Up from the Pit
It¹s time to sift the ashes of the burned-out telecoms for triple-digit winners

by Adam Lass

Most small cities are pleased when they make the national news.

Not Baltimore.

Whenever Charm City is featured prominently above the fold, its name is accompanied by some hideous headline like “Nation’s Syphilis Capital” or “Sets Record Murder Rate.” This week, I was thrilled to learn on the evening news that my office was about to fall into a flaming, acid-filled pit.

I am referring to the now-infamous railroad tunnel fire that raged out of control for days. For any of you who missed the fun, a mile-long freight train loaded with highly flammable industrial chemicals, wood pulp, and hydrochloric acid jumped the rails in a tunnel that runs under most of downtown—and promptly caught fire. The blaze got so hot that it blew up a water main, and the resulting flood threatened to undercut the foundations of several of the historic buildings owned by my publisher.

For days, sirens screamed, roads were closed, and columns of acrid yellow smoke billowed out of sewer lids. So when I say that I had the commute from hell, I mean that literally.

Each day, I tried to compensate by leaving for work earlier and earlier. Today, I left at 6:30… only to discover that all the streets were open. I arrived at Saint Paul Street ahead of everyone else, and had the entire office to myself. Hmmm, there’s got to be a lesson here somewhere.

In the pits

Ah, here it is: Tech investors, their portfolios torched by stupid business plans and dismal profit projections, have crumbled into acid-filled pits of despair. A damn shame, since their losses are primarily due to poor
timing. But their bad luck can become your personal
fortune, and once again, it’s a question of timing.

For the past few months, I’ve focused on manu-
facturing and software with rather nice results: Our
positions in ACSFF and ACLS as of this writing are up a
collective 52%. And the real payoffs are still a ways down the road.

Now I think it’s time to look at telecoms. You know, the companies that were going to wire us all up with high-speed “broadband” connections, turn the world into a single global village, and enable our cell phones to give us Swedish massages at the touch of a button.

To say that the field got a little ahead of itself is a massive understatement. Capacity has far outstripped anyone’s idea as to how to make real money off it. Instead, it has become the playground for global pranksters circulating pesky email viruses (I had to erase half-a-dozen “Sircam” messages this morning) and hyperbolic marketing campaigns (Coors has announced that it’s loading global positioning transmitters into
several bottles, which will automatically broadcast the “winner’s” location to a camera crew. I just hope the poor bastard who uncaps it down at the corner bar didn’t tell his wife he was working late.)

Unwired

At the peak of their excess, the whole wired-up crowd—local, long distance, wireless, telecommunications and network-equipment makers—boasted an ungodly combined market value of US$2.7 trillion
dollars. They have since shed almost two thirds of that
supposed “value.” That crash accounts for as much as 90% of the recent net loss in stock wealth.

Needless to say, investors are now doing their best imitation of Bastille Day, storming the bastions of Wall Street and screaming for blood. Merrill Lynch just paid out a cool US$400,000 to settle allegations that their “I get it” poster-boy, Henry Blodgett, was waaay too enthusiastic in his valuations. Now the sharks are circling around fellow hipsters Mary Meeker and Jack Grubman.

Do ya think the wunderkinder owned a share or two of these bubble bobbles? In a belated attempt to regain a little credibility, Merrill Lynch and Credit Suisse First Boston have promised that their analysts will no longer trade in the shares of companies that they are supposed to be dispassionate observers of.

Months after they helped to destroy billions.

Thanks.

Render unto Caesar

But, believe it or not, I come to praise the telecoms, not to bury them. At least some of them. Well, one in particular, which I’ll get to in just a moment.

Despite the puffery that pushed their valuations beyond reason, despite the fact that they tore up the streets laying down more fiber-optic pipeline between here and North Nowhere than anyone can figure out how to use in the next five years, they really do represent the investment of the future.

And the future will come, eventually, and it will change everything… eventually. It’s just a question of timing.

