THE RUMOR MILL

Wireless Runners Up Consider Options

Reports over recent weeks that Germany’s Deutsche Telekom (NYSE:DT) is considering a spin-out of its T-Mobile USA division, punctuated by Leap Wireless International’s (Nasdaq:LEAP) engagement of Goldman Sachs to explore its “strategic options,” highlight the quandary facing the majority of wireless carriers nowadays:  if you Can’t Hear Me Now, or offer an iPhone, you’re probably in a bit of a pickle.

For several quarters now, Verizon Wireless and AT&T Mobility have been stealing market share from the competition:  in the nine months ended September 30, the top-two carriers accounted for more than 11m net adds (excluding acquisitions).  All public companies combined added just 12.3m.  In the latest quarter, the two accounted for 600,000 more net adds than the group as a whole.  Verizon’s network quality, coverage and marketing machine are formidable and AT&T’s exclusive rights to the iPhone put the two carriers heads and shoulders above the competition.  Recent price cuts made by the two were immediately matched by competitors who literally have no other choice.

So what’s an ‘also ran’ to do?  Sell, merge, bulk up…we’ve said for years that several of these carriers belonged together—back in September we wrote that a MetroPCS (NYSE:PCS)/ Leap Wireless International/United States Cellular (NYSE:USM) union might make sense (The Deal Advisor, 09/09, p.4), although in October we noted that a T-Mobile/ Sprint (NYSE:S) combo was less appealing (The Deal Advisor, 10/09, p.2).  Sprint, which has a nationwide footprint, is probably more in need of broadening its product offering a la some form of combination with a wireline provider (see p.4).  But T-Mobile doesn’t have nationwide coverage, nor do we see an obvious merger partner, due largely to its GSM technology standard.  Most of the remaining smaller players have deployed CDMA technology, meaning integration could be tough, and AT&T, the largest GSM player, would surely run into Justice Department opposition.

A public offering is likely the best way DT is going to unlock some T-Mobile USA value for its shareholders, but we’re not clear that the market gets too excited.  We’ve run a discounted cash flow analysis on T-Mobile, and based on our estimates, the division might be worth about $36b, or 1.7x revenue and 5.9x cash flow. 

Critical assumptions include flat revenue in 2010-2011 (the top line actually fell in 2009 through the third quarter as ARPU was pressured by a growing prepaid component of the subscriber base), and moderately better OIBDA margins.  We think T-Mobile will slow its capital investment some, but given its relatively less strong 3G footprint, it can’t afford to cut too much here. 

We’ve estimated a required cost of equity to be 11.6% and the company’s cost of debt is around 6%.  T-Mobile’s relatively low debt—less than 40% of its total capitalization—makes for a lower risk profile but a higher overall cost of capital, which we put at 8.6%.

Our concluded equity value of about $20b is what DT might get in an outright sale—but publicly, the shares would likely trade somewhere between 60%-70% of that…or about $12b-$14b. 

The four publicly traded wireless companies we routinely track were trading at about 1.2x revenue, 5.1x OIBDA and $742 per sub at the end of the year.  If we apply these multiples to T-Mobile’s metrics, the equity cap comes in at less than $10b based on the revenue and per sub multiples, but it jumps to almost $15b using the OIBDA multiple…so about $12b is probably right.  A sale of 20% of the equity would then net DT about $2.4b.  That may or may not be enough to placate unhappy DT shareholders (including the German government).

As for Leap…we think the company does sell—fairly soon—but it won’t be getting anywhere near the $5b+ equity value implied by MetroPCS’ 2007 offer.  The churn and lower margins associated with its prepaid model have forced the company to retreat from previous cash flow guidance, which had been projected to be more than $850m in 2010.  In 2009 we’re estimating the company cash flowed less than $500m, and our forecast for this year is around $750m as recently launched markets begin to contribute to the bottom line.  Our guesstimate for the deal price?  About $20 per share, or a total enterprise value of $4.4b and $1.5b for the equity.  The most obvious buyer remains MetroPCS, but someone like cable operator Cox Communications might kick the tires in an effort to jump start its wireless operation.