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.

REFAIRE LE MONDE

Why Not Leap, MetroPCS AND United States Cellular?

“Refaire le monde,” literally, “Remake the World,” is an expression used by the  French when a group of people talk late into the night (usually accompanied by copious quantities of wine), philosophizing, debating and proposing their most inspired new ideas.

In The Deal Advisor, “Refaire le Monde” will be a periodic feature where we comment on and/or speculate about possible combinations within and between the communications subsectors we follow.  In some cases we might weigh in on current market speculations, like the rumored T-Mobile – Sprint Nextel (NYSE:S) union.  In other cases we might get creative and present our own thoughts on who might or should be teaming up.  The more creative our speculation, the more wine you can assume was involved.

This month there’s been a lot of chatter about wireless industry deal doings, but after taking a look at the players, we’ve come up with our own thesis.  Actually, it’s a variation on a theme that has been put forth repeatedly over the years, but one that might make sense given the increasing dominance of Verizon Wireless (VzW) and AT&T Mobility (AT&T). 

Whether or not T-Mobile and Sprint decide to tie the knot, there remains a handful of players with less than 10m subscribers each that in all likelihood need to bulk up if they want to survive in the long run.  We think that it would make sense for Leap Wireless International (Nasdaq:LEAP) and MetroPCS (NYSE:PCS) to get hitched, and this perennial rumor has been heard once again in recent weeks.  But, we ask, why not include United States Cellular (NYSE:USM) in the mix?

All three providers have deployed CDMA technology, so network compatibility isn’t an issue (unlike in the proposed T-Mobile-Sprint merger).  And their respective coverage maps work well together.  If we look only at cellular or PCS spectrum, there would remain a few holes, most notably in Texas and a big chunk of southern California, but most of the major U.S. cities would be covered, making nationwide roaming—a must in today’s competitive environment—a more profitable proposition.  When you include AWS and 700 MHz spectrum, the country is pretty well covered with the exception of the Dakotas, Minnesota and part of Ohio.

Furthermore, where LEAP and PCS have focused on essentially a wireline replacement business model built around unlimited calling plans, USM’s customer base is largely comprised of contract, post-pay subscribers.  The combined companies would now have experience on both sides of that equation.  Prepaid and unlimited plans have been popular recently, due largely to the weak economy, but in the long run, contract customers are generally more loyal and profitable.

Finally, where USM has failed to generate the 35%-40% OIBDA margins more typical of a mature wireless operation, both LEAP and PCS have managed to hit that mark in what each refers to as their “core” markets—those markets where service has been up and running for a number of years.  A combination of best practices along with the efficiencies that are expected in a larger organization might do wonders for the consolidated bottom line.

“United Metro International” (we’re pretty sure the marketing department would come up with a better name!) would have nearly $10b in run-rate revenue, and around 18.5m subscribers by year end.  We’ve run a combined discounted cash flow analysis (DCF) based on our subscriber, revenue, cash flow and net cash flow projections for the three companies.  Based on an 11.5% cost of equity and a 4% perpetuity growth rate—both LEAP and PCS are still growing net cash flow very rapidly due to their historic expansion programs—we estimate the enterprise value of the combined companies would be more than $21.3b. 

By way of comparison, the market value of invested capital for the three was just $17.3b as of September 21.  Should an investor demand a rate of return of just more than 13.2%, however, the combined value would be no more than the current market value of invested capital of the combined companies.

These days an 11.5% rate of return might be considered attractive, but we think the more salient point is that without some type of event, all three of these companies will find themselves on a steeper and steeper path, working harder just to stay in place.  Of course, as we noted back in March (The Deal Advisor, 03/09, p.1), the controlling Carlson family has long shunned overtures toward USM or parent Telephone and Data Systems (NYSE:TDS).  But the writing is on the wall, we think, and their go-it-alone attitude is unlikely to serve investors well in coming years. 

The government may be examining competitive practices in the wireless industry (The ILEC Advisor, 08/09, p.6), but we can’t imagine a three-way union that results in a company that still has less than one-fourth of the customer base controlled by ATW or VzW would be denied.  Makes sense, non?

DEAL OF THE MONTH: Verizon Alltel Divestiture Markets

An Estimated 7.9m POPs Going to AT&T

We reported last month on the announced sale to AT&T, Inc. (NYSE:T) of $2.35b worth of former ALLTEL and Rural Cellular wireless markets by Verizon Wireless (VZW) (The Deal Advisor, 05/09, p.17).  The deal is the first step toward VZW meeting its obligation to divest a total of 105 wireless service areas in order to comply with FCC and Department of Justice requirements for their approval of VZW’s acquisition of ALLTEL earlier this year.

