Bell U S West and pioneering broadband supplier, Qwest Communications. Investors coveted the New Economy side of the old Qwest. But now that a cash crunch has shut down so many once-hot network builders, they take solace in U S West, with its steadier revenue streams.

The company cut revenue guidance for 2001 to $20.5 billion, about 4% less than analysts' estimate of $21.4 billion. Meanwhile, Qwest trimmed its 2001 cash-flow guidance (measured by earnings before interest, taxes, depreciation and amortization) to $8 billion, 8% less than what Wall Street had expected. As for 2002, Qwest expects high single-digit revenue growth for sales and a slightly higher pace for EBITDA. On a conference call Monday, Qwest CEO Joe Nacchio was more specific, saying that EBITDA could grow at a low double-digit rate in 2002.

What's wrong with this? Well, Qwest is effectively saying that the 2002 EBITDA growth rate could be better than the pace for 2001. The Monday guidance projects 9% growth this year, while, as we've seen, Nacchio is holding out for a low double-digit number in 2002. This may well be achievable, considering that 2001 has been a tough year and thus an easy base to grow off. However, Nacchio isn't predicting a big economic recovery in the regions where Qwest operates. Quite the contrary. On the Monday call he cited economic forecasts predicting that a recovery won't happen till the second half of 2002, "if it happens at all."

Qwest spokesman Tyler Gronbach reponds that the 2002 EBITDA growth may be obtainable because of cost cuts as well as extra revenue from a planned entry into the long-distance market.

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The other problem with the rebound theory is that Qwest also said big sales of optical capacity, usually to other telcos, could slow. These deals, known as indefeasible rights of use agreements, or IRUs, have recently been a big source of revenue. In addition, though Qwest doesn't break out earnings from IRUs, analysts believe they are fat margin transactions. Morgan Stanley calculates that IRUs contributed more than 40% of total second-quarter sales growth. Some had questioned how sustainable the IRUs were. These skeptics were at least partially vindicated Monday. Nacchio said that IRU buyers have shortened the length of the deals, and he said there is less overall demand for this capacity.

Considering all this, where should Qwest trade? To figure this one has to estimate how to value the main components of the company. To get at a number for U S West, we take each of the company's 18 million access lines and value them at $2,000 each. This takes us to $36 billion. Subtract the company's debt of $25 billion (June 30 debt of $23.5 billion plus expected borrowings of $2 billion, minus cash of $500 million) gives an equity value of $11 billion for traditional telephony. Qwest's stake in Dutch telco



is valued at about $1 billion. Adding KPN to the old U S West, you get $12 billion. Divide that by the 1.68 billion shares outstanding to give a per-share value of just over $7 for those two businesses. With Qwest trading at $20, the market is effectively paying $13 a share, or $22 billion, for the classic Qwest.

Here's why that's too much. Let's assume, very optimistically, that the classic Qwest produces $2 billion in EBITDA in 2002. As a result, it's trading at 11 times an aggressive cash flow estimate. Given the concerns about IRUs, that's way too much. More realistically, classic Qwest should trade at, say, five times $1.5 billion in forecast 2002 EBITDA. That'd give it a value of $7.5 billion, or $4.50 a share. Add that to the $7 and you have total Qwest valued at $11.50, or more than 40% down from here.

Hang up on Qwest.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.