Thursday, January 27, 2005


As you may know, a few weeks back I encouraged readers to sell their small cap mutual funds as well as any foreign funds that have significant emerging market holdings. I advocated moving these funds to big cap American stocks and suggested defensive positions. I hope readers reacted because the small stock funds have been poor performers all year.

In one of my monitored accounts, we purchased AT&T as one of the defensive positions. Today, the owner of the account asked how it is that I keep hitting take over targets for him (in case you have not heard, the Wall Street Journal reports that SBC is in talks to buy AT&T).

I could respond that it is no secret that AT&T (T) is up for sale. BellSouth (BLS) and T had extensive talks back in 2003 and T sold off its wireless services and cable services and cut back on its growth plans just waiting for a bid. However, I did not buy the stock as a takeover target. I bought it because of the fundamental value.

The numbers are compelling. The stocks trades at 2 times cash flow, .46 times revenues, and at 2.28 times book value. The cash flow works out to about Seven Billion Dollars per year. Owning AT&T is almost as good as having a super-dooper master ATM card. (AT&T is a machine that keeps spitting out cash.)

The reason the stock is priced so low is that investors "know the long distance business is dying". This is absolutely not true but investors know it to be true! Investors are reacting to only one half the equation. Yes, prices for long distance services have declined for years, however, the volume is expanding dramatically and the volume will take huge leaps in the audio-video years ahead.

Every phone company in the world needs to be able to send large volumes of voice and data over real wires. The situation reminds me of the tomato vendor who parks his truck on the side of the road I often take to Myrtle Beach. When he has over-picked you can buy tomatoes in quantity really cheap. When he has under-picked, his price is dear. AT&T has had too many tomatoes for a long time but the demand is finally about to exceed the supply. VZ, SBC and BLS are currently spending billions putting fiber optic lines to homes. When that traffic is built out, much of the intercity traffic will have to travel on AT&T lines.

No one can tell if there will be much of a bidding war. FON has already announced plans to spin off its long-distance business which means that the big three phone companies, BLS, SBC and VZ could each end up owning a long distance company. Of the three long-distance players, the trophy would be AT&T and the next most desirable would be MCIP. Should SBC succeed in buying T, the surviving company (which may be called AT&T) would be the largest US phone company.

My amateur guess is that the buy out (if it indeed goes through) will be for at least $22 per share. I purchased more shares this morning as I believe the deal will be approved rather quickly by the regulators. A 15 to 20% return from the new stock in 6 months is my target.


A reader wants to know more about GOOGLE PHONE. The thing to understand is that it is only common sense that voice will eventually come to the internet. For many years companies have offered services that help surfers communicate by phone with web site vendors. The GOOG plan is the best plan yet.

Much of what I am writing here is based on reasonable assumptions and outright rumor. The company has not verified that they will start phone service. By the same token, they have not verified that they will start an internet browser. However, the company has hired the chief architect of the Fox-Fire browser that has stolen about 8% market share from Microsoft's explorer. It is also true that the company has advertised for employees with skills in the area of internet phone programming.

The reported rumor is that GOOG will offer an internet connection between advertiser and consumer. The idea is that a web site owner or a key word advertiser could post a "phone button". The consumer who searches for Myrtle Beach accommodations might find my ad or my web site where one of the phone buttons might be posted. When the consumer clicks the button, his phone rings and so does mine. This is powerful stuff. For years I have wished that there was an easy way to talk to my web visitors while they view the site. It is likely that software would be written to allow the vendor to take control of the consumers browser such that the vendor could help the consumer navigate to the best pages.

Another "free" GOOG service! Yes the advertiser would pay GOOG a fee but who wouldn't pay to connect by phone to customer who is interested in the advertisers service right now! The advertiser will pay a fee for a service that cost the provider almost nothing. It is possible that GOOG will offer VOIP to all commers free of charge tied into an internet browser! Can you see how the volume of traffic is likely to grow?

