By Kenneth Leon The seemingly inescapable chirping of Direct Connect wireless phones may set some teeth on edge, but it's a sweet sound to shareholders of Nextel Partners (NXTP). Standard & Poor's views the shares as attractive, when judged against the outfit's peers and the S&P 500-stock index. The stock, which has pulled back 12% from its recent 52-week high and now trades at around $11.50, carries our highest investment recommendation of 5 STARS, or buy.
Partners offer Nextel-branded wireless communications services in midsize and smaller markets throughout the U.S. It was a late entrant into the industry, and its financial and operating metrics such as EBITDA (earnings before interest, taxes, depreciation, and amortization) service margins have lagged its peers. We think better times lie ahead, however. We believe a positive catalyst for the shares would be a better-than-expected EBITDA margin from Partners in the next two quarters, possibly leading to profitability by the first quarter of 2004. In addition, we believe management continues to strengthen the balance sheet with recent debt refinancing, and the company expects to generate free cash flow in the first quarter of 2004.
SMALL IS BEAUTIFUL. Nextel Partners is 31%-owned by Nextel Communications (NXTL
: S&P ranking, 5 STARS, $25), its largest shareholder. (Subsequent mentions of "Nextel" refer to Nextel Communications unless otherwise indicated.) The relationship was created to accelerate the buildout and expand the reach of the Nextel Digital Mobile Network. While AT&T Wireless, Nextel, and Sprint PCS were involved with affiliate startups to enter smaller markets, only Nextel was successful in building Nextel Partners as a financially stable competitor in its service areas.
Nextel Communications and Nextel Partners entered a joint-venture agreement in January, 1999, which stipulates that any prospective acquirer of Nextel would be obligated to merge with or acquire Nextel Partners. The agreement also states that Nextel Communications cannot sell its ownership interest in Nextel Partners, and Nextel Communications is obligated to exercise the purchase of the remaining outstanding shares of Nextel Partners by Jan. 29, 2008.
The joint-venture agreement has other advantages, in our view. For example, Partners uses Nextel's systems and back-office support centers to service its customers. Nextel charges the company a low fee, which will not increase anytime soon, as Partners expands its business. The fees are tied to Nextel telemarketing and customer care, fulfillment, activations, and billing for the national accounts.
Indirectly, we think Partners enjoys the benefits of Nextel's national advertising program and NASCAR sponsorship, with select racing events within its service territories. This allows Partners to channel its marketing costs directly to customer-acquisition and -retention initiatives.
MUTUAL ADVANTAGE. Finally, we see the Nextel joint-venture agreement as beneficial to both companies. Nextel can focus on the top 100 U.S. markets, as Partners tries to increase its foothold in the secondary and tertiary markets.
Partners hold licenses for wireless frequencies in selected areas of the Central and Southeastern U.S., where more than 53 million people live and work. It offers Direct Connect (long-range digital walkie-talkie service), wireless data services, including e-mail, text messaging and Nextel Online, which provides wireless access to the Internet and an organization's internal databases and other applications. All of these services are fully integrated in a single wireless device, with no roaming charges nationwide.
Partners anticipates significant improvements to customer service from several initiatives in the past year. Direct Connect has been expanded nationally, allowing all of Partners' Nextel's customers to instantly communicate with each other using Direct Connect across the U.S. To further differentiate its services, Partners is offering a new Nextel/BlackBerry handheld device with both voice and data capabilities.
CUSTOMER ACQUISITIONS. The focus on business customers has led to one of the highest average revenue-per-user numbers in the industry: $68 in 2002, vs. an industry average below $50, and its average monthly customer churn rate, or turnover, of 1.6% in 2002 was below an industry average of more than 2%.
Partners' traditional methods of distribution have been through its direct and indirect sales force, and it expects to expand distribution. It planned to open 40 retail stores by yearend with at least 30 more stores expected in 2004. During the 2003 fourth quarter, Partners forecasts a decline in acquisition costs per new customer, since it would not be launching as many new retail stores and was continuing to decrease equipment subsidies and improve direct sales productivity.
