Fed cut awakens telecom stocks

Earnings season will be the true test Telecom shares staged a rally last week, buoyed by the Federal Reserve's slicing of interest rates and a smattering of good news among service providers. The Fed cut interest rates for the first time in two years on Jan. 3, lowering the discount rate by one-quarter of a percentage point to 5.75% and the federal funds rate on overnight bank lending by half a percentage point to 6%. In addition, the Federal Reserve's Board of Governors stands ready to approve a further reduction of one-quarter of a percentage point on the request of Federal Reserve Banks.

Feeding on the good news, the Nasdaq Telecommunications Index rose sharply, popping 17.5% in one day, and the broader market also benefited. But with earnings season hitting full steam this week, the warm fuzzies created by Fed Chairman Alan Greenspan may disappear quickly as the focus shifts to company fundamentals.

Overall, stock markets perform better than average in the three to six months following an initial rate cut by the Federal Reserve, said Russ Koesterich, director of quantitative research at Instinet. "Generally, lower interest rates are universally good for stocks," Koesterich said. According to statistics supplied by Robert S. Robbins, chief investment strategist at Robinson-Humphrey, initial discount rate cuts by the Fed since 1980 have boosted the Standard & Poor's 500 19.1% on average in the 12 months following the cut.

Why? The drop in interest rates means fixed-income securities offer lower returns, making them a less attractive alternative to equities. In addition, most stock valuation models factor in interest rates, and as interest rates go down, the net present value of future earnings increases, warranting an increase in projected stock valuations by analysts.

Some of the rebound in telecom share prices is due to a "technical bounce," said Mitch Carpen, senior quantitative analyst at Instinet. When a stock gets oversold in a short time span, there always will be some investors who see value in the stock and will move to buy it. For telecom, "there's nowhere to go but up from here," Carpen said.

Few believe reductions in Fed lending rates will have a huge impact on the fundamental problems facing service providers, said Michael Hodel, telecom stock analyst for Morningstar.com.

"It helps the more established telecom companies that have a lot of debt outstanding and that will be issuing additional debt as [bonds] mature," Hodel said. But no amount of interest rate cutting will help emerging carriers that are having trouble just getting access to capital and whose debt is selling at pennies on the dollar, Hodel said. "Investors and lenders see them as a money pit."

In the week following the Federal Reserve action, interexchange carriers AT&T (up 26.7%), WorldCom (up 33.3%) and Sprint (up 23.3%) all jumped.

The rate cut also put a charge into the shares of some competitive carriers, as names such as Allegiance Telecom (up 82%), Focal Communications (up 57.5%) and Winstar Communications (up 84%) rose steadily in the ensuing week.

Renewed optimism for CLECs was bolstered by large financing deals announced by leading players McLeodUSA and XO Communications. McLeod completed a $750 million high-yield bond offering, and XO raised $517.5 million in a convertible debt offering.

But analysts cautioned against thinking that the rally meant better times for struggling competitive local exchange carriers (CLECs).

"Despite the recent rally, we would argue that very little has changed from an access to capital perspective," said Daniel Zito, Lehman Brothers analyst, in a report. "[McLeod] and [XO] had alternatives before the Fed move and still do, albeit at slightly better rates. Other weaker players are not as fortuitous. We do not believe second- and third-tier carriers with debt at or near distressed levels will be able to access the markets for the foreseeable future."

The fourth quarter earnings season gets under way in earnest this week, and it will be a determining factor in how long this moderate rally lasts, Hodel said. While Verizon Communications and Global Crossing reaffirmed nervous investors last week that they would have good news to report, fourth quarter results and forecasts for 2001 are generally expected to be disappointing.

"Fourth quarter comparisons for corporate profits will be fairly ugly," said Abby Cohen, chief U.S. portfolio strategist for Goldman Sachs.

Interest rate cuts take as long as six months to affect general economic activity, so the stock market and the economy will remain vulnerable to any extraordinary shocks, Robbins said. However, stock prices probably will rebound before earnings do. "The stock market is a forward-looking animal - the market anticipates a turnaround long before it happens," Robbins said.

America Online and Time Warner were given a green light to complete the largest merger in U.S. history last week upon receiving FCC approval, with conditions designed to ensure open access to Time Warner's cable properties and some form of interoperability with AOL's powerful instant messaging platform.

All five commissioners expressed support for the $106 billion deal between the nation's largest ISP and the largest media company. However, there was division among regulators about the need for conditions to be attached to the deal.

Supporting the conditions were the three Democrats on the commission - Chairman William Kennard and commissioners Susan Ness and Gloria Tristani. The terms specifically relate to instant messaging, a market in which AOL has a market share in excess of 90%.

"Imagine if one company controlled all the telephone numbers that people needed to communicate," Kennard said. "That was the danger we faced with instant messaging."

To resolve the question, the FCC will prevent the merged company from offering advanced instant messaging services unless it meets one of three conditions. First, AOL/Time Warner must prove that it has implemented a promulgated standard for server-to-server interoperability that will allow their own and other providers' instant messenger users to detect and communicate with each other.

Option two has AOL/Time Warner signing instant messenger interoperability contracts with at least three competitors, with one contract actually executed, thereby proving good-faith negotiations. The final option would be for the merged company to prove that, because of a material change in circumstance, cross-carrier instant messenger communications no longer serve the public interest, convenience or necessity.

Republican Commissioner Harold Furchtgott-Roth said establishing the conditions was a "fundamentally flawed" process outside the commission's jurisdiction. Fellow Republican Commissioner Michael Powell also expressed opposition to the conditions.

"I concede there are serious questions presented by AOL's dominance of current IM products," Powell said. "But at the end of the day, I believe the record and the anticompetitive theory did not support mandating interoperability."

Of course, the key focus of regulators reviewing this merger has been ensuring that ISPs other than AOL have access to the media giant's broadband cable system. Requiring that AOL/Time Warner reach deals with other ISPs addressed the main concern of consumer groups.

"When this merger was announced a year ago, we were enormously concerned about the possible harm to consumers," said Gene Kimmelman, co-director of Consumers Union's Washington office. "We're very pleased at the final outcome. What could have been a disaster for consumers now holds the potential to promote competition and consumer choice."