The future is finally Arriving in Brazil

I am a bit of a contrarian. OK, make that a rabid contrarian. My idea of a good time is prowling war zones, garbage heaps and graveyards—searching for good deals.

I search for good companies in unpopular sectors. Stocks that have been unfairly pummeled because of their associates’ and competitors’ ill fortunes and bad choices.

I like it best when things appear to be at their worst. I’m peculiar that way. That’s why I came to work every day during the tunnel crisis. And that’s why I like Brazilian telecoms right now.

Because as bad as things appear to be in Baltimore, they appear to be worse in Brazil. Appearances, however, can be deceiving.

It was the best of times…

2001 didn’t start out badly at all for the boys in Brazil. Word around the bourse painted a rather pretty picture, with Brazil enjoying the best economic conditions in a generation, and seemingly well on the way to a period of sustained economic expansion.

Most of the leading indicators were pointing toward another strong year of growth, with GDP expanding by 4.5% in 2001, a 12.5% increase over 2000’s 4% growth rate. Better yet, real interest rates were about to dip to single digits for the first time in a decade or two.

But a series of brutal shocks managed to almost completely unwind that rosy scenario: Since the start of the year, the real has depreciated by more than 20%, and whereas 2.5% growth is hardly the makings of a disaster (heck, it beats the paltry 1.72% expected Stateside), it’s still well short of the bullish performance of earlier forecasts.

It was… oh, you get it

The problems afflicting Brazil would be familiar to any resident of, say, San Mateo, California. For several years now, Brazil has skirted the edge of major power shortages, neglecting to expand capacity to match the growth in demand and leaving the reservoirs that fuel the power stations precariously low. Despite the easy math required to predict the impending crisis, the introduction of rationing still came as a nasty surprise to most Brazilians.

Want a quick peek at where things will be headed in L.A. when state-imposed conservation wraps its hands around the economy’s throat? Just look at what happened in Rio when households and businesses were required to cut their energy consumption by 20%. Most economists have shaved their forecasts for growth this year by 1 to 2 percentage points.

This kind of damage would be disastrous in the States, where one or two points off the current projection would be a grim picture indeed.

But the actual effect of the crisis in Brazil is harder to pin down. To begin with, many forecasters are presuming that rationing will not succeed in reducing consumption, and that more drastic measures will be required. But the response from households has been strong, and anecdotal evidence suggests that many companies have been finding it relatively easy to cut energy usage.

That light at the end of the tunnel…

The economic impact of the crisis could be significantly reduced if the government succeeds in its efforts to launch an effective wholesale market for electricity. Many members of Brazil’s most power-hungry industries, such as aluminum producers, have indicated that they would welcome an opportunity to shut down production during price lags and still be compensated by selling back the energy they had contracted to buy. Brazilian companies for which energy is a small but critical cost—restaurants, shops, massage parlors, etc.—could carry on as normal.

On top of the energy crisis, the economy has taken several other hits. The slowdown in the U.S. has inevitably affected Brazil. More important has been the slow-burning crisis in Argentina, which has caused spreads on Brazilian bonds to widen and contributed to the depreciation of the real.

The infighting and corruption scandals within the coalition have given the impression of a government on its last legs, and increased the chances of a victory in next year’s elections for the left-wing opposition—another source of increased risk in the market’s mind.

…might be a burning train

These factors, however, have served to highlight an underlying weakness already apparent at the start of the year: Brazil’s balance of payments situation. The current account deficit is likely to reach around 4.5% of GDP this year. According to Standard & Poor’s, Brazil’s gross financing requirements for 2001-2002 are equivalent to between 260% and 290% of reserves—among the highest of countries it analyses.

For the past two years, a massive flow of foreign direct investment has just about covered this hole in the external accounts. But, while still strong, FDI is expected to be much lower this year and next. The result is an increased need for fresh foreign financing and vulnerability to external shocks at a time of heightened international uncertainty.

Even if the energy crisis turns out to be less serious than initially imagined, the 15-month run-up to the presidential elections promises to be filled with uncertainty.

