Communications stocks and funds might not be the New Economy's cash machine, but it's hard to believe they'll all be a money pit, either.
Among This Week's 10 Questions
Just as it's hard to fathom that this sector deserved the love and money it got on the back of the Internet buildout theme, it's difficult to imagine that today's negativity isn't a bit overdone. Today we're talking the situation over with telecom vets Bruce Behrens and Liam Burke, co-managers of the
Flag Investors Communications fund which Behrens has run since it launched way back in ye olde 1984.
Unlike many of their peers, this pair typically shops for firms they think are standing in front of big-time growth and hangs on to their shares for years, not quarters. Now this hasn't always worked like a charm; they admit to owning sputtering telecom-gear makers like the failing
, but they've consistently stayed ahead of their peers, including the past 12 months when the average communications fund lost more than 40%.
They're looking at phone carriers like
and they're also liking Net/media behemoth
AOL Time Warner
. They think these companies are winners, but admit that there will be losers. How do you tell one from the other and what could turn the sector around? Read on.
Managers: Bruce Behrens and Liam Burke
Fund: Flag Investors Communications
Managed since: January 1984 (inception)*
Assets: $1.5 billion
One-year return/Ranking: -34.9%/ Beats 76% of Peers
Five-year return/Ranking: 18.3%/ Beats 75% of Peers
Sales charge/Annual Expense ratio:5.5%/1.05%**
Top three holdings:
**Class A shares used as an example.
1. Much of the telecom sector looks like a big risk -- a lot of negative headlines, upstarts defaulting and they owe money to bigger telecoms. Why should investors look at telecom, and what should they expect in the next three years?
It's clearly an industry where top-line growth is going to be fairly decent. Who wins and who loses is more the issue. We're now moving to more stability.
The thing that was hurting the industry probably more than anything else was too many people were financed. We're getting back to the surviving companies, if you will, and we can have a little more reality going forward in their business plans, and the ability to earn returns, and not being driven by some artificiality that was made available by too-easy financing from Wall Street.
There will be winners, and losers. The trick now is to figure out how to distinguish the two. With that in mind, what kind of criteria do you examine in companies before you commit capital, and what time horizon do you typically go into a company with?
First, we look at it from an industry perspective. We divide the industry up into segments and look at the traditional carrier: RBOCs
regional Bell operating companies, long-distance companies and emerging carriers. We look to determine who is best-positioned within that segment. And we go down the line -- emerging carriers as well. Though we have a lower weighting, we're certainly active in that market.
We also balance that with actual fundamentals. And we can take the spectrum of a traditional RBOC that has pretty solid fundamentals, and go all the way down the spectrum to much earlier stage companies where we have to do some more forecasts to try to anticipate when and what kind of time horizon we might expect them to turn into better fundamental values. And that's always a balancing act that we've played.
Occasionally, especially in this market, it's been a lot tougher. A couple of years ago, with the bubble, you could throw money at anything.
Is That Your Bell Ringing?
Source: Morningstar. Returns through April 27.
What are the key criteria that get you excited about a company? You've got to look at what you're paying for growth, right?
Well, there's an issue of quality of earnings. We are very focused on free cash flow. There are lots of companies in our portfolio -- AOL, for example -- where the relevant metric is EBITDA
earnings before interest, taxes, depreciation and amortization. And EBITDA is a very difficult metric to get your hands around, because taxes, interest, depreciation and so on are significant metrics of value that you can't ignore. What is more important to us is to go back and look at the free cash flows behind those numbers and to really get a look at the quality of the earnings as well.
2. With that in mind, what sleeves of telecom look most attractive to you folks today?
The regional holding companies, the Bells.
, they continue to be extremely attractive. They have two real key characteristics.
One is access in that last mile, which is very hard to duplicate. And not only just a physical asset in connection, but it's a customer relationship that gives them a great deal of control. So for the big service sector, that is very important.
We certainly have that with cable TV as well. AOL Time Warner's cable operation is an attractive one. Media content with brand names is very attractive, and appears less an industry statement than it is a company statement with AOL.
3. What about the telecom-equipment companies. The expectations for the Ciscos (CSCO) , the Juniper Networks (JNPR) , the JDS Uniphase's (JDSU) of the world were just incredibly high. How should we be thinking about these outfits now?
It's a little simplistic for investors to say, well, these are great companies, they were too expensive but now they've got to be bargains because they've come down.
I think you have to look deeper. You've had a seller's market for their products a year or so ago. Then, it was fashionable to say buy the arms suppliers when there's a war among the big telco companies. Well, that's OK if that war's going to continue at the same irrational level, but as we shift off of that seller's market to more of a buyer's market, things don't return to the same fundamentals. We've seen it in so many cycles before that the leaders in one phase are maybe not as well positioned for the next phase.
