What Ails Wireless?

Too many players. Cutthroat prices. A shakeout looms

On a sunny, Saturday afternoon in March, Sam Sarna is yammering away with customers in his New York store, Everything Wireless. His shop, barely bigger than a walk-in closet, is plastered with neon signs, posters, and flyers blaring out deals for wireless phones and services. Sarna's job: to help buyers sort through the cacophony of options. After he recites his litany of possible deals, many customers ask about VoiceStream Wireless (VSTR ), the traditional low-cost provider. That's when Sarna pulls out a map that shows the gaps in VoiceStream's coverage, particularly in the West. "Most people who come in here choose AT&T (AWE ) or Verizon (VZ )," he says. "They want low prices, but they want good quality, too. Prices have come down so much that now they can get both."

Sarna and his store show why the U.S. wireless industry is every customer's dream these days--and every wireless company's nightmare. Those who walk into Everything Wireless and other phone stores reap all the benefits of full-throttle competition. There are lots of choices, good-quality networks, and humdinger prices. All the extras that cost a lot on your home phone--caller ID, call waiting, and voice mail--are usually free on a mobile phone. And over the past three years, wireless service rates have plunged 25% a year, to an average of 14 cents a minute, says Merrill Lynch & Co.

That's nifty for phone junkies, but it's putting the competitiveness of the U.S. wireless industry at risk. Wireless companies are suffering from severe financial pressures that many industry experts think are unsustainable. Prices are in a free fall, subscriber growth is slowing, capital spending remains high as telephone carriers roll out new technologies, and the credit crunch that's wreaking havoc in the rest of telecom is starting to squeeze wireless players. Wireless stocks are down an average of 45% since the beginning of the year, wiping out $45 billion in shareholder value. "The wireless sector is sick," says analyst Luiz Carvalho of Morgan Stanley & Co.

That signals consolidation ahead. There are six national wireless companies, and the competition is so fierce that the wireless business isn't anywhere close to generating cash--20 years after the service was launched in the U.S. Indeed, Morgan Stanley projects the sector will burn through about $10 billion in cash this year. Most investors, Wall Street analysts, and industry executives think the field needs to be cut to no more than four players. "There will undoubtedly be some consolidation," says Dennis F. Strigl, the chief executive of Verizon Wireless. "It's a crazy marketplace today."

How that consolidation plays out in the wireless sector is crucial for telecom services and for the U.S. economy. The reason: Wireless is the last, best hope for competition in the telecom industry. Six years ago, Congress passed telecom reform legislation to bring competition to the local telephone markets. That was supposed to help the entire economy by spurring innovation and lowering telecom prices, a key cost paid by businesses and consumers. Today, the hope for wireline competition in the local phone market is fading. While more than 50 upstarts tried to take on the Baby Bells, virtually all of them are now bankrupt, dead, or crippled by financial woes. The Bells, after promising they would compete with each other, decided it was easier to be rich monopolists. Many analysts expect the Bells to swallow the long-distance companies in the near future.

Wireless could be the antidote to an industry that's all Bells, all the time. Wireless service is developing into an alternative for traditional phone service. Though less than 5% of the U.S. population has disconnected their home phones in favor of wireless service, that rate is growing. And more and more people are using mobile phones for second and third phone lines. Wireless accounted for 12% of all telephone minutes in 2000, the last year for which the government has data, and that's expected to hit 25% of all minutes in 2003. "This is an area where telecom policy has worked very well for consumers," says William Kennard, former chairman of the Federal Communications Commission. "There has been a huge benefit in consumer welfare."

That could change in the coming months. Experts think that Cingular Wireless, the second-largest player, owned by SBC Communications (SBC ) and BellSouth (BLS ), may buy AT&T Wireless (AWE ), the No. 3 company. Several analysts, including Daniel Reingold of Credit Suisse First Boston, expect such a deal in the next 12 months. They figure the companies use the same wireless technology and could save billions by building one nationwide network instead of two. Further out, market leader Verizon Wireless may try to acquire Sprint PCS (PCS ), No. 4, which uses the same wireless technology as Verizon. That would leave two players controlled by the Baby Bells--which would claim 65% of the wireless market--and two much weaker contenders, VoiceStream and Nextel (NXTL ). "To me, that's the nightmare scenario," says Blair Levin, former chief of staff at the FCC and now an analyst at Legg Mason Inc.