Charmed?

For a start, there are the elections themselves. It is possible that investors will be convinced by the charm offensive the opposition is currently undertaking. More likely, the currency will continue to come under pressure due to fears of a new government less committed to maintaining stability.

In addition, Argentina, which has bought itself some time to kick-start its economy, could still face a severe economic crisis at any time over the next year, which would have a sharp and immediate impact on Brazilian markets.

The obvious response from the government to such a shock would be a steep hike in interest rates and perhaps a new round of fiscal tightening. In the past, the economic team has always had support from President Fernando Henrique Cardoso when it came time to dish out such harsh medicine.

Attractive

If all of this sounds like the makings of a horror story, you’d be right—and wrong. Oh, there’s no doubt at all that emerging markets are a conflagration just waiting to happen.

The place is stacked high with kindling, and the house at the end of the row is already burning. No sane investor would dream of stepping in now.

Wrong! No smart investor walks away from a heavily discounted situation like this without first taking a good look around. Because the reward for squinting into the smoke and wind is frequently a flash of brilliance amongst the ashes.

In this case, the flash that caught my eye is Tele Centro Oeste Cellular (TRO:NYSE), one of the companies formed as a result of the breakup of TELEBRAS by the Brazilian Federal Government in May 1998.

TRO offers analog and digital cell phone service, as well as the usual pricey add-ons like voicemail, call forwarding, call waiting, caller ID and three-way calling. In ’99,TRO began selling cellular handsets in connection with the introduction of prepaid service, an alternative plan designed for lower-volume cellular subscribers.

Cash up front

The setup is sweet: subscribers must purchase a card with prepaid credits within 90 days of activation. Once the credits in a card are used, a new card must be purchased within 180 days, or else service is canceled and the subscriber must request a new activation in order to regain service. The deal is all cash and up front.
Through its agreements with other cellular service providers, TRO offers automatic roaming services throughout Brazil, allowing subscribers to make and receive calls while out of their region. TRO also offers international roaming in Argentina and Uruguay through agreements with local cellular service providers in those countries. As of January 2000, TRO began offering international roaming in over 60 countries in North America, Europe, Asia, South Africa and Australia.

TRO’s comparative values are par or better. Its price/earnings ratio of 22.82 holds up well against the communications industry’s 22.49, and beats the S&P 500’s 27.76. (The S&P is still shockingly bloated after a year’s punishment. No wonder they are having such troubles maintaining any kind of rally.) Same story with price/sales: 2.30 versus 2.66 and 3.97 respectively.

Sweeter still

Where the company’s numbers really become impressive is when you get to sales and net profits: TRO’s Q over Q sales increase of 43.32% dwarfs the industry’s paltry 15.51%—and all without giving away a dime in profits, which, at 8.92%, are 25% higher than trade’s 6.31% figure.

My sources expect the company to continue its rapid subscriber growth and reach 2.1 million subscribers at the end of 2Q01. I believe that the attractiveness of the company’s main territory and TRO’s outstanding financial performance will help it to continue to yield above-average returns.

For 2Q01, expect a 3% growth in net revenues over 1Q01, to R$286 million. I am projecting a net income of R$33.5 million, or US$0.12 per ADR, in 2Q01. This net income compares to R$34.5 million, or US$0.13 per ADR, in 1Q01. You can expect results in general to remain stable from 1Q01. For 2001 overall, I am looking for earnings of R$144 million, or US$0.46 per ADR.

Net revenue should grow at a lower rate than in 1Q01, as 1Q01 included rate adjustments. As the company maintains its subscriber growth, revenue from handset sales will continue growing to R$56 million.

All told, the gross revenue from services should be R$301, or slightly greater than in 1Q01. For the entire 2001, we are projecting R$1.16 billion in net revenue, which is 28% greater than in 2000.

The play: Buy TRO below US$8, with a 12-month target of US$16 and a -20% trailing stop.