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Time to Pause on Wireless Services?

On July 23, we at S&P lowered our opinion on the U.S. wireless services industry to neutral from positive, due to our growing concerns about rising competition and more difficult quarterly financial comparisons on a year-over-year basis expected in the next six months. As of Aug. 6, the S&P Wireless Telecommunications Index was up 22% year-to-date, vs. a 4.2% decline for the S&P 1500, and it was up almost 95% in the past 18 months, vs. an increase of 23% for the S&P 1500.

In our opinion, the U.S. wireless services industry is likely to change as a result of the planned acquisition of AT&T Wireless (AWE

; 3 STARS, or hold; recent price: $14.30) by Cingular Wireless, expected to close by yearend, and the recombination of Sprint PCS with Sprint FON Group (FON

; 2 STARS, or avoid; $18.11), which took place in April. Removing two of the top national wireless-service providers may reduce the group's market capitalization by about $50 billion, to approximately $37 billion to $38 billion, from more than $88 billion, when it included AT&T Wireless and Sprint PCS.

What are the fundamental reasons for downgrading the U.S. wireless industry? We believe it will become increasingly difficult for most of the wireless-service providers to exceed the Street's expectations on net-subscriber additions; service revenue growth; earnings before interest, taxes, depreciation, and amortization (EBITDA); service margins; and earnings per share estimates.

PAST THE PEAK. Signs of increased competition are evident from wireless-service providers that are boosting handset subsidies and monthly service plan minutes in order to renew existing customers with 24-month contracts or acquire new subscribers. To date, we see no evidence of aggressive pricing related to monthly service rates, but this continues to be another key indicator of the industry's competitive outlook. We see wireless carriers being more aggressive with handset promotions, with some offering up to $100 credits on new handsets to renew 24-month contracts or a discounted phone, along with a free phone, to new or existing customers.

While we expect wireless carriers to still show double-digit revenue growth in the next 12 months, we think service revenue and EBITDA growth rates may have peaked in the first half of 2004 due to our expectation that there will be fewer net subscriber additions in upcoming quarters. Slower net subscriber additions may impede service revenue growth despite higher average revenue per user (ARPU) from new data services. We believe upgrades to enhance data networks and third-generation handsets with Web-based capability can potentially boost growth, but not at the same magnitude at which increased net new subscriber additions drive higher revenue growth.

We also see EBITDA service margins leveling off -- even declining for some companies -- as marketing costs increase due to companies' attempts to gain or hold market share. While local number portability may have less of an impact on the competitive landscape, we think industry consolidation will enable the largest wireless carriers like Cingular Wireless and Verizon Wireless to take advantage of their market size to offer more aggressive price plans, handset subsidies, or bundling with broadband and other wireline services.

GETTING A GRIP. Over the long term, however, we view emerging wireline substitution as a positive for the wireless industry. Nationwide, wireless carriers report higher minutes of use attributed to long-distance traffic, and T-Mobile USA stated recently that 10% to 15% of its subscribers don't have wireline service. We expect wireless substitution trends to continue.

The closely-watched event in the industry is the agreement announced in February, 2004, by Cingular Wireless, a joint venture between SBC Communications (SBC

; 2 STARS; $24.86) and BellSouth (BLS

; 2 STARS; $26.84), to acquire AT&T Wireless for $15 per share, or $41 billion. The deal is expected to close as soon as late 2004, subject to necessary approvals. Cingular must wait for the acquisition to close before it can realize merger synergies.

For the rest of 2004, we believe Cingular will slow its marketing and network capital outlays until it can "put its hands around AWE" after the merger closes. In our view, Cingular will need to show the market that it can grow and gain market share with the AWE acquisition, in order to refute industry observers who believe Verizon Wireless may regain its No. 1 ranking, measured by total subscribers, through organic growth.

TIDE COMING IN? In the interim, AT&T Wireless has fallen behind its principal competitors, although there are signs the company has improved its customer service and support. In our view, Verizon Wireless and T-Mobile appear to be the major beneficiaries of Cingular's merger distractions, gaining the most net-subscriber additions in the first half of 2004.

However, we believe the tide may change in the next 12 months. We see Cingular as a formidable competitor in the early part of 2005, and the market's largest wireless service provider should be able to shift its focus to acquiring new subscribers and retaining existing customers with a single brand and a larger geographic footprint for service coverage.

What about Nextel Communications (NXTL

; 3 STARS; $21.42), which could represent almost 70% of the U.S. wireless industry index after the AT&T Wireless acquisition closes? We believe Nextel faces increased competition in the market segments it dominates -- business and government.

We're also less confident that the company can expand its share in the consumer market with higher-priced plans for its traditional service and a slow rollout of Boost Mobile for the prepaid market. Uncertainties surrounding the final costs of spectrum reallocation, to be decided by the FCC, and third-generation (3G) broadband technology are risks to consider when investing in Nextel shares, in our opinion.

SUBURBAN EDGE. As the two major pure-play wireless companies -- AT&T Wireless and Sprint PCS -- get absorbed, investors may shift to alternative ways to play the U.S. wireless service industry. We believe investors may look for integrated telecommunications service companies with a higher proportion of wireless assets and revenues than their peers, such as ALLTEL (AT

; 5 STARS, or buy; $51.40), Sprint, and Verizon Communications (VZ

; 5 STARS; $38.34).

In our opinion, ALLTEL is the most attractive stock within this group, because of its stable wireline business and fast-growing wireless business in second-tier U.S. markets. We would also buy Verizon shares given its position as the market leader in the U.S. wireless market, based on most operating and financial metrics.

Overall, with all the changes and rising competition we see in the industry, we believe investors should limit their purchases to stocks such as ALLTEL that have a unique edge in wireless services in certain suburban areas.

Note: Kenneth Leon has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received non-investment banking compensation from AT&T Wireless, ALLTEL, Verizon, SBC, BellSouth, and Nextel Communications during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at

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