As promised, we’ve dug into the FCC filings, entered on May 22, and analyzed the details of the transaction, and also compared them with what we predicted back in February (The Deal Advisor, 02/09, p.1).  We’ve focused on the 79 cellular licenses included in nine separate applications filed, but we also wanted to point out that there are numerous common carrier fixed point to point microwave licenses included, presumably for microwave backhaul, as well as a number of broadband PCS licenses and partitioned license segments in the various applications for assignment.

The entity being assigned the licenses has been dubbed “Abraham Divestiture Company, LLC”—maybe a reference to the Biblical story of Abraham and Lot splitting their flocks??—but AT&T, Inc. is the “Real Party in Interest”.  And of the nine “assignors” filing, all but one appear to be former ALLTEL divisions.  The ninth is RCC Minnesota, Inc., and includes eleven former Rural Cellular markets across Kansas and Minnesota.  We couldn’t find an application that appeared to relate to one or more license that had been strictly VZW’s, as opposed to ALLTEL’s or Rural Cellular’s, although the company press release issued in May indicated that such a license(s) were included. 

Before we get lost in the details, however, the Big Picture remains pretty close to what we said last month:  We weren’t far off last February when we handicapped the likely buyers of the so-called ALLTEL divestiture markets.  In fact, of the 79 CMAs being acquired by T, just 12 were markets that we had called for either CATV company Cox Communications, or United States Cellular (NYSE:USM).  And of the licenses we figured Cox or USM would go after, there are seven that T is buying.  The Lee, VA-1 market, not included in the original divestiture market list, makes a 8^th we didn’t call for T.

Specifically, we had predicted T would acquire markets in Illinois, Ohio and Idaho, but they remain available.  It did go for all of the Kansas markets, however, which we had called for USM and Cox, as well as Gila, AZ-5, which we thought Cox might like.  T is also acquiring three Virginia markets; we had figured USM to go after the two in the divestiture list. 

At the end of the day, based on 2000 census POPs, we count about 7.2m POPs in 18 states that T is acquiring.  If you figure the U.S. population grows at about 1% a year, we estimate that about 7.9m total 2009 POPs are included in the transaction, implying a deal value of just under $300 per POP. 

Our analysis of the revenue and cash flow multiples remains as we published last month:  Based on Alltel’s historical performance, the deal comes in around 2.2x revenue and 6.3x cash flow—adding in the $400m in additional capex T intends to spend converting the CDMA networks to GSM pushes those multiples to 2.6x revenue and 7.3x cash flow.  Based on the 1.5m subscribers reportedly included in the transaction, T is paying $1,567 per subscriber.

So what remains for VZW to divest?  We count 26 markets from the original list of 105, in 7states.  2000 census POPs total 4.8m, so we figure there are about 5.3m POPs in the remaining markets today, but penetration appears to be lower in the remaining markets.  Originally, 2.1m subscribers were reportedly available in the divestiture markets—T is obtaining nearly three quarters of those in its deal.

The largest remaining chunks are found in Georgia and Ohio, with 1.3m and 1.4m (2000 census) POPs available.  Based on the T deal, the remaining markets would be worth in the neighborhood of $1.57b—although, as we pointed out in our analysis back in February, we’re not clear that all of the possible buyers—USM in particular—would be willing to pay as much as T, particularly given the weaker penetration levels.

Back in February we had suggested, based on an analysis of capitalization and cost of capital, and synergistic operating assumptions, that where T might spend upwards of $3.7b were it to buy all of the divestiture markets, that USM might offer only $2.1b ($172/ POP) and Cox, around $2.9b ($244/ POP).  We extrapolated to the markets we thought each would desire to come up with our predicted deals and prices for each….

Turns out all our fancy number crunching was in vain….As we were going to press, a relatively unknown company—Atlantic Tele-Network, Inc. (Nasdaq:ATNI) announced a definitive agreement to acquire the remaining divestiture markets, for $200m in cash. The press release indicated that ATNI will acquire wireless properties, including wireless spectrum licenses and network assets, serving over 800,000 subscribers primarily in rural areas across Georgia, North Carolina, South Carolina, Illinois, Ohio, and Idaho.   We’re not sure where VA-4 fits into the picture, but we’ll be back next month with a thorough analysis of the sale.  Our back of the envelope analysis indicates fire sale prices, however--$38 per POP and just $250 per subscriber!  Guess USM, Cox and those private equity guys weren’t as interested as everyone previously thought…

Moreover, it means that in the end, VZW gets just $2.55b for the whole shebang—we had expected closer to $3.3b.  Guess VZW just wants to look forward and focus on the markets it keeps, rather than dwelling on those it had to sell…and in the grand scheme of things, a few hundred million dollars is just a rounding error for the U.S.’ largest wireless company.