A company's earnings conference call is one of the most insightful tools that investors have when analyzing a company. It allows them to hear from management directly, and hear what their plans are for the future. When analyzing a conference call, it is important to not only listen to (or read) what management says, but how they say it as well. Their tone offers just as much insight. And sometimes, it may even provide a tip that a sale of the company may be on the way.
Leap Wireless (LEAP) is in such a position, and its Q2 earnings release and conference call contain suggestions that a sale is being explored. That, alongside its sagging stock price and industry trends, could be signs that a sale of the company is on the way. We will explore the possibility of a sale from 4 angles: management's conference call comments, industry trends/M&A transactions, potential regulatory changes, and potential activist investors entering the picture.
After the markets closed on August 6, Leap reported its Q2 2012 results. The company's GAAP loss of 54 cents per share on revenues of $786.772 million missed estimates that called for a loss of 51 cents on revenues of $837 million. Leap also posted a net subscriber loss of 289,000 and elevated churn. As of this writing, Leap is down nearly 11% in after-hours trading, and it is possible that those losses will intensify on August 7 (for the record, any valuation calculations in this article will be based on the last after-hours price of August 6, which is $4.92 as of this writing).
Our article will be focusing more on the potentials of a strategic transaction, rather than Leap's fundamentals, which are unquestionably challenging. The prepaid wireless market is even more challenging than the postpaid wireless market. And while MetroPCS (PCS) is able to compete profitably in it, the same cannot be said of Leap. That is why the company's stock has lost over 93% of its value in the past 5 years. While MetroPCS has also lost a great deal of value, the company is at least profitable, and is in a much stronger position.
Management's Comments: Reading Between the Lines
The situation at Leap is ripe for a strategic resolution, and the company's management hinted at this on its Q2 earnings conference call. In his opening remarks, CFO Jerry Elliott stated that, "As Doug [CEO Douglas Hutcheson] has been talking about, and I want to reiterate to everybody, our results for the second quarter are not acceptable. Going forward, we cannot keep doing the same things and simply try harder, but instead, we have to take specific and significant actions to increase our margins and be on a clearly demonstrable path to free cash flow, realize the value of our assets [emphasis added] and return to growth over time."
The comment about realizing the value of assets is the most notable. Leap's most valuable asset is its spectrum, for which demand is constantly increasing. Any transaction involving Leap's assets will involve its spectrum. As of the close of Q2 2012, Leap's spectrum is carried on its balance sheet at a value of $1.605256 billion (at a stock price of $4.92, Leap's market capitalization is just $389.664 million, and it has a book value per share of $6.18). CFO Jerry Elliott took the unusual step of saying that in Leap's view, the market value of its spectrum is near $3 billion, almost 87% more than what they are being carried at on the balance sheet.
On its own, that statement suggests that Leap is considering a deal involving its spectrum. There is no reason for the company's CFO to point out that he thinks the company's spectrum is undervalued if the company does not plan to fix that discrepancy. Given the focus Leap has regarding its cash flows (a key issue for the company; operating cash flow fell by over 50% this quarter from 2011 levels), CFO Elliott stated that not all markets have the same cash flow characteristics, which is code for the fact that management is considering exiting certain markets. That would mean a sale of spectrum. Leap has just over $524 million in cash and investments, but over $3.2 billion in debt. While Leap does have time to resolve its debt issues [the company will receive $100 million from a pending spectrum swap with Verizon (VZ), and its first debt maturity is in 2014 for $250 million), shareholders may not be willing to wait.
On the conference call, analysts essentially grouped themselves into two camps. The first camp were those who wanted to know what happened in this quarter, and why results missed estimates. The second group largely ignored this quarter's results, and instead focused on the potential for a strategic transaction. Merrill Lynch analyst David Barden posed questions from both side, but his question about the company's strategic direction was the most important one asked on the call.
Barden asked, "So Jerry, you're crystal clear. You're looking at every available option. It'll be helpful to kind of -- for us on the other side of the table to kind of hear what the options are. The -- when I heard it at the beginning, it sounded like maybe you were looking at maybe selling off an underperforming market here or there or some other assets or things like that. But, I mean, what is the magnitude of what we're talking about? Are we talking about selling the company? Are we talking about restructuring the company? Are we talking about selling licenses or sale leasebacks? I mean, how significant should we be really thinking about this? Is the objective function of your role now to be getting the stock price up?"
