AT&T, Verizon Earnings in Shadow of iPhone

BOSTON ( TheStreet) -- Apple's ( AAPL) iPhone 4 will soon be available on Verizon's ( VZ) wireless network after a four-year exclusive agreement with AT&T ( T), shaking up the industry close to fourth-quarter results.

Verizon Wireless, the joint venture between Verizon and Vodafone ( VOD), revealed the pact earlier this month on the worst-kept secret in the telecom sector: the iPhone 4 will arrive on Verizon's network next month, the first time the iPhone will be compatible with a network other than AT&T's since its launch in 2007.

The iPhone 4's availability on Verizon provides a spark for a sector in need of a shakeup. While industries such as energy, basic materials, industrials, consumer discretionary and financials have surged in the past three months, telecoms have lagged behind the broader market. The Dow Jones U.S. Telecommunications Index has climbed 3.8% in the past three months, trailing a 9% gain of the S&P 500.

On the heels of the iPhone 4 announcement, one of the sector's big winners is Verizon, the first of the big telco firms to report quarterly results. The stock jumped to a 52-week high of $37.70 on investors' iPhone euphoria. However, as the excitement waned, and worries that subsidies for the handsets will damage earnings, Verizon shares have come back to Earth. AT&T shares, meanwhile, are down slightly since the announcement.

For AT&T and Verizon, as well as Sprint Nextel ( S) and T-Mobile, strength comes down to subscriber numbers. The only issue for wireless providers is that the pool of subscribers isn't growing rapidly, and instead the companies are forced to fight for bigger slices of the pie. With the addition of the iPhone 4 to its lineup of handsets, Verizon looks to have scored a big win. However, investment managers say the growth in the number of users migrating from old mobile phones to new Internet-capable smartphones is the bigger trend to pay attention to.

"As you go through the technology cycle, we're starting to move from early adoption to mass adoption," says Channing Smith, manager of the Tulsa, Okla.-based Capital Advisors Growth Fund ( CIAOX). Capital Advisors Growth Fund has 3% of its $23.5 million in net assets allocated to AT&T and 4.5% dedicated to Vodafone.

"From a mobile-device standpoint, the key will be penetration of smartphone users in the U.S. as that is where more revenue is," Smith adds. "The profitability of these companies will depend on the continued trend toward smartphone adoption. There is still a pretty good runway for smartphone adoption."

Craig Moffett, a senior analyst at Sanford C. Bernstein, notes that fourth-quarter earnings results will close the books on the pre-Verizon iPhone era. "That already seems a long, long time ago," he wrote in a research note Monday. "Given how transformational the iPhone is likely to be to market share and growth dynamics, the real question is ... will anyone care what happened in Q4?"

Yes, the fourth quarter happened and these telecom companies will be reporting on it. But as Moffett wonders, will it matter what these companies say about the final three months of 2010 if so much of the focus will be on the impact of the iPhone 4 in 2011 and beyond?

"It matters to some degree, but I don't think investors are expecting a negative surprise," says Smith. "That's why everyone will be listening very closely to what management has to say about 2011 expectations in terms of earnings and revenue growth and the thoughts on margin trends. That will be the real focus."

The battle for subscribers between Verizon and AT&T has nearly cut Sprint Nextel out of the picture. For its part, Sprint Nextel announced a new plan to spend $5 billion to upgrade its network over the next five years. But without a "killer" handset like the iPhone, investors aren't sure what to expect out of the struggling wireless provider.

Like Smith, James Dailey, manager of the TEAM Asset Strategy Fund ( TEAMX), turned to the telecom sector as part of his portfolio construction as a way to play the mobile Internet space. But while Smith will be focusing on each company's outlook, Dailey says the most important aspect of earnings season is how the stocks react after reporting.

"We think there is tremendous information in trying to identify if the stock is in strong hands or weak hands," says Dailey, whose fund has investments in AT&T and Verizon. "We look for persistent uptrends if the stocks selloff on good news."

Unlike Smith, Dailey also cautions investors or potential investors in the telecom stocks about placing too much importance on what management says during conference calls.

"There is a tremendous amount of political realities in the job of a CEO or CFO," he says. "They're so constrained by lawyers at this point that they rarely come up with anything useful in that setting. With some limited exceptions to the rule, they're like politicians in that sense. They're never going to tell you anything that bad. They'll always try to spin things in a positive way."

On the next few pages, TheStreet previews these telecom stocks and what fund managers are looking for in the fourth-quarter financial results from AT&T, Verizon and Sprint Nextel.

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AT&T ( T)

Company Profile: AT&T is the largest communications holding company in the world by revenue, according to its Web site. Based in Dallas, AT&T is one of the 30 components of the Dow Jones Industrial Average.

Reporting Date: Jan. 27, before the market opens

Expectations for the Quarter: On average, analysts are looking for AT&T to report a fourth-quarter profit of 55 cents a share on revenue of $31.5 billion, according to a poll by Thomson Reuters.

Fund Manager Take: Capital Advisors Growth Fund's Smith says AT&T will beat earnings estimates by a small margin, although he'll be particularly interested in listening for hints of AT&T's strategy in the wireless segment as Verizon rolls out the iPhone.

