Huge drops in shares of prepaid wireless providers Leap Wireless (LEAP) and MetroPCS (PCS) since 1Q results around the end of April have many on Seeking Alpha calling these "value" plays that are too cheap to ignore at these levels. However, poor earnings the past two quarters have been attributed to higher subsidy costs as users upgrade to smartphones and increased competition, including Verizon's (NYSE:VZ) recent plans to enter the prepaid market. Are these just temporary troubles or do they represent a structurally broken business model for these cheap, prepaid providers?
Here's what you need to know about the prepaid market.
Prepaid carriers were performing very well until 2007, when Leap hit an all-time high of $99.04 a stock. Prepaid providers offered cheap, regional service to those looking for no-frill devices that did the job. Operating costs were low and national carriers did not want to compete in fear of competing with their own postpaid businesses. However, customers started demanding nationwide coverage and smartphones that require subsidies to attract new customers. Margins went down tremendously.
Prepaid carriers also have to worry about their network disadvantages. With only a limited amount of spectrum available, they have lower internet speeds and less capacity. As the national providers switch to 4G, there may be 3G capacity for prepaid subscribers. But as customers look for the latest gadgets and the fastest speeds, will MetroPCS and Leap be able to charge a profitable rate, or continue seeing shrinking margins?
Here are the comps for some of the regional wireless providers:
Leap was upgraded by Piper Jaffrey (NYSE:PJC) from an underweight to a neutral over the weekend. RBC Capital downgraded Leap from an outperform to a sector perform on May 1st, with a $6 target. Deutsche Bank cut their price target from $13 to $8 on April 27, while Canaccord Genuity reiterated a hold rating on April 26.
Leap hasn't been profitable since 2005, and its latest earnings report missed the top and bottom number, and reported poor subscriber growth. I believe that Leap Wireless will continue to struggle as they continue to lose big on subsidizing smartphones without the security of contracts. Sprint has a similar fate, as they continue to subsidize iPhone and run into trouble financing such large costs. If struggles continue, look for consolidation in the field. MetroPCS and Leap have talked about merging in the past, but look for that to be a possibility again in the future. On top of that, Leap Wireless holds spectrum that may be worth $2.1 billion. Look for AT&T (NYSE:T) or Verizon to purchase Leap if they need the spectrum.
While MetroPCS is a profitable business, profits dropped 63% during Q1. The addition of 131,654 new users was way lower than last year's 725,945. Their ambitions of using a 4G LTE network does not look well. Only 6% of all subscribers are using the network, and the company continues to hurt margins and offer mail-in rebates just to entice customers to purchase smartphones. The company's cost per gross addition went from $157 last year to $235 this year. Average revenue per users remained flat. A potential acquisition by Sprint (NYSE:S) was overturned by Sprint's board of directors.
Until there is more certainty, these names continue to look like value traps, as margins continue to drop and trends continue to benefit the national mobile service providers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.