Barden essentially asked point blank if a sale of the company is in the cards. And CFO Elliott did not say no. Rather, he responded, "from the strategy perspective, I wouldn't eliminate anything right now from what we're thinking about [emphasis added]. So you can -- we can all create our own menus and choices. I guess I'd like to think that everywhere I've been, I've been there to create shareholder value. So I don't think anything's changed in terms of what my role is and what my responsibility is. So as we talked about earlier, the way we think we create value is investing in 4G for growth in the right ways and at the right places and the right times to create that growth. And at the same time, the rest of the business has to produce greater cash flow, and we have to realize the value of our assets that we've got. So there's nothing that you can think of that you should eliminate right now from the list of possibilities. We prefer to always control our own destiny and worry about ourselves and what others might do later. So we're going to be taking a lot of steps to control our own destiny and run the business far more profitably. And hopefully, that results in value creation."
When translated from "CFO-speak," that answer essentially says, "we'd like to remain independent and continue to execute on our growth strategy, but the analyst community should not rule out anything, even a sale of the company." Most executives, when pressed about whether or not a sale is in the cards, respond that it is not. CFO Jerry Elliott, however did not say that. And CEO Hutcheson did not step in to reject that notion either.
Leap's management left the door wide open to a sale on its conference call. The company's CFO and CEO both said that they are open to strategic transactions, and when asked directly if that includes selling the company, neither one of them said no. And given the degree of the slide in the company's stock price, and its challenging outlook, a sale may be the best chance Leap has for preserving shareholder value.
Industry Trends and M&A: Looking at Leap's Potential Suitors
Despite its problems, Leap still has value: The company holds over $1.5 billion of spectrum (and given the demand for it in the market, management's claim that it may be worth $3 billion could prove accurate), and has almost 6 million subscribers. In the right hands, those could prove to be profitable assets. There are three potential suitors for Leap: Verizon, AT&T (T), and Sprint (S). While MetroPCS did make a bid for Leap in 2007 (one that Leap should have accepted, given that it was valued at $4.7 billion), we do not think that MetroPCS would be a suitor this time around. Investor sentiment regarding the prepaid market has soured, and turning MetroPCS into a bigger prepaid wireless company would likely do little to solve that issue. In addition, MetroPCS would have to deal with Leap's $3.2 billion in debt, and the company is in a much weaker financial position than the Big 3 carriers to absorb that. With that in mind, we will analyze Leap's remaining potential suitors.
- AT&T: Leap and AT&T have reportedly held merger talks this year, and AT&T has been vocal about the need for more spectrum. As Leap's stock price continues to drop, it is possible that AT&T is reconsidering a bid. With the FCC having blocked its bid for T-Mobile, AT&T may look to Leap for spectrum. But, a deal is complicated by the fact that the two companies have incompatible networks. That would make integrating them costly and time-consuming. In addition, AT&T already has another pending spectrum deal: the $600 million takeover of NextWave Wireless (WAVE). This deal will likely be closely scrutinized, given the FCC's stance on anti-trust, and the agency's history of legal battles with NextWave. Therefore, we do not think that AT&T would ultimately make a bid for Leap at this point in time (however, should the political landscape change, AT&T may reconsider; we will discuss politics later in the article).
- Verizon: Verizon is a more likely suitor for Leap. Both companies use the same network technology, making integration easier. And Verizon has been just as vocal about its spectrum needs as AT&T. Given the fact that a merger with T-Mobile would present an integration nightmare (merging the #4 and #2 carriers, all while fixing the problem of having 2 incompatible networks would be a Herculean task), a takeover of Leap would be much easier. With careful financial oversight, Verizon's balance sheet could handle Leap's debt. But Verizon is in the middle of multiple spectrum deals, valued at billions of dollars, and those deals are being closely scrutinized by the FCC. In such a climate, Verizon may not want to stir the pot with a deal for Leap that would raise obvious anti-trust concerns. Adding 6 million subscribers to the nation's #2 wireless network will certainly not be compatible with this FCC's view of the need for more competition in the market. Verizon is unlikely to make a bid for Leap at this point in time.