In each of the markets in which Partners operates, it competes with at least two established cellular licensees and with as many as six PCS licensees, including AT&T Wireless (AWE), Cingular Wireless, Sprint PCS (PCS), T-Mobile, and Verizon Wireless. Many existing operators have significantly greater financial and technical resources, customer bases, and name recognition. However, these five national wireless carriers are more focused on the top 100 major U.S. markets, which are separate from Partners' service territories.
THE BIG SIX. Partners' ability to compete depends, in our view, on the continued satisfactory performance of iDEN technology developed by Motorola (MOT) in its digital networks, the establishment and maintenance of roaming service among its markets and those of Nextel, and the development of cost-effective direct and indirect channels of distribution for its products and services. In July, 2003, Partners entered into an agreement with Extend America to build Nextel's iDEN wireless network coverage in a number of rural markets.
The 11 largest U.S. wireless carriers accounted for 125.3 million subscribers in 2002, or 89% of the total. The top six national carriers -- Verizon Wireless, Cingular Wireless, AT&T Wireless Services (accumulate, $7.50), Sprint PCS (hold, $4.55), Nextel, and T-Mobile USA -- accounted for 78% of the total subscribers in 2002. The top six national carriers' share of the market continues to grow, and we expect them to have 80% to 85% of the total market at the end of 2003. Instead of M&A activity, the national carriers have opted to sign roaming agreements with carriers covering smaller rural to suburban markets.
We rank Partners as 10th in the industry, based on total number of subscribers at the end of 2003's third quarter. It finished the September quarter with 1.14 million net subscribers. Its EBITDA service margins of 22% still lagged behind its peer group average of 35%, but average revenue per user of $70 was second only to Nextel at $71 per subscriber, and customer churn at 1.5% was the lowest in its peer group.
EXPANDING MARGINS. After growth in 2003 that we project at near 50%, we expect Partners' total revenues to advance 38% in 2004, as it continues to expand faster than its peers. We believe its partnership with Nextel will serve as a catalyst for expanded net new subscriber additions with strong support for network and customer services. With a focus on business customers, we expect Partners to maintain one of the highest monthly average revenues per user, at $70, and one of the lowest monthly customer churn rates, at 1.5%.
We believe EBITDA margins will widen to 19% in 2003, from 1% in 2002, and we see a further gain to 23% in 2004, as the customer base expands. We estimate an operating loss of 46 cents a share for 2003, with earnings per share of 14 cents for 2004.
Our Standard & Poor's Core Earnings analysis suggests that our 2003 operating loss estimate of 46 cents a share would be widened by 23 cents if stock-option expenses were included along with other one-time special items. Our 2004 EPS estimate of 14 cents would be reduced by 11 cents for similar stock-option expenses and other adjustments.
Partners trades at a slight premium to the second-tier wireless services stocks on the basis of enterprise value to our 2004 sales estimate. Both Partners and Nextel trade above the peer group average based on 2004 price-to-sales analysis.
discounted cash-flow model indicates a fair value of approximately $15.20 per share. Our model assumes a weighted average cost of capital of 11.9%. Our assumption for approximately 47% compounded annual cash flow growth during 2004-2010, followed by a gradual decrease in growth to 12% at year 15, appears reasonable, in our view, for a company that should realize positive net cash flow in 2004.
PROFITS AHEAD? Our investment thesis has several risks. These include increased wireless competition in Partners' non-top 100 U.S. markets, higher-than-expected marketing costs along with increased customer churn from the introduction of number portability in the non-top 100 U.S. markets, effective May 24, 2004, and cellular competitors offering push-to-talk services in its markets.
Other investment risks may include whether Nextel has the financial wherewithal to purchase the remaining Class A common shares of Partners on or before January 29, 2008, or if Nextel experiences financial or operational difficulties, Partners' business may be adversely affected.
Despite these risks, we believe Nextel Partners has executed well in many of the areas that it can control. We think this is demonstrated by the ability to strengthen its balance sheet and its commitment to be customer-focused and cost-conscious. In particular, we find insiders' equity interest -- as of December 31, 2002, officers and directors (including Nextel representatives) owned 52% of the total common shares outstanding -- to be a positive quality in order to maximize return on invested capital and boost shareholder value. With the stock trading at only a slight premium to its industry peers and operating leverage bringing Partners to profitability in 2004, we would buy the shares. Analyst Leon follows telecom, wireless services, and equipment stocks for Standard & Poor's