Right now, anyone can down-load the free SKYPE internet phone service. The service is free provided the call originates and ends on an internet phone. The key is that one does not need an internet phone to use the service. If the call terminates on a traditional phone or on a cell phone, the cost is 2 cents per minute. Of course most of the 2 cents goes to a company like SBC or BLS. It is in GOOG's interest to send the calls directly through the internet.

Of course, most SKYPE users encourage their friends and family to join such that all calls between them are free. GOOGLE may require the advertiser to use an internet phone. Although it is not clear if GOOG would actually sell internet phone equipment; Why not?

The future cannot be foretold but it is clear that plans are being made to integrate the internet and phone service. Actually, Verizon just started offering FOX TV service over the phone. "Convergence" is still in the works.


A little knowledge is a dangerous thing. If you need assistance please not that I offer free consultations. Please be extremely careful when buying high priced growth stocks. Always make sure that there are value characteristics to the stocks that you own or at least balance one position against the other. I like to write about an AT&T and a GOOGLE in the same article because owning either of these stocks makes sense only in terms of an overall portfolio.

Let me use Goodyear Tire (GT) and Yahoo (YHOO) to illustrate some of the dangers and synergies.

Yahoo is an incredible company. It just announced 4th quarter revenue growth of 154%! The company has operating leverage and indeed fourth quarter earnings were up 240%! The operating margin before taxes is 25%! The debt to equity ratio is .12! The company is building service after service that are each real values. Consumers are signing up for these paid services in addition to clicking on pay per click advertisements!

However the market is in love with the stock. Historically, when the market falls in love with a stock it trades far too high and can then under-perform the market for years to come. AOL is an interesting case study. In 1996 AOL dropped from $78 per share to $38 per share and even at that price it traded at 166 times estimated earnings. Those who were wise enough to buy the stock at $38 made a killing during the next 4 years.

After the bubble broke, AOL dropped again and this time it has not recovered. Since the bubble broke, the high flyers have not flown so high and yet they trade a dizzy hieghts. YHOO trades at 90 times earnings, better than 7 times book value, 15 times sales and 54 times cash flow! Contrast those numbers to the ones given above and you can appreciate either how cheap T is or how expensive YHOO is.

How about this for a comparison; Delta airlines trades at .o6 times sales which means the YHOO buyer pays 250 times as much for a dollar of sales as the DAL buyer. DAL is a distressed company and the buyer must know that the risk of bankruptcy is real. Not so for Goodyear. Goodyear is a recovering cyclical stock and has the worst behind it. Yet the stock still trades at only .15 times sales. The YHOO buyer pays 100 times as much for a dollar of sales as does GT.

I have stated before that I plan to continue to own YHOO, GOOG, and EBAY based on my belief that the internet is just getting started. To rationally own these stocks at current prices I must believe that extraordinary growth will continue for many years to come. I believe that although growth rates will have slowed dramatically ten years from now, growth rates will still be high enough for these stocks to trade at 2 or more times the market multiple. This is a long-term bet fraught with peril but in the mean-time I will continue to by some of the T's and Goodyears of the world. In aggressive accounts I will even buy an occasional DAL.

By the way, one should remember that the human being is apt to "know" things that are not true and to discount fundamental truths. In the text above, I implied that the growth rates must eventually come down. The concept involved is called "regression to the mean". The concept was discovered by Sir Francis Galton more than 100 years ago. The idea is simple. He noted that unusually tall men tend to have tall sons but not as tall as their fathers; unusually short men have short sons but not unusually short sons. The height of sons tends to regress toward the mean. Google had revenue growth of 233% this year. It is simply not realistic to expect this rate to continue in the same way it is not reasonable to expect two unusually tall parents to have an 8 foot or even a 7 foot tall child. On the other hand, one should not assume that because long-distance prices are in decline that there is little value in owning a long-distance business.