- Sprint: If anyone is to acquire Leap, it would be Sprint. The two companies already have a 3G wholesale network deal in place, and they operate compatible networks. Earlier in 2012, it was reported that Sprint was just hours away from buying MetroPCS in a deal valued at $8 billion that featured a 30% premium for MetroPCS investors. That deal is reported to have been blocked by Sprint's board of directors. We doubt the deal was ever about boosting Sprint's subscriber rolls. Rather, Sprint likely wanted MetroPCS' spectrum. Its 9.3 million subscribers were likely viewed as just an added bonus. When reports of this deal surfaced, analysts were quick to say that Sprint may set its sights on Leap. At the time, Sprint's board seemed to reject the deal due to issues of timing, as well as the company's sagging stock price. In addition, worries over finances played a role. Since then, however, things have changed. Sprint's stock has soared in 2012, as the company continues to recover from both a financial and operational standpoint. Acquiring Leap would be much easier from a financial standpoint for Sprint. While MetroPCS may have net debt of $2.371561 billion versus $2.678094 billion at Leap, MetroPCS has a market capitalization of over $3 billion, compared to under $400 million for Leap. While it is possible that Sprint may come back to a deal with MetroPCS, the company may also look to make a cheaper boost to its spectrum portfolio by making a bid for Leap.
Regulatory Changes: A Change of Political Colors in Washington May Change the Wireless Landscape
We do not venture into politics in our articles here on Seeking Alpha. We prefer to focus on the economics and finances of investing, and leave political debates for other forums. But with regards to a sale of Leap, we must make an exception to that rule, for potential changes in the regulatory landscape may alter the company's sale prospects.
This FCC, as well as the Justice Department have been very active on the anti-trust front when it comes to wireless issues (whether or not that is appropriate is a judgment we leave to readers). And should President Obama be re-elected in November, and Democrats maintain control of the Senate, it is likely that the current FCC and Justice Department will maintain their stance towards deals in the wireless market. But should Governor Romney be elected, and/or Republicans take control of Congress, the regulatory landscape will likely change (for the record, nothing in this article should be seen as an endorsement of President Obama, Governor Romney, or the Democratic or Republican parties; we are simply pointing out that the two sides would regulate the wireless market in different ways).
Under a Romney administration, the FCC and Justice Department are likely to take a different approach towards wireless deals, with less anti-trust scrutiny. If that were to happen, there would likely be an acceleration in wireless M&A, and Leap is likely to be caught up in it. AT&T would likely go back and relaunch its bid for T-Mobile, and Verizon would likely respond by bidding for Leap (and since the FCC is now more lenient, maybe MetroPCS as well). If the FCC starts evaluates wireless deals in a more relaxed way, then buying Leap becomes a more and more attractive option. After all, the company's stock has lost over 40% in 2012 alone. The cost of buying Leap's spectrum and millions of subscribers has never been cheaper. If the regulatory landscape does indeed change in 2013, the chances that Leap will remain an independent company are reduced, in our view.
Activist Investors: As Stocks Slide, They Rise
The fourth, and final element to the Leap story is the possibility that activist investors will push for a sale. The fact that the company's chairman holds over 30% of the company adds fuel to this notion. MHR Fund Management is Leap's largest holder, with over 23 million shares, and it is controlled by chairman Mark H. Rachesky. As Leap's shares slide, MHR has seen the value of its stake fall sharply. Seeing millions in wealth vanish is a powerful incentive for a company's chairman to push for a sale to restore some of it.
Furthermore, Leap has had brushes with activist investors. In 2011, Pentwater, which owns over 6% of Leap, criticized the company's management and board for mismanaging the company and rejecting the 2007 takeover offer from MetroPCS (in hindsight, that is a valid complaint, in our view). Pentwater nominated 3 directors to Leap's board, and the company ultimately bowed to pressure and settled its proxy fight with Pentwater. Currently, Pentwater's representatives hold 2 of Leap's 9 board seats. Given that the stock is likely to continue sliding as the market digests the company's Q2 results, it is possible that the board may give serious consideration to what it should do to increase (or perhaps even simply preserve) shareholder value. Furthermore, Leap's stock price may bring in other activist investors who will push for a strategic transaction.
Leap Wireless is a company in turmoil. It operates in a fiercely competitive market and the company has had a difficult time competing. As the company's stock slides, the time may be ripe for a sale. The company's CFO and CEO both left the door open, with CFO Jerry Elliott telling Merrill Lynch directly that, "I wouldn't eliminate anything right now from what we're thinking about." Such statements, when combined with industry dynamics, potential changes in the regulatory landscape, and the chance that activist investors may step in, has dramatically increased the chances that a sale of the company is on the way. In our view, investors who believe that the company will be sold should take advantage of a post-earnings selloff and buy shares of a company that would offer a great deal of value to a potential acquirer.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LEAP over the next 72 hours.