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Waiting for the Wireless Mergers

By Olga Kharif The wireless industry has been in deep trouble for the past year. Subscriber growth, once leaping at 50% annually, has slowed to 8.4% and is expected to stay near that level through 2005, according to Morgan Stanley analyst Luiz Carvalho. When third-quarter figures are released, two of the Big Six national service providers -- Sprint PCS and Cingular -- are expected to report that their customer bases have shrunk.

Considering that most service providers won't turn profits until late 2003 at the earliest, the outlook remains decidedly gloomy. Long-suffering investors have made no secret of their dismay: The Philadelphia Wireless Telecom Index, which includes wireless-service providers and equipment makers, has plunged 70% since the start of 2002. Yet, wireless outfits are far from dead -- and their stocks seem capable of rising once again.

The good news: Both the number and the duration of cell-phone calls continue to rise. And if Europe is any guide, the U.S. market is far from saturated. On the Continent, roughly 70% of the population owns cell phones, vs. 48% in the U.S. However, as subscriber numbers grow, profits will remain elusive until overcapacity is wrung out of the system. Right now, there are just too many wireless players -- a fact brought into sharp focus by per-minute prices, which have been dropping at an average rate of 6.5% a quarter.

CUE TO BUY? Consolidation among the biggest providers, which analysts expect to begin almost at a moment's notice, should reverse the pricing slide, according to Yankee Group marketing consultancy. The day a big merger is announced could mark the bottom for the sector, says Michael Mahoney, portfolio manager for EGM Communications & Technology, a hedge fund in San Francisco that doesn't hold any wireless shares.

Given today's bargain-basement stock prices, some investors will likely take any announcement that the consolidation is under way as their cue to buy. That logic certainly appeals to Invesco Telecommunications (ISWCX) fund manager Brian Hayward, who oversees $321 million in assets. He sees the fund's wireless holdings, which now represent 15% of the total portfolio, "going higher in the next 6 months to 12 months."

The key here is betting on long-term winners: companies that will benefit from the wave of mergers that should reduce the six national players to a mere three, perhaps four at most. Analysts reason that the survivors will have the resources to hold on through a few more years of turbulence as the industry claws its way toward the promised land of profitability.

THEN AND NOW. The most likely winners, sector-watchers say, are Verizon Wireless and Cingular -- businesses supported by Baby Bells. Neither outfit yet trades separately from its local-calling parents. Market leader Verizon Wireless, with 30.3 million subscribers, is is a joint venture between telecom giants Verizon (VZ) and Vodafone (VOD). And No. 2 national carrier, Cingular, is a joint venture between SBC Communications (SBC) and BellSouth (BLS), with results reported on both parent companies' financial statements.

Investing indirectly in these wireless players would mark a break from the norms that applied when subscriber growth was booming. Back then, investors picked independent, publicly traded wireless outfits rather than, say, Verizon, where growth has been constrained by its core business of local calling.

Analysts now tend to the view that the wireless business could become the main growth engine for Verizon's stock, which closed on Oct. 10 at $32.95, well down on its 52-week high of $49.99. Even if wireless units increase revenues only by percentages in the high single digits, they should still grow faster than the parents' core businesses. An added plus: Wireless is replacing regular phone service. About 3% of the U.S. population has forsaken land lines in favor of cell-phone service, according to industry insiders.

LIFE SUPPORT. And Verizon's local-calling business is a cash cow. Verizon should report earnings per diluted share for the year of $3.05 to $3.09, according to its Oct. 1 guidance. The Baby Bell also has nearly $3 billion in cash (and $45 billion in long-term debt, which is high, but not out of line with the industry). According to Invesco's Hayward, whose fund holds Verizon shares, the core local-calling business can help keep the unprofitable wireless unit afloat until it makes it into the black at some point in the next few years, when he expects it to crush its smaller rivals.

Similar logic applies to Cingular. While everything isn't rosy with its two parents -- on Oct. 8, SBC said that 2002 earnings will come in at the low end of previous guidance -- both outfits remain profitable. The Street expects SBC to report $2.26 a share in yearly earnings, excluding one-time charges. Cingular, which has 22 million subscribers and is widely perceived as being unprofitable, could be the main beneficiary of the anticipated mergers. Eventually, analysts say, it could rival Verizon Wireless in size.

According to reports, Cingular might be a candidate to acquire No. 6 carrier T-Mobile, a unit of Deutsche Telekom (DT), perhaps in a matter of weeks. And some analysts believe Cingular might also have an eye on merging with the third-largest player, AT&T Wireless (AWE).

THREE OPTIONS. While both AT&T and Verizon declined to comment on merger speculation, a spokeswoman for the latter, Brenda Raney, did say: "We are realistic about the industry. We realize customers have lots of choices. And we provide our customers with very good service." At Nextel Communications (NXTL), spokeswoman Elizabeth Brooks says three options will be considered -- remaining independent, a merger, or acquiring other companies.

SBC's stock hit a 52-week low of $19.57 on Sept. 30. Its price of $21.25, as of the closing bell on Oct. 10, is down almost 50% on its year-ago high of $39.17. Its Cingular partner, BellSouth, is also profitable -- issuing guidance for $2.06 to $2.13 in earnings per share for the year. BellSouth closed on Oct. 10 at $22.17, down from $39.11 a year ago.

Industry cheerleaders still champion the independents, such as AT&T Wireless, which with $3.8 billion in cash and $10.7 billion in debt, has the strongest balance sheet of any public wireless-service provider. But while AT&T Wireless might post a positive cash flow next year, it faces more difficulties upgrading its network than do rivals.

SHOULDER TO LEAN ON. Then there's Nextel, whose 2%-a-month subscriber turnover is the industry's lowest. With 9.6 million customers, it also enjoys the highest revenue per user and has consistently met estimates, says Hayward. On the other hand, Nextel has more than $15 billion in debt. A recent JP Morgan report raised questions about its accounting approach to its debt load, but Nextel insists all was done correctly.

Still, Baby Bell proteges will have a shoulder to lean on in the difficult time immediately ahead. Realistically, per-minute prices may not stabilize for several years, when the anticipated consolidation is complete, says Craig Mathias, founder of wireless consultancy FarPoint Group.

The ramp-up of new data services, such as sending e-mail via cell phones, is expected to inspire growth, even though it's not happening as quickly as anticipated. Beyond that, reaching profitability will be tough: As subscriber growth falls, so do increases in revenue and cash flow. At No. 4 player Sprint PCS (PCS), cash flow should climb by 10% in 2003 before falling to single digits, says Sean Butson, an analyst with Legg Mason.

The wireless sector should someday prove itself a source of profits. But the heady days of spectacular subscriber growth are behind it. All but the hardiest of long-term investors might want to avoid this industry in the near term. But the wireless outfits that emerge victorious when the wave of consolidation has passed should be positioned to dominate the field for years to come. Kharif writes for BusinessWeek Online from Portland, Ore.

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