Solid Signals for Wireless
By Kenneth Leon, CPA
Industry consolidation continues to alter the competitive landscape for wireless telecom services companies. The latest example: Deutsche Telekom's (DT ) May 25 announcement that it agreed to purchase a wireless network in California and Nevada for $2.5 billion from former partner Cingular Wireless -- which itself agreed in February, 2004, to acquire rival AT&T Wireless (AWE ). DT's U.S. unit, T-Mobile USA, will also cease a venture with Cingular in New York, California, and Nevada. We at Standard & Poor's Equity Research view the deal as favorable for T-Mobile to expand its U.S. network coverage vs. its major competitors.
Indeed, S&P sees a vibrant and growing market for the overall wireless-telecom industry in 2004. We expect greater traffic volume and the introduction of enhanced nonvoice services to largely offset price declines. We believe wireless-telecom services will remain an attractive investment subsector in 2004, given the growth in subscribers and earnings before interest, taxes, depreciation, and amortization (EBITDA) -- and the carriers' positive free cash flow. These factors may support higher stock-price multiples.
The U.S. has six nationwide wireless carriers: Verizon Wireless, a joint venture of Verizon Communications (VZ ) and Vodafone Group (VOD ); Cingular, jointly owned by SBC Communications (SBC ) and BellSouth (BCS ); AT&T Wireless; Sprint PCS (FON ); Nextel Communications (NXTL ); and T-Mobile USA.
Skeptics say the business is approaching maturity, but S&P believes opportunities remain. Although market penetration rates now exceed 50% of the U.S. population, wireless carriers continue to find new ways to drive subscriber growth, stimulate minutes of usage, and expand nonvoice services. They are strengthening their customer retention strategies. They're also shifting their attention to untapped market segments, such as prepaid services, the youth market, and wholesale customers.
Although wireless services remain highly competitive, the exit of smaller carriers and undercapitalized resellers has eased the pressure somewhat. Today, it's unusual to find carriers competing aggressively solely on price. Instead, we observe them trying to retain their best customers under extended two-year contract renewals.
In our view, pricing has become more stable. Although select carriers are offering more "anytime" minutes and monthly rollover minutes in their rate plans, as well as handset subsidies, the group is showing quality growth: higher average revenue per user (ARPU) from enhanced data services and lower customer churn.
WINDOW OF OPPORTUNITY.
And in 2004, the top 10 carriers may show wider differences in performance, with the stronger players such as Nextel and Verizon Wireless gaining market share. However, we believe the weaker carriers are less likely to aggressively cut prices, given the potential negative impact this would have on operating earnings and free cash flow.
In 2003, leading carriers completed most of the major investment programs undertaken to upgrade their networks to the intermediate second-generation (or 2.5G) technology that supports Internet and other data-related offerings. Thus, most of these companies made limited capital expenditures during the year. Coupled with healthy revenue gains, these flat to slightly lower outlays enabled most operators to realize positive free cash flow despite increased competition.
What are the current prospects for the biggest wireless-telecom players? Cingular expects the AT&T Wireless merger to yield cost synergies. We see the period before the merger's closing as an opportunity for other nationwide carriers to gain market share from AT&T Wireless, which we expect to show a net decline in total subscribers in the first quarter of 367,000 subscribers. In our opinion, Nextel, T-Mobile USA, and Verizon Wireless should continue to gain share until about the end of 2004 or early 2005, when Cingular expects to close the AT&T Wireless acquisition. We currently rank AT&T Wireless 3 STARS (hold).
In March, 2004, Sprint's board of directors approved the recombination of its two tracking stocks into one publicly traded company. Unlike the Cingular acquisition of AT&T Wireless, we don't see the recombination as having a major impact on the industry.
In our view, Sprint may be less aggressive on direct marketing in the nationwide wireless market and rely more on its wholesale program with Qwest and Virgin Mobile -- and AT&T Wireless' former corporate parent, AT&T Corp. (T ) -- to expand its national presence for certain consumer segments, such as prepaid services directed toward low-income or high-credit-risk users. We have a 2-STARS (avoid) recommendation on the combined Sprint shares.
At present, European giant Vodafone has a 45% ownership interest in Verizon Wireless -- Verizon Communications holds a controlling 55%. However, S&P wouldn't be surprised if Vodafone revisited its joint-venture relationship should it find a U.S. wireless carrier in which it could gain a controlling interest. Under the terms of Verizon Wireless agreement, Vodafone can require Verizon Wireless to purchase up to $20 billion worth of its interest in Verizon Wireless at designated times between 2003 and 2007.
Of the major carriers mentioned here, Nextel remains our favorite. We believe its recent results and strong outlook support its market-leading status among its peers. Nextel has long differentiated itself with its iDEN Direct Connect, a "push-to-talk" feature that allows instant access to more than 20 Nextel customers at once.
S&P believes Nextel's strong market position with blue-collar businesses will help protect its market share. It continues to have the most profitable and stable customer base of all wireless carriers. Nextel enjoys the highest revenue per user and one of the lowest churn rates in the industry, as well as one of the widest EBITDA margins.
In our view, Nextel's success is driven by strong management execution with differentiated products and services. A stronger focus on retaining subscribers, especially those providing higher monthly revenues, has given Nextel a churn (or customer turnover) rate of 1.5%, vs. more than 2.5% on average for the industry. The risks of local-number portability and of plans by competitors to offer a push-to-talk feature may put some pressure on Nextel's operating performance, but we believe its nationwide service will help it retain most of its customer base.
We think uncertainty surrounding a possible reallocation by the Federal Communications Commission on Nextel's radio-frequency spectrum continues to put pressure on the shares (see BW Online, 5/17/04, "Can Nextel Strike Up the Bandwidth?"). While we see risks tied to the spectrum issue, we believe Nextel is gaining market share. With its shares recently trading below the market on a price-earnings basis, we have a 5-STARS (buy) ranking on Nextel.
Analyst Leon follows stocks in the wireless telecommunications industry for Standard & Poor's Equity Research