By Olga Kharif
So far this year, investors have moved cell-phone stocks from the deep freeze to the front burner: Shares of the leading wireless service providers are up 50% or more. Now, it looks as though these shares are approaching another transition point -- but the direction is a bit hard to predict.
Reasons to be wary include signs that the stocks are stalling in anticipation of Nov. 24, the date when federal law will require carriers to provide wireless number portability (WNP), which will let customers keep their phone numbers when they switch providers. Pessimists think this will swell customer churn (now 25% a year), scare away investors, and slam cell stocks.
The other line of thinking is that the damage from WNP is being exaggerated -- and that with the carriers' customer rolls, revenues, and profits all rising, the stocks could keep climbing, too. Juxtapose those viewpoints, and it's possible that if the stocks retrench, the next few months could offer a buying opportunity for investors willing to shoulder significant risk. At least, that's the view of Michael Mahoney, portfolio manager at EGM Capital hedge fund in San Francisco, who bought several wireless stocks this summer.
Undeniably, many carriers are healthier than they've been in years. Of the big six, ranked in terms of earnings -- Verizon Wireless, AT&T Wireless (AWE ), Nextel (NXTL ), Cingular, Sprint PCS (PCS ), and T-Mobile -- the first three are now profitable. Moreover, their debt has dropped this year. Among the most striking developments has been the $1.3 billion in debt shed by Sprint (FON ), Sprint PCS's parent company. With debt now standing at about $17.1 billion, the improvement appears to have scuttled rumors that Sprint might seek Chapter 11 bankruptcy protection.
The industry's fundamentals have improved, in part, because the carriers have stopped waging price wars. That has cut churn -- the rate at which customers switch carriers -- by nearly a third for some carriers, vs. the rates of two years ago. At the same time, services such as push-to-talk, which turns a cell phone into a two-way radio, are attracting new subscribers. In the second quarter, 3.84 million customers signed up for cell-phone service, more than in any of the previous six quarters, according to analysts at Prudential Financial.
The current quarter might come in even higher, says Jonathan Schildkraut, an analyst with SG Cowen Securities. Verizon Wireless, with 34.6 million customers, rolled out push-to-talk in August, and Sprint PCS and regional carrier Alltel (AT ) should introduce it later this year.
As a consequence, industry revenues are growing briskly, if not as fast as in the recent past. They'll be up 9% to 10% this year, to about $80 billion, estimates Thomas Lee, an analyst with J.P. Morgan. Some of the revenue will come from a monthly fee of about $2 that carriers have already tacked on for WNP. Some will come from the extra fees customers pay to send text messages or photos via phone: Text-messaging customers, who spend an extra $2 to $3 a month, should number 37.7 million by yearend -- up 66% from last year, says Tole Hart, an analyst with market researcher Gartner Group.
Cell-carrier earnings are also benefiting from reductions in spending, particularly for infrastructure. In the second quarter, AT&T Wireless reported a 700% gain in profits, to $228 million, or 8 cents a share, as revenues rose 8.7%, to $3.95 billion, and capital spending fell 37.4%, to $542 million. The industry's capital investments won't need to rise again for at least two years, estimates Shiv Bakhshi, research manager for wireless and mobile infrastructure at tech consultancy IDC.
Such good news has prompted a series of upgrades by brokerage houses. On Sept. 5, Prudential Financial raised its rating on the cell-service sector from market perform to market outperform, while bumping Sprint PCS from hold to buy (Prudential makes a market in and/or has banking relationships with a number of wireless companies). Merrill Lynch upgraded AT&T Wireless from neutral to buy, while on Aug. 27, Banc of America initiated its own coverage on the carrier at buy. It noted that AT&T Wireless, at $8.56 a share, is trading at a price-to-estimated 2004 earnings ratio of 32 -- or half the p-e of wireless-equipment provider Ericsson (ERICY ). (AT&T Wireless closed at $8.94 on Sept. 24.)
That leaves WNP as the primary problem facing the industry right now. EGM Capital's Mahoney suspects it probably won't cause much damage. But if it does, and the industry consolidates as a result, he thinks investors should still be O.K., because the surviving companies should be healthier -- and their stocks stronger.
The case for why WNP won't be all that disruptive has to do with timing. About 70% of wireless customers will still be under contract to their current carriers come November, estimates Thomas Watts, an analyst with SG Cowen Securities. Unless they cancel their contracts -- and incur a penalty of more than $100 -- such customers won't be able to switch until 2004, and perhaps not until late in the year. That's because carriers are trying to lock existing customers into one- to two-year contracts before Nov. 24 by offering discounts on activation fees and new phones.
Technical glitches could slow switchers as well, since it may take weeks for WNP systems to get the bugs worked out of their systems. Moreover, even though phone numbers won't change, one carrier's phones won't work on another's network -- which will force customers who switch to buy new handsets. Only 11% of the 3,000 cell customers recently surveyed by Convergys (CVG ), the world's largest provider of wireless billing services, realize that, says Mike Cholak, vice-president of the company's market-research division.
In short, don't expect WNP to make much difference this year, says Andrew Cole, an analyst with wireless consultancy Adventis. Even in 2004, SG Cowen's Watts estimates, WNP will increase churn by only 0.3 percentage points each month -- to 2.7% for Sprint PCS, for example. While that's significant, it wouldn't be disastrous. So far, worries over WNP may have actually helped the industry, because as carriers have worked to improve service and add features, they've reignited subscriber growth after a lackluster 2002.
True, WNP won't be a picnic. This year alone, it'll drive up the average cost of acquiring a new subscriber by $10, to $377, estimates Watts (though carriers will recoup some of that through the $2 WNP fee). As a result, he anticipates that AT&T Wireless' growth in earnings before costs such as depreciation and taxes will slow from 23% this year to 9% in 2004. Still, many analysts say carriers will likely find ways -- such as charging extra fees or bundling higher-cost features into calling plans -- to recoup these higher acquisition costs.
Some analysts also worry that carriers may need to increase their network investments sooner than anticipated if competition for customers heats up again. That could lead to an erosion in profits, says Peter Hofstra, senior investment analyst at AIC Diversified Science & Technology Fund, a hedge fund that so far has resisted buying wireless stocks. "We're waiting on [cell-phone] operators to see that they can scale their businesses profitably," he says.
One alternative for cautious investors is to consider rural carriers, such as Western Wireless (WWCA ). They shouldn't be as affected by WNP as the national carriers, says Mahoney, who has bought Western Wireless shares. Prudential just increased its 18-month price target for Western Wireless to $24. As of Sept. 24, it was trading around $20 -- just shy of its 52-week high of $21 on Sept. 9.
Though they could be riskier, the shares of national carriers ultimately might have more upside, Mahoney says. He particularly likes -- and holds -- Sprint PCS, which he thinks investors have undervalued through the downturn. At $5.97 as of Sept. 24's close, it's now 12.2% off its 52-week high of $6.80, which it hit in July.
Cell carriers may not have clear skies yet. But the outlook for their businesses -- and their stocks -- seems brighter than it has in years.
Kharif covers technology for BusinessWeek Online from Portland, Ore.