CONFESSION ABOUT LEAP

I noticed a worrisome and clearly morbid (but easily explainable and understandable) pattern in my head - after big gains and significant victories I tend to check account more often and I want to brag. This time there is no exception. I would like to believe and promise that once I will confess a big loss, in detail.

2013 just clocked the first half and 4 of my ~10 long holdings have been taken out. In a similar settings, 2010 brought me also 4 take-outs but this year has 6 months to go.

The last one came in a spectacular fashion. +100% on the takeout day and +150% in the last month. It was not an easy one because I almost sold it 2 month ago but decided to wait for long-term gain and while waiting it dropped 15%. In the time of waiting, another holding was taken out, price was low and urgency subsided. It is enigma, why I did not add :)

It was a difficult one because the multiple was high and because the leverage was high, too. Because what a guy in the other side of the world may know about intricacies of the US wireless telcos and smart people were thinking that prepaid niche is a poor business without competitive advantages. It turned out that prepaid were and are good quality assets comprising not only of multiples but also of spectrum, subscriber base (market share), and attractive cost structures. I am speaking about LEAP (and PCS).

To summarize the 2013 take-outs:

PCS – 425 days | 140% IRR

DELL – 270 days | 21% IRR (went down 25% before that)

MBND 430 days | 34% IRR (went down 30% before that)

LEAP 440 days | 155%

Interestingly, I stepped twice into the PCS river – in 2010/11, 425 days brought me 150% IRR.

Finally, last 12 month I spent only 1-2 hours per week working on my investing account. What could I do if it were a full time job? I am afraid, it could also be the opposite... Happy hunting.

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.

TRADING UPDATE (i)

I initiated a small 2.5% position @ $0.31 in a bankrupt airline on the last day (April 10) of its trading on Nasdaq, so it was reasonable to assume that there will be some forced sellers. In a funny hindsight, I could have made it a 10% position and a quick double in 2 weeks. In any case, it was my fastest double so far, if only for a brief moment yesterday, and I wanted to feel a little genius for a minute.

Date Open High Low Close Volume Adj Close* Apr 23, 2012 0.51 0.67 0.48 0.53 506,200 0.53 Apr 20, 2012 0.41 0.49 0.41 0.47 195,800 0.47 Apr 19, 2012 0.44 0.44 0.41 0.42 182,100 0.42 Apr 18, 2012 0.40 0.44 0.40 0.44 99,400 0.44 Apr 17, 2012 0.38 0.41 0.38 0.40 118,800 0.40 Apr 16, 2012 0.40 0.40 0.39 0.40 205,600 0.40 Apr 13, 2012 0.41 0.42 0.39 0.40 172,200 0.40 Apr 12, 2012 0.42 0.44 0.30 0.43 1,063,700 0.43 Apr 11, 2012 0.33 0.45 0.32 0.44 764,300 0.44 Apr 10, 2012 0.32 0.34 0.28 0.30 1,487,200 0.30

Growing volume is a concern but most likely it is normal for normal people to run away after such a quick double.

Obviously to some, it is Pinnacle Airlines, a long time holding of Mohnish Pabrai. It is bankruptcy #2, if I remember correctly, from his recent portfolio names and #2 with the name Delta attached to it (Delta Financial was #1). Delta is the only client of Pinnacle. Delta is its death and life at the same time, future and past, profit and loss. Whatever… I like that it is doing not bad at the moment (EBITDA $3.7b and net debt of $10b) and PNCLQ is only a few percentage points of its operations.

In summary, my full of naivete investment thesis is:

== book tangible equity is +$200m (deferred revenue of ~$150m is accounting fiction)

== there are activists involved (Meson, Nantahala)

== Delta damages unsecured claim size is unclear but should be below $100m

== management is in the pocket of Delta and does not have any skin in the game

== bankruptcy fees will not exceed $50m

== as a result of confluence of all observations, Delta will have to maintain some face and will not cancel the entire equity (now valued at $10m) – my wild guess is $40m or 4x from today but in 18 months

And @$0.6 odds reflect the following: 30% probability of $2.0 ($40m) and 70% of $0. Or 15% - $4 (80m) and 85% - $0. Only with money I can afford to lose.

What's next: Pursuant to section 341 of the Bankruptcy Code, the United States Trustee for the Southern District of New York (the “United States Trustee”) has scheduled a meeting of creditors to be held on Thursday, May 3, 2012 at 3:30 


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This is not recommendation to buy or sell this stock. Please perform your own due diligence. I may sell or buy at any time in the future without any notice.