A CURIOUS CASE OF WIRELESS & AIRLINE CARRIERS

I started to follow a story of PCS and LEAP in 2008 and watched how they went down one from $35 to $7, another from $80 to $5. They always had a pretty good sponsorship of hedge funds, which saw value in those stocks even at now unimaginable levels. Both, of course, failed on their original projections.

The story in 2008 was based on excellent situation in “existing markets” and “true profits” masked by “new [loss making] territories”. E.g. Q2 2009 LEAP’s OIBDA (their name for EBITDA) was $192m in “existing markets” and -$54m in “new territories”. Wild imagination could have assumed that once a loss making business turns into a profit, sky is the limit and annual run rate of “OIBDA” would be $900-1,000m. Fast forward a few years and as of Q1 2012 TTM adjusted OIBDA is $582m. LEAP’s story is especially sad because it turned down merger proposal with PCS back in 2007 (1 LEAP’s share would have been equal 2.75 PCS shares or LEAP now would be worth $19.25 vs. $5 current price). Although, anecdotes float that PCS stole business plan from LEAP, in reality, based on pure numbers, it would have been much better if, in exchange, LEAP had stolen business practices of PCS (now the latter’s EBITDA is 3x larger).

Somehow, I tend to identify prepaid carriers with low cost airlines (e.g. SAVE, DTG.L, ALGT): they both ride the same long term wave of a newcomer against the incumbent’s high fixed cost and slow bureaucracy. LCCs (low cost carriers) are being pursued now by ULCCs (add “ultra”), which probably will be replaced by UULCCs. This sounds almost like textile 40 years ago when new ‘looms’ were coming every year and the entire progress went straight to consumer. [Deflection: Ch. Munger is also puzzled why there is pricing discipline in one industry (my guess is that it is uncoordinated cartel) and it’s absent in another]. I think that LCTelcoC is not a goner.  They sell commodities and give more and more of everything for the same amount of money (or even less) but there is crucial difference in the industry structure (both are oligopolies, btw) – barriers to entry are much larger for telcos (money, license, spectrum). In any case, low cost carriers in both industries are doing ok.

Can They Remain Cheaper & Make Money?

The story goes that PCS/LEAP have (i) newer more efficient equipment without legacy cost, (ii) unlimited and prepaid model is inherently cheaper to operate, and (iii) prepaid is slowly eating into postpaid in the entire world. Their services are 2x less expensive than postpaid plans of major carriers. Of course, that service is not the same (there are plenty of horror stories about any LCC service on internet) but, for a price junkie like me, such things leave impression. Chart below provides good illustration (it is taken from PWC annual survey - Link). PCS & LEAP are both small carriers with revenue <$5b.

Back in 2010, I was fascinated by a slide from PCS presentation. That was the first time when I purchased it @ $5.61.

Can you imagine having price per minute, which is lower than your competitor’s cost? You must be killing them. I was puzzled all this time.

<$5b carriers clock almost 2x more minutes than the big guys. When denominator (number of unlimited minutes) increases, cost/revenue per minute are going down. I do not think that this leads to any new conclusions (big guys also have postpaid plans and I do not have the minutes for them). It is just an observation that some slides are not what they seem.

Another concerning data is that in 2011 cost per new cell site has leveled for big and small carriers. I do not have expertise to make any conclusions – I would be grateful if anybody could take a look and make sense of that. It could be that all cheapest sites are taken and it’s not technology cost only. On the other hand, depreciation per served population (POP) is still materially smaller at smaller carriers… but depreciation per average subscriber jumped in 2011 considerably (LTE). PCS and LEAP depreciation expense went up by 20% in 2011. I present this info fearing that this is the weakest link in the investment [bear] thesis but I think it is not terminal.

PCS was one of the first carriers to implement LTE, which contradicts the lowest cost provider’s modus operandi (they buy only proven technology and at a cheap price, they follow and not lead).

What Happened?

My understanding is that PCS/LEAP stumbled on a set of factors, all temporary in their nature: technological [transition of new technology to mainstream], airwaves [capacity issue – now most of smartphones are on CDMA and clogging up the system and will be fixed after cheap LTE smartphones arrive], competition [aggressive pricing from peers and incumbents], and delayed tax refunds [very relevant for prepaid segment].

Noteworthy, PCS is further advanced in LTE, which also could explain why it did worse than LEAP in Q1. LTE is faster, cheaper technology and has better spectral efficiency but is still very early in the adoption cycle [= expensive smartphones]. Smartphones use lots of data, which degrades user experience (on 2G and 3G networks). I would say, normal pains of growing and changing business.

Additionally, the incumbents cannot aggressively bid on the prepaid front because they fully depend on majority of postpaid subscribers paying $80-$100 [cannibalization risk].

Future Business

In 12-24 months, PCS and LEAP will merge, will be bought out or will post decent net subscriber addition numbers. In the frugal new normal, prepaid should continue taking from postpaid and low cost carriers taking from incumbents. I do not know if they can sustain providing cheaper service but odds are reasonable for people with a longer time horizon (for those who think that 10% pa is good enough [from 10 positions like this and fully hedged with IWO]). I like PCS more because of a lower multiple and better historical track record.

Miscellaneous Housekeeping Items

== LEAP is apparently losing “take over” or “merger” premium.

== current selloff means “no hope” for a quick deal or fix – shareholder base is changing from momentum to value. Since earning call on April 26, LEAP changed 39% of shareholders, PCS 19%, and since year end correspondingly 195% and 137%.

== nothing spectacular on short volume of PCS (might jump after May 1):

Settlement Date	Short Interest	Avg Daily Share Volume	Days To Cover
4/13/2012	7,113,455	3,598,927	1.976549
3/30/2012	3,958,263	3,596,369	1.100628
3/15/2012	3,304,612	6,087,233	1.000000
2/29/2012	4,412,210	9,979,631	1.000000
2/15/2012	3,978,746	4,656,915	1.000000
1/31/2012	3,184,186	3,745,916	1.000000
1/13/2012	4,334,154	6,876,245	1.000000
12/30/2011	3,097,568	2,994,850	1.034298

LEAP’s short interest is more impressing because of higher leverage:

Settlement Date	Short Interest	Avg Daily Share Volume	Days To Cover
4/13/2012	13,303,205	1,458,904	9.118629
3/30/2012	13,065,663	1,280,425	10.204161
3/15/2012	12,969,396	1,560,998	8.308400
2/29/2012	12,163,006	2,039,200	5.964597
2/15/2012	12,065,177	1,399,445	8.621401
1/31/2012	9,926,338	1,386,823	7.157610
1/13/2012	12,385,466	2,611,363	4.742912
12/30/2011	11,769,102	1,768,184	6.656039

== nothing to note on insider activity and ownership changes: CEO is 74 and owns many times more stock than his annual salary (5.6m shares vs. $2.5m salary)

== LEAP: debt 3.2b - cash 0.6b = 2.6b net debt + @$5 market cap 0.5b = 3.1b EV and EBITDA 0.55b = 5.5x

== PCS: debt 4.4b - cash 2.2b = 2.2b net debt + @$7 market cap 2.5b = 4.7b EV and EBITDA 1.3b = 3.6x

== combined: debt 7.6b – cash 2.8b = 4.8b + 3.0b market cap = 7.8b EV and 1.85b EBITDA = 4.2x

Disclaimer: long PCS and LEAP, 5% position each, ~10% in red at today’s level.