If this comes to pass, it could affect data and Internet services, as well as voice services. Today, mobile phones are not a viable alternative to home phones for tapping the Internet--much less an alternative to broadband service. But that's changing. AT&T, VoiceStream, Verizon, and others are rolling out new technology this year that will let customers connect to the Net--either from their mobile phone or from a laptop connected to a mobile phone--at 40-to-60 kilobits per second, about the same as a traditional modem. The next generation of wireless service, scheduled for 2003 or 2004, is expected to connect people at speeds of up to one megabit per second.

The question is whether the Bells, if they were the only strong wireless players, would hold back any new services to avoid cannibalizing their existing voice and data services. Says Steven Sunshine, a former Justice Dept. official who is now a partner at the law firm Sherman & Sterling: "Justice is going to be keenly interested in whether consolidation is going to interfere with the pace of innovation."

Top wireless execs say talk of consolidation is pure speculation. Verizon Wireless' Strigl says he has no interest in pursuing a big acquisition anytime soon. "I'd just as soon somebody else be on the bleeding edge of merging in the industry," he says. Cingular CEO Stephen M. Carter says he doesn't want to do a deal in the near term either, although he would not rule one out altogether.

Still, wireless mergers will take place--and when they do, government regulators will have to strike a tricky balance. Some consolidation will help the financial health of wireless companies so that they can afford to roll out whizzy new services. But too much consolidation could choke off the competition that has made wireless the most dynamic sector of telecom. "The question is whether a merger is going to hurt consumers or is it going to help consumers? There are cost savings that lead to innovation that gets passed on to consumers," says Eleanor M. Fox, a professor at New York University School of Law.

Certain deals, in fact, could help innovation. An AT&T-VoiceStream combo would save the merged companies billions on capital expenditures and overhead, allowing them to compete head-on with any company. Alltel (AT ), a regional player based in Little Rock, could buy Sprint PCS to become a national competitor. Even one big Bell deal--Cingular-AT&T or Verizon-Sprint PCS--probably wouldn't hurt competition. Thomas J. Sugrue, chief of the FCC's wireless bureau, says the commission would carefully weigh the competitive impact of any proposed merger.

Meanwhile, the financial troubles of the wireless players are becoming more serious. Competition is so intense that only two--Verizon and Cingular--made money in 2001, even as industry revenues climbed 24%, to $85 billion. Losing dough was no big deal when the number of U.S. subscribers was growing 25% to 30% annually, as it did during the second half of the 1990s. But subscriber growth dropped to 18% last year, down from 27% in 2000. The number of new subscribers in 2001, 19.5 million, was less than the year before for the first time ever in the U.S.

An aberration? Probably not. On Feb. 4, Sprint CEO William T. Esrey warned that this year wasn't going to be any better than 2001. He said his wireless business, Sprint PCS, would miss its forecasts by a wide margin in 2002. Instead of adding 3.7 million subscribers this year, Sprint PCS will add only 3 million. The reason, Esrey explained, was that the wireless sector in the U.S. probably would grow by only 17 million or so new subscribers in 2002, not the 23 million most had expected. New-subscriber growth would slide to 13%, and the number of new subscribers would fall for the second year in a row. Sprint PCS's stock plunged 20% the following day, to $10.99, dragging down other wireless players.

And the slowdown looks as if it's here to stay. Merrill Lynch predicts that subscriber growth will slow every year through 2005, until just 10 million subscribers are added, for a measly 6% growth. That would bring U.S. penetration to 61%, Merrill Lynch estimates.

Why is the growth slowing now? Part of the reason is the economic slowdown, which persuaded some people to hold off on any unnecessary expenses. "I think what we saw [last year] was that the wireless industry is part of the national economy," says John W. Stanton, CEO of VoiceStream.

