Are The Short Sellers Right About These 2 Stocks?

In any industry, the only way to avoid price wars is to offer a superior product or service.

Customers will pay full price only if they think your offering is top-notch. And you'll find no clearer example to that approach than Verizon Wireless, a subsidiary of Verizon (NYSE: VZ). In most consumer surveys, Verizon repeatedly comes out on top in terms of customer satisfaction, even as its service is often the most expensive choice.

On the flip side, Verizon's key rivals -- Sprint (NYSE: S) and AT&T (NYSE: T) -- are learning what happens when you skimp on network investments. Both of these firms garner inferior consumer ratings, and despite billions being spent to upgrade their networks now, they still can't close the perception gap against Verizon.

Yet even as Sprint and AT&T evaluate how to catch up to Verizon, behind-the-scenes discussions may upend the entire wireless service industry. That may help explain why short sellers are now targeting both Sprint and AT&T in a big way.

Rising Short Interest (in millions)

Recommended

Here's the Final Tally on How Much Money Trump Raised for Hurricane Victims Katie Pavlich

Since When Did We Republicans Start Being Against Punishing Criminals? Kurt Schlichter

Delivering wireless services is quite lucrative. Though it takes billions to build out a national network, the profit margins on those monthly bills are quite robust (once network amortization costs are backed out). Verizon Wireless' margins on earnings before interest, taxes, depreciation and amortization (EBITDA), for example, now exceed 50%.

If a company could tap into that lucrative market without the need to spend billions on a new network, it would. In fact, that may be just what is happening. Google (Nasdaq: GOOG), for example, is actively developing wireless networks in emerging markets, according to The Wall Street Journal.

If the company's low-cost balloon-based approach succeeds in those markets, look for a similar effort to play out here in the U.S. in coming years. The Wall Street Journal also notes Google's plans to roll out super-strong Wi-Fi in U.S. cities where it offers its fiber-based telecom and cable service, an effort that is likely being closely watched by the wireless incumbents.

Yet even as Google's efforts are a long-term threat, a near-term threat is rapidly emerging. Globalstar (Nasdaq: GSAT) is pushing to offer its "Terrestrial Low-Powered Service" in the U.S., which would deliver voice and data from a series of low Earth orbit (LEO) satellites.

The Federal Communications Commission is reviewing GlobalStar's application.

You can bet Amazon.com (Nasdaq: AMZN) is tracking the FCC's moves. According to a recent report, Amazon would like to use GlobalStar's network to offer its own wireless service. Amazon ostensibly wants users to connect to its site without the need of the major wireless carrier networks. But that's just a Trojan horse. Google and Amazon have repeatedly talked about their interest in creating real competition for the wireless service providers.

The key takeaway: Both Google and Amazon are less interested in wireless service profits and more interested in creating deeper ties into their ecosystems. That means they are likely to undercut the incumbents on price -- if they choose to enter these markets.

Does the rising level of short interest in Sprint and AT&T have anything to do with possible imminent announcements from Google, GlobalStar, the FCC, Amazon, or others? That's possible. But short sellers may also be looking at other issues.

For example, Sprint's impressive multi-year rally has pushed the stock above fair value, according to Merrill Lynch, noting that valuations for companies are now quite rich "given the risks and challenges facing them as they try to grow market share and margins simultaneously to meet consensus expectations."

Merrill Lynch also explains why short sellers are leaving Verizon alone, even as they go after the company's biggest rival, AT&T. "We believe the absolute and comparatively larger increase in T shorts is likely driven by a perception that of the big two it is relatively more vulnerable to rising wireless competition."

For a number of years, investors have accepted a secular decline in AT&T's landline business for offsetting growth in its wireless unit. Yet that trade-off is increasingly being questioned.

In the second quarter, AT&T's EBITDA margins fell 4.9% from a year ago as "profit margins (in the company's wireless division) took a quarter-over-quarter hit for the first time since 2010," note analysts at Goldman Sachs. The key culprit according to Goldman: "Wireless peers have ramped (and will continue increasing) competitive activity, driving AT&T towards potentially more promotional activity." That's a sure sign of a mature low-growth market.

AT&T and Sprint are starting to feel the heat of a more price-competitive market, even before the potential entrance of Google, Amazon or others. With those kinds of headwinds in place, it's no wonder short sellers are targeting these firms and anticipating a move down in their share prices.

Risks to Consider: As an upside risk, AT&T and Sprint could look to ease near-term investor concerns by pumping up cash flow through restrained capital spending, though that would put them at a further long-term disadvantage to Verizon.

Action to Take--> Neither AT&T nor Sprint is headed for deep trouble, nor are their stocks poised to plunge. But the headwinds are mounting, and they are running harder just to stay in place. Over the long haul, investors should brace for more intense price wars for wireless services, which is bound to erode cash flow. AT&T, in particular, with its still considerable exposure to a declining landline business, looks set for steady declines in revenues in coming years as the wireless end of the business maxes out.