S = Supply and Demand

ducati998 said:

Limited Supply, and an increasing demand, combined with low price/ earnings = winner
Good article, and gives some food for thought.
cheers d998

The next big telecom play isn't in sexy techs -- it's in sweat equities, the folks who'll dig the ditches that will bring fiber optic to every doorstep. Get in now.

By Jon D. Markman

One of the great ironies of the investment trade is that the best prospects often occur in the most unlikely places at the most inopportune times -- and vice versa.

For a timely example of the versa, consider the recent hoopla over the opening of the Steve Wynn casino-resort in Las Vegas. In the 30 months between its initial public offering in late 2002 to the day it won its Nevada gaming license in March, Wynn Resorts (WYNN, news, msgs) shares rose 475%. But ever since, amid a massive publicity blitz to celebrate the grand opening -- when you would intuitively imagine that shares would rock -- they’ve fallen 30%.

You really need to get way out in front of major events with money-making potential, in other words, and then get out of the way, at least for awhile, when the potential becomes widely apparent to the public.

Cue the trumpets
So today we consider the case of the long-heralded, much-delayed rollout of fiber-optic communication lines to homes across America. The notion that regional Bell operating companies would need to compete with cable companies by digging up streets around the country and dragging super-high speed lines from their central offices directly to customers has been something of an urban myth for several years. Interrupted by the dot-com bust and distracted by war, the nation’s big phone companies have dragged their feet so long on local fiber that many observers bet that it would never get done.

Companies expected to supply devices to the rollout have seen their shares cut in half or worse in the past year: Blue-chip optical components maker JDS Uniphase (JDSU, news, msgs) is down nearly 60% in 2005 alone despite a material pickup in business, and 98% since 2000, while key subcomponent maker Avanex (AVNX, news, msgs) is doing even worse, if that’s possible, down nearly 70% this year and 99% since 2000.

You might surmise from these results that the so-called “fiber to the premises” theme is doomed, but I think you would be wrong. For even as these stocks are getting sold to the walls, the business is actually finally starting to pick up -- and in a more massive way than we ever imagined. The problem is that the vendors with sexy technology stories have turned out, so far, to be the wrong way to invest in the fiber rollout. The right way might be via the shares of the most humble and low-tech players of all: The companies that dig the holes in the ground into which the fiber and all those cool components are buried.

Niches, ditches and riches
You may have heard in a Marketing 101 class that “niches are riches.” Well, in this case it seems that ditches are riches. Utility construction small-caps Dycom Industries (DY, news, msgs), MasTec (MTZ, news, msgs) and Quanta Services (PWR, news, msgs), and mid-cap Fluor (FLR, news, msgs), are up 5% to 11% this month as word that the biggest regional Bells have really, truly launched on the quest to compete with cable companies by providing customers with the speediest data and video connections on the planet. It has long seemed to observers that Verizon Communications (VZ, news, msgs) and SBC Communications (SBC, news, msgs) have needed to do this or die a slow and painful death, but it’s only recently that concrete evidence has emerged in conference calls and truck roll-out sightings. Verizon set a goal of passing 1 million homes last year and has vowed to pass 2 million more homes this year.

What’s so interesting about the ditch-diggers and pole-climbers as opposed to the component makers is that while the value and prices of technology erodes over time, the cost of labor virtually never recedes. Plus, in a given market area, there are typically only a couple of companies that combine technical know-how, experience with local permitting and certification by the carriers. After years of cutthroat competition followed by consolidation in a brutally cyclical industry, they have finally learned to keep pricing rational.

Ready to haul in buckets of money
Analysts believe that the Bells are on track to spend $1 billion to $2 billion annually over the next five years on outsourced construction work. So for the telecom construction specialists, the future is all about how much of that incremental revenue they can nab, and how fat they can keep their gross margins. With such a massive secular capital expenditure on tap, you don’t really have to worry about how strong the U.S. or global economy will be, or the price of energy, or the obsolescence of technology. MasTec, Dycom and Quanta are standing in front of an absolute tidal wave of spending, and they simply need to stick shovels out of their trucks to haul in buckets and buckets of money.

Each has a special angle that makes them more or less attractive. MasTec, which fell the most from its 2000 high due to accounting snafus that led to restatements and regulatory investigations, largely seems to have cleaned up its act and represents a nicely diversified bet. It not only serves regional Bells aiming to extend fiber to homes, but also works for their arch-rivals, the cable companies and satellite television providers. Paul Kim, analyst at Traditional Asiel Securities in New York, said in a recent research note that MasTec is “one of the most ideal risk-adjusted ways to play the looming battle among . . . monopolistic communications giants.” He sees the potential for the company to peak at $2 in earnings per share in 2007, which implies terrific growth for a company expected to earn 10 cents this year and 40 cents next year. Of course, that’s not all fiber expectations. DirecTV is MasTec’s largest customer, supplying $300 million a year in revenue -- largely for home installations.

In 2003, MasTec went from $2 to $16, and it then fell all the way back to $4 amid concern about its finances. Shares struggled back to $10 late last year and have reeled back to $7 this year. If you can stand that kind of volatility, given a real rebound in business it should be able to revisit the $16 area in the next year as its business visibly improves.

Dycom is more of the grand dame of the group, with a strong balance sheet and history of profitability. It signed a long-term deal with Verizon, the country’s largest local phone company, to do the lion’s share of its fiber-related work. But it also has major deals with BellSouth (BLS, news, msgs), and does a lot of work with wireless providers on towers. Because it fell the least in the aftermath of 2000, it likewise has the least amount of ground to make up. And it was more cautious in its latest conference call about the effect of the fiber rollout on earnings, citing the need for greater expenditures at the beginning to prepare.

A piece of the electrical grid revamp
Quanta Services is in some ways the most interesting of the group, benefiting from a tailwind not just from the telecom buildout with contracts from Verizon in Oregon, California, Florida, Pennsylvania, Rhode Island and Massachusetts, but also from improvements to the electrical grid as specified in the major energy bill now wending its way through Congress. Last week in a conference call, Quanta reported its telecom backlog up 42% year over year and their electrical utility backlog up 8%, but an executive said he considered the first number as conservative because the FTTP buildout “is so massive that it can overwhelm the municipality’s ability to issue permits."

The tremendous rally in the health of electric utilities in the past couple of years has led them to finally spend money on the nations’ fragile transmission and distribution network, and if President Bush signs an energy bill as expected this summer, then 2006 and the next decade should be very lucrative for shareholders. Estimates of the cost to rebuild the U.S. electrical grid range from $50 billion to $200 billion -- a set of figures that has been a pipe dream until now, but might finally become reality. If Quanta just gets a fraction of that business, and it would actually get a significant sum, shares will easily get back to the $18 area at which it rested in 2002.

John LaForge, chief investment officer at the deep value-oriented SRQ Capital in Florida, said late last week after listening to the Dycom, Quanta and Fluor conference calls that he thinks the stocks “are going to scream” over the rest of the year at least, and potentially well into the next couple of years. He said the Street is ignoring the group and treating them as if business were lousy, in sharp contrast to the incredibly bullish views of the company’s normally dour executives.

I echo his view that the way to play this now is to just own all three, and hang on during any volatility at least through the next couple of years. You rarely have an opportunity to buy in front of such a massive spending campaign at a time when skepticism has depressed shares.

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RUDEBOY said:

Ducatti. It's not up to you to decide. If the money has gone in....go with it.

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