The market also is maturing. The big dream for the U.S. wireless industry was that Americans would become as enamored of their cell phones as people are in Europe, where penetration rates are said to be as high as 80%. But wireless penetration rates in Europe have been overstated for years. For starters, European carriers used to count customers as subscribers even if they hadn't spent money on wireless service for months. Second, subscribers often are double-counted if they buy a subscriber identity module (SIM) card, a computer chip that stores wireless minutes, from two different carriers. If you adjust for these two factors, many people, including Cingular's Carter, think European penetration would be in the mid-to-low 60s.

While the U.S. market still has room to grow, it's tough to make new customers profitable. Most analysts think the next round of buyers will be people who subscribe only if they can pay less: teenagers, the elderly, and the tightwads. That means wireless companies may need to become more aggressive about offering prepaid service or wireless service by the minute. But snagging this reluctant group of subscribers could pose risks that carriers aren't accustomed to. Last year, when Sprint started offering service to customers with poor credit history, it found most of them couldn't afford the service for long, resulting in a costly increase in the company's churn. "Carriers need to get smarter about how they segment and attract customers," says Martin Dunsby, a partner at Deloitte Consulting.

Wireless companies have high hopes that lucrative data and Internet services can make up the difference. In April, Verizon Wireless will launch trials in Washington, D.C., and San Diego of high-speed technology that allows connection speeds of 2.4 megabits--plenty for watching full-motion video or swapping digital photos. Verizon expects to offer the service commercially in some markets in 2003. Research firm Frost & Sullivan Inc. expects the wireless-data market to surge from $1.2 billion in 2001 to $20 billion in 2005. Says Andre Dahan, president of AT&T Wireless' mobile-multimedia services: "We believe the opportunity is gigantic."

So are the risks. AT&T, Sprint, and others offered wireless-Internet services to their customers two years ago and found few who were willing to pay the extra money. "Nobody showed up," says Dunsby. "It was a bust." This time, Dahan and his rivals vow they've got the service right. AT&T Wireless plans to market its data services to companies first so employees on the go can get e-mail and other critical information. As services such as short messaging and instant messaging get simpler and cheaper, Dahan anticipates that they'll take off with consumers too.

Which wireless players are best positioned to take advantage of the opportunities on the Net and elsewhere? Start with Verizon Wireless and Cingular, the two largest outfits, with 29.4 million and 21.6 million subscribers, respectively. While other carriers are losing money, Verizon Wireless earned $2.3 billion in operating income last year, and Cingular reported $2.5 billion in operating income. That will allow them to pour money into new networks and services, some $5 billion each, according to analysts.

AT&T Wireless is showing signs of strain in trying to keep up with its larger rivals. The company will need to come up with $15 billion for capital investments between 2001 and 2003, analysts estimate, as much as either of its larger rivals. That's because it's upgrading its network for new data services at the same time that it's switching to a new wireless technology, the Global Standard for Mobility (GSM). On Mar. 18, J.P. Morgan analyst Thomas Lee downgraded the company's stock from "buy" to "market perform" because he thought AT&T Wireless would have a hard time remaining competitive with such heavy capital demands. John D. Zeglis, chief executive of AT&T Wireless, says the transition to GSM will be a competitive advantage in the long term because it's the most popular wireless standard in the world. "We don't have to beg, borrow, and steal from a vendor to get new technology," he says.

Perhaps the most vulnerable player in the industry is Sprint PCS. It has stressed growth at any cost since its start in 1996--and the strategy worked brilliantly for a while. Its stock soared tenfold between 1998, when it went public, and 2000. Since then, Sprint PCS's shares have plunged 85% from its peak in 2000, to $10.50 as investors have soured on fast-growing money losers. Now, the company is losing money--$1.3 billion in 2001--and its debt load is climbing, to $15.4 billion at the end of the year. It also needs to raise $2 billion this year to pay for network investments, according to Sanford C. Bernstein.

As the U.S. wireless industry matures, shareholders, customers, and regulators must face the changes ahead. With wireless companies losing money and with investors reluctant to give them more, some carriers will be forced into mergers. "The capital markets are ruthlessly efficient," says Zeglis. "They will enforce discipline on players over time." No doubt, but it's critical that consolidation not be allowed to go too far. Rigorous competition in the wireless sector is vital to the country's future.

By Peter Elstrom, with Heather Green in New York, Roger O. Crockett in Chicago, Charles Haddad in Atlanta, and Catherine Yang in Washington

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