Take Cisco. Our sense is that, productwise, they are getting squeezed from the bottom and the top. Often, those kinds of companies tend to be pretty lousy investments in the recovery phase.
These new companies come to the surface. We're continuing to look at the intellectual property and platforms out there and it's harder to value these but for the long term. Look at
and wireless: Digital data is going to have to be in a Qualcomm-licensed system, and they're going to ride that, and that's a very high-margin, very profitable licensing business over time.
in the PDA
personal digital assistant markets, their operating system is highly profitable. They make a lot more money on every product sold by their competitor
than Handspring itself does, because the intellectual property is worth more than just the marginal profit of the hardware.
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4. Are you bullish on wireless across the board, then? Whom do you see as the longer-term plays? You mentioned Qualcomm and Palm. What about Nokia and Ericsson?
Right now, our only wireless exposure is Qualcomm. That's an area we're looking very carefully at. Obviously, we're looking at the
of the world.
You can't ignore the sleepers, either -- the
of the world as well. But what we're really thinking about is: How is this infrastructure buildout going to occur?
When you look at the carriers, right now they run at fairly low speeds to support the limited data demand. And they're trying to move up the curve.
If you look at what investment that needs to be made today to make the speeds vs. what people anticipate
third-generation wireless technology to be, there's a big gap between reality and expectation. And that's something we want to be very careful about. Right now there's really two pieces of the wireless equipment: the actual physical equipment -- the handsets and the PDAs -- and then there's the infrastructure. On the infrastructure side, there's a lot of promise. We just want to be careful that we have the right players lined up right, with the products that meet today's demand, rather than the future's.
If you had to pick two or three, who are the right players for the longer-term buildout?
That's something we're working through. There are a lot of the traditional players jockeying for position. It all depends on the technology, it depends on the carrier, it depends on where they are in the investment cycle. And we have some real firm ideas as to how this might play out, but it would tie into our investment approach.
We're very comfortable with Qualcomm. We do have a holding in Lucent, but we're not going to stop there. We're going to keep pushing this issue until we see if there are any others in that space.
Do you think it's up in the air now, and not really necessarily actionable or clear?
Well, yes and no. Regarding infrastructure issue, Europe is different from the U.S.
with Verizon in the U.S. is very different than with Vodafone in the U.K. And we're just trying to be very careful in separating the hype from reality.
Beating the Pack
Source: Morningstar. Returns through April 27.
5. Investors in communications or technology are constantly underestimating some trends and products, while overestimating others. What would you say is the most underestimated theme, product or company out there right now? On the flip side, what's the most overhyped?
That's a tough question.
Nokia is perceived as really strong, but it's also in the price, so it's not like it's missing on Wall Street.
I would have said a couple weeks ago some of the contract manufacturers like
were kind of beaten down, but they have come back pretty strongly, so it's not like they're unrecognized.
might be a bit of a sleeper to some people. It does a lot of test and measurement work, which is a lot more reliable and will be there when the business is decent.
: A lot of the companies we have are tied to the
integrated chips business, specifically Qualcomm and Agilent. Obviously, the expectations for any type of IC have come down considerably. But if you look at both those cases, there are some interesting technologies that develop within these organizations as a result of their core competency. And that's been our focus for a while.
6. At the end of February, you owned shares of Winstarundefined, which has filed for bankruptcy. Their failure drives home that we've all had to learn from our mistakes this past year. What are you going to do differently?
We think that their product, their positioning and the way they run the business is very attractive and promising. There are a few short-sellers that are questioning whether the product works and it's a lot of baloney. Their key Achilles' heel was the financing market; in a different environment, they would be able to get the financing to build this thing out.
But, as with a lot of these communications systems, you have to build a huge network before you can start reaping the benefits of the revenue, and can you finance that gap?
From our perspective, we saw the risks there and we understood them. But I guess we didn't appreciate that if the environment was so extreme, can they carry that all the way out, what are the consequences of that?
When things go bad, they just go real bad. And you know, it's a little like
Long Term Capital Management
in 1998, where they had a reasonable portfolio for normal times and even somewhat extended times of a spread portfolio, and even Warren Buffett was interested in buying their portfolio out at the bottom because he could finance it.
Their problem is they were leveraged, and they couldn't afford the extreme situation when the Russian bonds went down and so forth, and the whole market backed away, and then it becomes self-perpetuating because people see the problems and they even further discount it. And they couldn't bridge that gap.
