This column was originally published on RealMoney on Aug. 11 at 10:31 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.
Today my focus returns to
. Over the past three years, SBC hasn't moved much -- closing Wednesday at $24.65, it sits about where it was at the end of July 2002. It has gone several dollars higher and even several dollars lower, but the net effect has been flat.
SBC does pay a 5.22% dividend and really doesn't appeal to the "hot money" crowd, but for patient investors, it presents an increasing value given management's efforts, and acquisitions will soon bear long-awaited fruit. Shares still have outperformed the
this year and may very well find participation in the coming months. I'm long the stock now and am starting to build up a larger position.
I have a very small position in SBC, but I am adding to it at current levels and will even do so down to $24. Those who don't want to establish a full position at or near current levels would do well to start at current levels and add to it in 50-cent increments up from $24.50. My target for the shares is upward of $31 (again, this trade is likely to be slow, but it should be profitable for those who are patient enough).
Now let's look at the fundamental arguments I see supporting this trade.
First, the business environment for SBC is improving. Both residential and business segments have stabilized and are starting to grow. Residential wireline is improving modestly, as would be expected given the regulatory changes that don't require the Bells to provide artificially low wholesale lease rates.
In fact, in the second quarter SBC captured about 40% of its wholesale line losses. This was lower than the first quarter's 50%-plus capture rate, but impressive nonetheless. This provides better margins and still leaves room for improvement. Margins remain lower than
Business access lines fell year-over-year, but retail business lines were the surprise standout, finally increasing after a four-year hiatus. This was an unexpected development, which indicates SBC is starting to make inroads into the segment. Consequently, I don't believe the current share price has accounted for how positive this trend toward improvement really is.
In addition, margins are expanding, as I alluded to earlier, and cash flow is increasing too. The most recent quarter's results were rather impressive -- wireline operating margins were 13% vs. Verizon's 15% -- and I expect them to improve further because of higher wholesale profitability and lower spending in the business space.
However, full benefit will be offset by increased spending for Project Lightspeed, its plan to deliver fiber broadband, video, and phone services to households. Management suggested that free cash flow would be between $3.1 billion and $3.2 billion, but I would look for even further upside as capital spending is likely to be below its lower target of $5.4 billion.
Finally, the company's acquisition of
should soon bear fruit. SBC Chairman and CEO Ed Whitacre is adept at integrating acquisitions, and AT&T is bound to be no exception. From an operations standpoint, this integration presents a challenge: SBC is having some trouble keeping AT&T customers. This means costs have to be cut to the bone. This is a challenge to my thesis, but a challenge I trust Whitacre is painfully aware of. I believe he and management are up to the task.
Once again, this position isn't sexy for those looking for a short-term trade, and really requires scrutiny as the company's operational improvements are improved upon and improved upon again. I'm a Whitacre fan, and I like his prudent strategy, but most important, SBC's cash flow allows me to get paid as I watch this story unfold.
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At the time of publication, Rhodes was long SBC Communications and Verizon, although holdings can change at any time.
Richard G. Rhodes, Jr., is president of Rhodes Capital Management and editor and publisher of the Rhodes Report. He specializes in recommendations with emphasis on world macroeconomic fundamental and technical analyses. While he cannot provide investment advice or recommendations, he appreciates your feedback;
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