"That's what I want to hear about," Smith says. "Most likely what you're going to see is a rise in operating margins in the wireless segment. The subsidy payments that AT&T has to pay to Apple are very high. I think the loss of the iPhone exclusivity will slow wireless growth for AT&T in 2011, but I think this might be a blessing in disguise."

Smith acknowledges the fear that AT&T could see a mass exodus of subscribers as they flee the network for Verizon now that Apple has launched the iPhone on Verizon Wireless' CDMA network. However, he contends those fears are overblown.

The key, Smith says, will be the average revenue per user, or ARPU, that AT&T reports. "AT&T's net revenue per user has been climbing and people will want to see that trend continue," he says. "This is where the action is for Verizon and AT&T."

Smith and TEAM Asset Strategy Fund's Dailey remark about the attractive valuation of AT&T shares compared to Verizon, and both note that AT&T trades at a significant discount to Verizon on a multiple basis.

"That's really the key to why we own AT&T over Verizon," Smith says, adding that the stock has an attractive 6% dividend yield.

Dailey says he would be a net buyer of AT&T right now and also notes the overblown fears of a subscriber exodus.

"The reality is that it won't be as bad for AT&T or as positive for Verizon," Dailey says. "AT&T has done a lot of things making it hard for these people to leave. There is a very steep penalty for them to get out, which gives AT&T ample time to address their network issues. They're doing a lot of spending on their network."

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Verizon ( VZ)

Company Profile: Verizon is the New York-based provider of voice, data, wireless and Internet products and is also a member of the Dow Jones Industrial Average. Verizon Wireless, the joint venture between Verizon and Vodafone, is the largest wireless provider in the U.S. based on subscriber totals.

Reporting Date: Jan. 25, before the market opens

Expectations for the Quarter: Verizon should post earnings of 55 cents a share on revenue of $26.5 billion, according to a poll of analysts by Thomson Reuters.

Fund Manager Take: As an investor in Verizon, TEAM Asset Strategy Fund's Dailey said the fund bought the stock about 25% below where it's trading now. Continued weakness in the wake of the Apple euphoria would have him looking to buy more, but Dailey concedes that AT&T looks more attractive based on valuation.

Dailey says the reaction to Verizon's quarterly results will tell him a lot about whether the stock can continue to push higher, or if the stock will slide further in the wake of the iPhone announcement.

"That type of reaction is indicative that a trend is exhausted, and I think that's what you're seeing with Verizon after the announcement of the iPhone," he says. "Often times you'll get a sell-the-news reaction even if it's good news. It's in a period of digesting those gains. The valuation disparity with AT&T has gotten pretty significant."

That said, Dailey notes several positives for Verizon by examining the company from a top-down perspective.

"Exclusively to Verizon, their network is widely regarded to be the best of the large players," he says. "There was the potential catalyst of the iPhone. But can the Verizon network perform as well as people expect with an influx of iPhones?"

Dailey also notes one bullish argument in favor of Verizon in that the company has not seen the same penetration among its subscribers in smartphone usage. The argument is that Verizon customers using dated handsets will now convert and upgrade to the iPhone, which will increase the average revenue per user, or ARPU, that Verizon collects.

Capital Advisors Growth Fund's Smith is big on the idea of mobile Internet, although he said the fund instead chose to play the strength of Verizon Wireless through Vodafone, not Verizon, noting valuation concerns.

"When we look at AT&T and Verizon, we feel more comfortable with AT&T and then owning Vodafone," he says.

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Sprint Nextel ( S)

Company Profile: Sprint Nextel, like AT&T and Verizon, offers wireless and wireline communications products and services. The company was created in the 2005 merger between Sprint and Nextel.

Reporting Date: Feb. 10, before the market opens

Expectations for the Quarter: As with the last eight quarters, analysts are forecasting that Sprint Nextel will post a quarterly loss. According to a Thomson Reuters poll, the average estimate is for a loss of 30 cents a share in the fourth quarter on revenue of $8.2 billion.

Fund Manager Take: In the fourth quarter, Sprint announced Network Vision, a plan to spend $5 billion to upgrade Sprint's network over the next five years. The plan will merge Sprint's 3G and 4G towers but spells the end of the push-to-talk iDEN network, which the company has had difficulty integrating since the 2005 merger with Nextel.

Despite these developments, fund managers who are bullish on mobile Internet are not completely sold on Sprint Nextel's prospects.

"For us, we feel that our exposure to AT&T and Vodafone gives us enough exposure to telecom," says Smith, the manager of the Capital Growth Advisors Fund. "We want to own stocks that are levered in the mobile technology trend that have dominant technology designs."

TEAM Asset Strategy Fund's Dailey says that on a valuation basis, it's difficult for Sprint to compete based on their capital structure.

"It's a question of whether they'll have the resources to invest in their network and build it out," Dailey says. "They'll be a pricing player, meaning that they'll provide value with offerings like their $69 all-inclusive package. But I don't think they can afford a price war with AT&T and Verizon given the size of their network and their balance sheet."

Dailey also notes that, unlike AT&T and Verizon, Sprint doesn't pay a dividend. As his fund wants an income stream to act as a bond replacement, Sprint doesn't fit the mold.

"And for us, it has also been an issue of quality," Dailey adds.

-- Written by Robert Holmes in Boston.

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