And I'm not exonerating them because they were supposed to understand those things as well, nor am I exonerating us, because we're supposed to anticipate these things. The key for us was that we didn't do a lot of investing in this area, but we did some. You can't escape it.
This is a sector that so much was going on there that we were trying to pick the best business models that we could within that area. We're really proud of
as the key long-distance network provider that we also have owned the stock in. And they're proving to be the key survivor there and with the best plan, their cash flow will break even and are going to be quite a survivor and they'll flourish coming out of this thing.
In this environment -- with a lot of younger upstart shops having a lot of debt on their books -- are we going to see a lot of M&A? Do people want to buy these things?
We think it would be inappropriate for us to double down, if you will. In other words, we still have to look at what are the risks we're in.
Some of the risks are greater in the environment we're in than they were before. And we're not going to close our eyes to that. But I think our focus is that we've been burned on a couple of the names where we ventured out a little bit.
7. Let's talk about two big-name telecom companies that have really hit a rough patch: AT&T (T) and WorldComundefined. What's your take on these companies, and do you own any shares?
We don't own either of those, and we've had both macro and individual issues with both.
On the macro issue, if we look at established carriers, we think the
, Worldcoms and AT&Ts are continuing to operate at a strategic disadvantage.
I don't want to pick on AT&T. If you look at their core business, they're net share losers. And then, if you go back and you look at what they're trying to do to create value, and that's sort of breaking up the companies into pieces, we're not sure whether that creates value, or just sort of shift assets from here to there, and there's been a great deal of debate as to whether or not these assets are more valuable together or apart.
There's still negative cash flow numbers; as we've seen with WinStar, you can't do that forever.
There are capital issues, which we think are important now because over time you're going to have to begin to generate an acceptable return in excess of your hurdle rates. Right now is sort of a wait-and-see type of situation with both them and Sprint.
There is not a sustained model that's highly attractive on an ongoing basis, and so I would say the risks of being wrong are not far from the opportunities of being right. That's not an equation that compels us.
The Telco Tithe
Source: Morningstar. Returns through March 31.
8. Tell me a little more about Lucent. This is a one-time "can't miss" stock that's been missing for a while. How long have you folks owned the shares, and what's your take on the company?
We've owned the shares since its IPO in 1996, added to the position in 1997 and then
again, unfortunately, when it came down in 2000. If you can ask about lessons learned, Lucent is probably as powerful a lesson to have been learned as Winstar.
Having said that, what do you do now with this stock at $9? We've given a lot of thought to that, there's a lot of I-don't-knows.
If you look at their ability to sell both the physical fiber optics and look at the potential equipment business, we give them a fairly good odds that this turnaround will take hold. Their lender is keeping them on a short leash; we're not ignoring that.
They just went in last month, received a $5 billion order from Verizon. That's not insignificant. If you look at the major investment on the carriers, really, when you look at large carrier type of investments, it's not just equipment, it's the ability to provide the integration expertise at that level. And when you look at that, there are really only several companies that can do that, Nortel and Lucent being two of them.
9. What return are you folks expecting for your fund this year?
I really would have to honestly admit I have no idea for the year. The group's been down hard; we probably should have some bounce year-end, it may be a bounce relative to the rest of the market of this year.
I think more important to us is over the next two to three years, we still think this is an area that ought to exceed the S&P. We think values are pretty solid, and top lines in this industry should grow worldwide.
We always call our fund a sector fund with a difference: Unlike a lot of sector funds, this is a huge macro area. There are established companies as well as emerging companies. It's truly international. There's lots of capitalization, it's service, it's hardware, it's a variety of things, it's not nearly as narrow a fund as, say, biotech or energy is tied so much to a commodity price.
And this information age is a real thing and a real concept. It got overdone and we're paying the price for that. But from this point forward over a several-year time frame, I think we ought to be able to earn higher rates of return with good growth. If the S&P gets back to a 10% return over time, we think this could be 12%.
Clearly being a sector, it can and will be more volatile than the diversified market and people shouldn't put their whole 401(k) in it.
10. If you had to name the three companies to buy and hold for five years, what would they be and why?
We have a lot of confidence in AOL. We have a lot of confidence in Qwest, though Qwest has got a funding gap that's manageable. AOL's cash flow generation is just beginning to take root.
is a lower-growth trajectory, but one of pretty good assurance. They've had some recent disappointments in the sense that they're not that unique vs. the industry. But they're still somewhat more unique, and we think the management is very capable there.
We talked about Winstar. At the other end of the business spectrum, we have the SBCs of the world, though their growth rates are coming down; we're looking at great cash flow profiles. We're looking at great returns on invested capital. A company that's being managed to maximize financial return, it's got to be worth something.