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Making the Case for Sprint PCS

It's hard to get excited about a company that has $14 billion in debt, faces increasing competitive pressures, and is projected to report significant losses through 2005. That's the kind of stock Sprint PCS (PCS) is. Long considered a laggard among the top six wireless carriers, Sprint PCS took a turn for the worse in the third quarter by disappointing Wall Street with the number of new customers it attracted to its mobile-phone service.

Instead of the more than 300,000 in net new subscribers that analysts were hoping for, Sprint PCS signed up 184,000. The stock, which traded as high as $65 in mid-2000 and as low as $1.75 in October, 2002, took a sharp dive on Oct. 23, the day PCS posted results, falling from $5.32 to $4.41. It has pretty much stayed there since, closing on Nov. 10 at $4.39.

Now that analysts see Sprint PCS as the cheapest wireless stock, the question for investors is whether it's worth taking a gamble on. The answer, at least for those willing to tolerate some risk, is that it may indeed be.

NEW CALCULATIONS. The fact is that Sprint PCS (the tracking stock for parent Sprint's (FON) wireless business) looks so bad on so many key measures investors focus on - debt, profits, competitive position -- that it's easy to miss some positive developments.

For example, Sprint PCS's financial performance is improving. It reported a loss per share in the third quarter of 7 cents (or $69 million), which looks a heck of a lot worse than the 1-cent loss reported in the same quarter a year ago. But last year's loss would have been 13 cents if PCS hadn't gotten a tax break and sold a division that quarter. Taking that into account, this year's third-quarter loss was a 46% improvement over last year.

More important to investors is that when you focus on free cash flow, Sprint PCS is actually making money. Its reported losses are due mainly to interest payments on its massive debt, which cost it $378 million in the last quarter, as well as depreciation on its expensive network - an additional $678 last quarter. Free cash flow (which includes the interest expense but not the depreciation) was $273 million in the third quarter, up from a negative $113 million a year earlier.

HEALTHY DEVELOPMENTS. In reporting its third-quarter results, Sprint PCS raised its guidance on free cash flow to $300 million for 2003, up from $200 million. Its $3.34 billion in revenues for the period were up 5.8% from the same quarter a year ago and 8% more than the prior quarter -- also a bit better than forecast.

Gross profit margins on PCS's service revenues also improved to 31.4%, some 0.4 percentage points better than the prior quarter and 2.10 points better than the estimates of analysts at Soundview Technology. The analysts kept their neutral rating on the stock, as well as a $6.25 price target within 12 months. But they conceded in an Oct. 23 research note that "the company trades at a substantial discount to its peers," and that if it "improves execution, lowers its churn and level of debt, and outperforms EBITDA [earnings before interest, taxes, depreciation, and amortization] margin expectations, we believe the shares may move higher."

SG Cowen's analysts, who rate Sprint PCS outperform, took a more optimistic view in their Oct. 24 report on the quarter, entitled "Operating Improvements Lost in Net Add Shortfall." Investors may have missed two important business developments in PCS's third quarter while they were licking their wounds over the lack of new subscribers, Cowen argues. (Also, Sprint PCS has already adjusted its pricing to be more competitive with other carriers in attracting subscribers in the current quarter.)

WHOLESALE BLOWOUT. One often-missed dynamic in PCS's favor is that it's doing a good job selling data services. That should help it make more money per customer, argue Cowen analysts Tom Watts and Jonathan Schildkraut. PCS now has a total of 5 million customers paying extra to use data services on its state-of-the-art nationwide network. One year after launching its high-end PCS Vision program, the service has 2.7 million subscribers, up from 2.1 million in the second quarter. The popularity of e-mailing photos, which Sprint PCS has been advertising heavily, is a major driver of data services.

Moreover, its wholesale business is growing like gangbusters. S&P analyst Kenneth Leon estimates that wholesale revenue will grow from less than 5% of total sales in 2003 to 15% to 20% in 2004.

One component of that business, Virgin Mobile, a joint venture between Virgin Group and Sprint PCS, announced on Nov. 3 that its youth-oriented prepaid service, which debuted in mid-2002, had reached the 1 million-subscriber mark (and not all those subscribers are teenagers). It made that milestone as fast as any other wireless service. Also, in 2004 PCS will provide service for Qwest Communications' 1 million wireless subscribers.

CHURN UP? Strengthening, but still weak, fundamentals and improving dynamics in some aspects of its business don't entirely offset the problems Sprint PCS must overcome. Its staggering debt alone is enough to scare off many investors. "As a rule, we don't like to buy companies with that much debt," says Gabriel Erdi, an analyst with tech investment firm Skye Investment Advisors, who's passing on all the wireless carriers for now.

Plus, PCS's subscriber churn level ticked up in the third quarter to 2.7% from 2.4% -- and could worsen after a new federal regulation that permits customers to keep their wireless phone number when they change carriers takes effect in late November.

Still, this is 2003 -- a year when some of the best stock market performers have been companies that look terrible by most financial measures but that boasted improvements in business dynamics and fundamentals. At a time when so many tech stocks are getting expensive, beleaguered Sprint PCS is looking cheaper than ever. That alone makes it worth at least a backward glance. By Amey Stone, a senior writer at BusinessWeek Online who covers the markets as a Street Wise columnist

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