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Dave Ebner

 

TORONTO (GlobeinvestorGOLD)—AT&T Canada Inc. and Call-Net Enterprises Inc. are ready to take another swing at their larger competitors, but just because they've jettisoned billions of dollars in debt, it doesn't necessarily mean they'll succeed, either in the marketplace or in your portfolio.

Some investors displayed renewed lust in early April for shares in the revitalized phone companies even though the challengers have disappointed before, both coming close to bankruptcy before restructuring their bloated balance sheets. Unfortunately, the enthusiasm that hoisted their shares in April may wane as the difficulties in going toe-to-toe with Bell Canada, a unit of BCE Inc., and Telus Corp. become apparent to more investors.

AT&T Canada Inc., formerly Unitel and before that CNCP Communications, has battled Canada's onetime monopoly phone companies for more than a decade. Last October, debt of $4.7-billion pushed it into creditor protection. AT&T Canada emerged mostly debt free on April 1 as bondholders and other creditors accepted all the equity in the recapitalized company. AT&T Canada will be renamed by September, having lost the rights to the well-known American AT&T brand.

The Toronto-based company sells long distance, Internet and data services to mid- and large-sized businesses, such as WestJet Airlines Ltd. and Toronto-Dominion Bank.

Call-Net, meanwhile, owns Sprint Canada Inc. Call-Net began life in the late 1980s reselling long-distance service using Bell Canada's network. In 1993 it took on the Sprint brand-another American name-and built an extensive, but not complete, network itself. In the first few months of 2002, Call-Net restructured outside court protection, shedding about $2-billion of debt. It still has about $500-million of debt on its books.

Call-Net is the only national competitor to Bell and Telus in the local residential telephone market, and it also sells long-distance services. It has customers in the small- to mid-sized business segments as well.

Round Two

So, with debt discarded and a new lease on life, the bell's rung for round two. But there's no guarantee either company will fare better this time. Bell and Telus dominate, controlling the bulk of the domestic telecommunications market. Telecom is a business of scale and the little guys typically don't have what it takes to make significant advances.

It's likely, at least, that AT&T Canada and Call-Net will be more judicious with their capital expenditures than during the booming late 1990s, but this, too, presents some difficulties. Telecom is a capital-intensive business. Even in today's depressed market, the big guys spend 15 per cent or more of annual sales on network building, maintenance and such. Financially constrained Call-Net is spending less than 10 per cent of sales and AT&T Canada projects about 10 per cent. As customers clamour for more advanced services, Telus and Bell are in a far better position to offer them.

AT&T Canada and Call-Net have extensive networks but both still need some network services from the onetime monopolies to connect fully with customers. And this is costly, accounting for about a third of AT&T Canada's $1.5-billion in 2002 sales and more than half of Call-Net's $801-million.

The federal regulator has offered some relief. One decision last December should save the two an estimated $45-million annually, according to investment dealer TD Securities Inc. Industry Minister Allan Rock recently encouraged the regulator to look for ways to do more: "Local competition is virtually non-existent in all but our largest cities," Mr. Rock said in a March speech. TD Securities estimated that further savings could amount to as much as $140-million annually for AT&T Canada and Call-Net.

This is helpful, but a business model based on the vagaries of government decisions is not one to inspire confidence in an investor. Call-Net and AT&T Canada don't depend on more rulings going their way to survive, but they're also hobbled by a lack of capital to expand and compete, and the inability to raise new equity or debt.

Valuation

AT&T Canada shares began trading on the Toronto Stock Exchange again on April 1. The more widely-traded class B shares opened at $31.55, giving the company an enterprise value of $631-million - about $631-million of equity plus $20-million in capital lease obligations. That valued the company at 4 times its projected 2003 EBITDA of $163-million.

By the end of its second day of trading, AT&T Canada shares had jumped more than 20 per cent to $38.90, pushing the valuation to 4.9 times. Shares that were briefly cheap suddenly became pricey. By comparison, Bell and Telus both trade at about 5.5 times on the EV/EBITDA measure, according to recent research from Merrill Lynch Canada Inc.

(Bell is owned by Montreal-based BCE Inc. and accounts for almost all the conglomerate's sales and profit. BCE also controls Bell Globemedia Inc., owner of The Globe and Mail and Web sites including this one.)

Call-Net is less expensive, trading at about 4 times, again on the EV/EBITDA basis, as of the April 2 close. When it recapitalized this time last year, its class B shares traded at around $6.50. Soon thereafter the company came up short on its financial results and saw a major regulatory decision go against it. The shares bottomed at 37 cents in last September and have traded around $2.39 in recent sessions. Call-Net is a levered play with about only a tenth of its enterprise value represented by equity, making it a riskier bet.

The future

As standalone entities, growth prospects are limited for AT&T Canada and Call-Net. A number of analysts and investors reckon that AT&T Canada will be taken over eventually with Telus cited as a possible buyer. But for Telus, there's no particular rush, especially since AT&T Canada stock is no longer in the bargain bin.

For Call-Net, a buyer is less clear. The potential loosening of foreign ownership restrictions on domestic phone companies might eventually prompt a large American telecom to sniff around, but then again, it might not.

The last time round, Call-Net and AT&T Canada produced little but grief for investors; there's little evidence that things will be much different this time.

Dave Ebner writes about phone companies and network equipment makers for The Globe and Mail's Report on Business.

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