U.S. Cellular Stung by Smartphone Subsidies: Corporate Finance

Traders see growing risk in the debt of U.S. Cellular Corp., whose ability to compete with AT&T Inc. and Verizon Communications Inc. is hampered by the costs of subsidizing the pricier smartphones sought by consumers.

Credit-default swaps tied to the eighth-largest U.S. wireless carrier have almost doubled in the past year while the average for peers rose 15 percent. U.S. Cellular bonds have been trading at levels that imply junk status since October, according to Moody’s Corp.’s capital markets research group, and their relative yields have widened even as spreads on investment-grade phone company debt tightened.

Smaller wireless carriers such as Chicago-based U.S. Cellular, which is run by a former McDonald’s Corp. marketing chief, are struggling to bridge the gap between the wholesale prices they pay and the lower retail prices they charge for smartphones including the Samsung Galaxy line, which the company offers for as little as $79.99. U.S. Cellular reported its seventh straight quarterly decline of customers in May.

“This is a business of scale, and this company, like a lot of other companies, has not yet shown that it’s able to carve out a niche for itself,” Dennis Saputo, a New York-based analyst at Moody’s Investors Service, said in a telephone interview. “It’s unclear to us whether or not the industry in general, and U.S. Cellular in particular, is going to be able to increase average revenue per user enough to offset some of the highest priced handsets.”

Steve Carlson, Kelly Harfoot and Laura Lualhati, spokesmen for the company, didn’t respond to voicemail messages and e-mails seeking comment.

Implied Rating

U.S. Cellular had $886 million of debt outstanding as of March 31, including $544 million of 6.7 percent bonds maturing in December 2033, according to a May 4 regulatory filing.

The 6.7 percent notes fell 0.6 cent on July 3 to 104 cents on the dollar to yield 6.38 percent. The notes have implied a credit rating of Ba1 since Oct. 5, two steps below the actual ranking at Moody’s of Baa2, according to the capital markets research group, a separate Moody’s unit that analyzes market data.

The company’s ratio of debt to earnings before income, taxes, depreciation and amortization was 1.03 as of March 31, the second-lowest leverage among 15 of its peers, according to data compiled by Bloomberg. That makes U.S. Cellular a “good acquisition target,” said Chetan Sharma, an independent wireless analyst who covers telecommunications from Issaquah, Washington.

Swaps Climb

Telephone & Data Systems Inc., the telecommunications company controlled by the family of Chairman LeRoy Carlson Jr., owns 73 percent of U.S. Cellular, Bloomberg data show.

Credit-default swaps on U.S. Cellular have climbed 78 basis points since July 1, 2011, Bloomberg prices show. The contracts increased 1 basis point to a mid-price of 170 basis points at 12:30 p.m. in New York, compared with 92 basis points. That means investors would pay $170,000 annually to protect $10 million of U.S. Cellular debt.

The average cost of guarding against losses on the debt of 16 investment-grade telecommunications companies has increased 12.4 basis points to 95.5 basis points since July 2011.

Credit-default swaps, which typically rise as investor confidence deteriorates and fall as it improves, pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

‘Necessary Evil’

U.S. Cellular, which operates in 26 states, reported a net loss of 34,000 customers in the first quarter, its seventh straight quarterly decline. The erosion of the company’s customer base has made it more difficult for it to compete in an industry increasingly dominated by subsidized smartphones, according to Jennifer Fritzsche, a Chicago-based analyst with Wells Fargo Securities LLC.

“It’s kind of a necessary evil; they’ve got to do these smartphones because if they don’t, they are totally irrelevant,” she said in a telephone interview. “It’s longer-term positive because it will generate higher revenue, but it puts more pressure near-term on margins.”

Apple Inc. is said to charge carriers about $600 per iPhone, while Google Inc.’s Motorola Mobility Holdings Inc. and Samsung Electronics Co. typically ask about $300 for their smartphones, according to Fritzsche. Wholesale prices on devices are not disclosed to the public. U.S. Cellular said on June 4 that it would offer the new Samsung Galaxy S III online and in stores starting this month. The phone is being offered for as little as $199.99 in preorders on the company’s website.

Service Revenue

The difference between wholesale and retail prices is more easily absorbed by larger carriers that command greater service revenue, Sharma, who heads Chetan Sharma Consulting, said in a telephone interview.

Service revenue at U.S. Cellular was $1.02 billion in the first quarter, compared with $14.6 billion for AT&T and $15.4 billion for Verizon.

“Smaller operators just don’t have the bank balance to foot the bill of multiple such handsets,” Sharma said. “Their role in the market is very marginal.”

Unfavorable pricing led the company to turn down an offer from Apple to add the iPhone to its device offerings, U.S. Cellular Chief Executive Officer Mary Dillon said in November.

“The terms were unacceptable from a risk and profitability standpoint,” Dillon said during the company’s third-quarter earnings call with analysts and investors on Nov. 4. “It would have forced us to compromise on our commitment to offering an unparalleled customer experience.”

Dillon served as chief marketing officer for McDonald’s from 2005 to 2010 before joining U.S. Cellular.

No iPhone

While the decision not to offer the iPhone makes sense from the perspective of the company’s small scale and pressured margins, it puts U.S. Cellular at a significant disadvantage, Saputo said.

“They’re one of the few carriers in the U.S. that doesn’t offer their subscribers the iPhone,” he said. “There’s a whole host of consumers who will only want an iPhone, and they don’t want to hear about the other devices or how much it may be better suited to their lifestyle and needs.”

Shares of U.S. Cellular fell 32 cents, or 0.8 percent, to $39.31 at 3:20 p.m. in New York. The stock had declined 9.2 percent this year through July 3.

The extra yield that investors demand to hold U.S. Cellular debt rather than government securities has increased 4 basis points to 411 basis points since May 31, while the spread on all telephone companies has narrowed 15 basis points, according to Bank of America Merrill Lynch index data. A basis point is 0.01 percentage point.

Standard & Poor’s rates U.S. Cellular at BBB-, one level less than Moody’s. High-yield, high-risk or junk bonds are rated below Baa3 by Moody’s and lower than BBB- by S&P.

Wireless Contracts

As U.S. Cellular struggles to gain share in the smartphone market, sales of wireless contracts across the industry are declining for the first time, forcing even the larger carriers to seek revenue from new sources, said Avi Greengart, research director for consumer devices for market research firm Current Analysis.

Total wireless customer contracts across the industry were 346.6 million in the period, down from 359.5 million in the fourth quarter, according to Bloomberg Industries data.

That means that strategies such as U.S. Cellular’s deal with Alltel Corp. to offer prepaid, or no contract, wireless service through Wal-Mart Stores Inc. will provide only a small boost to revenue as the four largest carriers, AT&T, Verizon, Sprint Nextel Corp. and T-Mobile USA Inc., rush into the market, according to Sharma.

The lack of opportunities for smaller companies as the four largest carriers shore up market share has left the industry “begging for consolidation,” he said.

“It’s going to be hard to see how they’re going to be able to provide a level of service that overcomes the lack of scale,” Saputo said of U.S. Cellular. “Because they are relatively small, they don’t get the same access to handsets, they don’t get it on time, and they end up paying a little bit more because their volumes are lower.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE