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A Front-Runner in Wireless

By Kenneth M. Leon Who would have thought that a radio-dispatch and walkie-talkie operator could become one of the leading nationwide wireless carriers? Nextel (NXTL), now the fourth-largest U.S. wireless phone carrier, ended the June quarter with 11.69 million subscribers and is still growing.

To achieve this level of success, the Reston (Va.) company made major inroads into the blue-collar business market with its distinctive two-way radio service, Direct Connect, which provides instant communication at the push of a button (with no dialing, ringing, or replay delays), and new services. More than 90% of Nextel's customers now use Direct Connect. In August, Nextel launched Nationwide Direct Connect, making it the first nationwide walkie-talkie service.

Today, Nextel's wireless services are targeted at small and midsize businesses, such as construction, manufacturing, professional services, and government employees. Last December, it signed a $200 million contract to provide nationwide Enhanced Specialized Mobile Radio (ESMR) to all U.S. federal agencies as well as to state and local agencies with federal funding. Part of the agreement is for Nextel to offer unique interoperability advantages for emergency preparedness and response.

LOW CHURN. Nextel shares, which closed at $19.84 on Oct. 2, are up over 65% year-to-date, well above the performance of other nationwide wireless carriers. We believe the stock has risen thanks to the company's actions to increase its financial performance, reduce its outstanding long-term debt, and improve its cost of capital. On Sept. 18, Nextel announced that it may refinance $1.2 billion of total debt. As a result, we at Standard & Poor's estimate annual pretax net interest cost savings of $40 million to $45 million.

Led by President and Chief Executive Officer Tim Donahue, Nextel has shown wide success with its differentiated products and services, including Nextel Direct Connect and Nextel Online. It has boosted its brand-name recognition through increased advertising and marketing, such as its NASCAR premier car-racing campaign. Plus, while the major carriers engage in price wars, Nextel has been leading the charge to introduce more competitive pricing plans, including a variety of fixed-rate plans with bundled monthly minutes and other integrated services and features.

A stronger focus on subscriber retention, especially its higher-quality subscribers, has given Nextel one of the lowest monthly customer churn rates of 1.6% vs. more than 2% on average for the industry. Nextel also has one of the highest average service revenue per user (ARPU) of $70 in the second quarter of 2003 compared to the industry average at $54 per subscriber.

SOLE SUPPLIER. Greater effort on improving the efficiency and effectiveness of its marketing expenses and distribution channels has helped Nextel realize above-average earnings before interest, taxes, depreciation, and amortization (EBITDA) margins at 42.2% in the June quarter, compared with 35.8% for the industry.

Another reason for Nextel's success, we believe, is that it has a number of important strategic and commercial relationships with Motorola (MOT), which owns about 8% of its class B nonvoting common stock. Motorola, as Nextel's sole supplier, provides the infrastructure equipment and substantially all the handsets used by Nextel's customers. Motorola provides handset service and repair, rented transmitter and receiver sites, and training for Nextel.

Although Nextel is running strong, a few challenges may be on the horizon. On Nov. 24, wireless local number portability (WLNP) will go into effect, which allows customers to move to an alternative wireless carrier without changing their phone numbers. We believe this regulatory mandate will cause Nextel and other wireless carriers to evaluate ways to differentiate their products.

EVERYBODY'S WALKIE-TALKING. WLNP may spur some surprising price initiatives and other maneuvers to retain customers and protect the revenue base from higher churn. We expect the marketing battle to start right before the December holiday period and continue in the first half of 2004. We believe Nextel may increase its customer-care program (which includes support) to retain its best customers and aggressively target the attractive market segments.

Nextel's main competitors are also introducing services that offer push-to-talk services. Last month, Verizon Wireless (a unit of Verizon (V) launched its push-to-talk service. Sprint PCS (PCS) and AT&T Wireless (AWE) are expected to launch this new services later this year. We believe competing push-to-talk offerings that use traditional cellular networks don't offer real-time capability like Nextel's, which has latency less than one second. It's longer on the Verizon cellular network for a walkie-talkie conversation.

In response, Nextel filed suit on Sept. 23 in New York federal court seeking damages and an injunction prohibiting what it calls continued false and unsubstantiated advertising claims by Verizon Wireless. Nextel charges that Verizon is misleading the public with claims its push-to-talk service is available on the best, most reliable networks.

CORE HOLDING. The risk of WLNP and competing push-to-talk offerings may put some pressure on Nextel's operating metrics in 2004, but we believe it will be able to retain most of its customer base with nationwide service. We believe Nextel's recent results support its market-leading status among wireless carriers. We expect 20% revenue growth, to $12.6 billion, in 2004 given that it has one of the most profitable and stable customer bases.

We at S&P project earnings per share of $1.16 in 2003 and $1.78 in 2004. We believe stock-option expense is a moderate negative factor for earnings quality and estimate S&P's Core Earnings of 83 cents in 2003 and $1.45 in 2004.

Overall, we think Nextel shares are undervalued and should be a core holding among U.S. wireless stocks. Our 12-month target price of $24 is based on a blend of forward price-earnings and discounted cash-flow analysis. (Our discounted cash-flow model indicates a fair value of $24 per share, assuming a weighted average cost of capital of 11.18% and a terminal growth rate for free cash flows of 5% after year 15.) With Nextel shares trading below its peers' levels, at 10.9 times our 2004 EPS estimate of $1.78, we recommend buying the stock. Analyst Leon follows telecommunications services stocks for Standard & Poor's

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