The massive drop in stock prices due to concerns about the consumer spending environment and the broader economy has created some interesting long opportunities among companies that should be well-insulated from economic woes.
Dallas-based MetroPCS (PCS) is one of these. The company is a provider of unlimited wireless communications service for a flat-rate with no signed contract. MetroPCS owns or has access to licenses covering a population of approximately 149 million people in 14 of the top 25 largest metropolitan areas in the United States, including New York, Philadelphia, Boston, Miami, Orlando, Sarasota, Tampa, Atlanta, Dallas, Detroit, Las Vegas, Los Angeles, San Francisco and Sacramento. As of Q2 2008, the company had 4.6 million subscribers, up from 3.6 million in Q2 2007.
Reasons to invest
1. Customer base is somewhat insulated from economy
Wireless communication has quickly become a basic need, right next to food, water, shelter and housing. There are a lot of things people will give up before ditching their main connection to the rest of the world. Importantly, on MetroPCS’s Q2 2008 earnings call, management stated that approximately 60% of subscribers do not own landlines, making it highly unlikely they will churn.
Thus, PCS’s addressable market may actually increase as the economy contracts, and, at the very least, should be secure. Even though its customers are typically lower income with poor credit, the low price point, flexible service plan and lack of credit risk make the MetroPCS offering quite attractive. Furthermore, the new family plan offering will diversify the customer base to “safer” demographics which should have a positive effect on customer lifetime value and churn.
2. Compelling service offering in difficult times highlights attractive unit economics
MetroPCS plans run from $30-$50 per month, dramatically lower than the national carriers. It is able to do this for a few reasons:
- Lower-end phones and low subsidies decrease subscriber acquisition costs
- Regional footprint decreases network costs and allows for targeted advertising
- Less spectrum requirements
- Prepaid plan limits credit exposure
Despite the relatively low ARPU, MetroPCS’s customer economics are extremely compelling. At its current churn levels, a typical customer is worth between $800 and $1,000 while costing approximately $135 to acquire.
3. Launches of NY, Philadelphia, Las Vegas and Boston will drive growth
PCS’s growth strategy is simple – buy licenses in large metropolitan markets, build network infrastructure, market the product and acquire customers cheaply. It has successfully executed this in over a dozen markets, achieving penetration rates in excess of 12%.
The company entered Las Vegas in Q108 and Philadelphia in Q208 – both significantly ahead of schedule – and plans to enter the New York and Boston markets within the next 9 months. These new markets will almost double the potential customer base, and should provide a tremendous avenue for continued revenue growth.
Moreover, as these markets mature, the strong cash flow dynamics of mature markets will begin to shine through. Maintenance capital expenditure requirements are relatively low, and customer acquisition costs decrease with lower churn.
4. ‘Houdini’ is undervalued
MetroPCS launched MetroFlash – a product that allows owners of CDMA phones (read: Verizon and Sprint (S) customers) to have their phones reprogrammed for compatibility with the MetroPCS network. This is based on Houdini software licensed from the founder of quasi-competitor Pocket Communications.
Wall Street has ascribed no gross subscriber addition uplift to this announcement, which is a mistake. Combined with the reasons outlined above, this product has the potential to allow PCS to substantially exceed estimates.
5. Analyst estimates are conservative
After a slight miss on gross subscriber ads in Q2, the stock fell substantially on concerns that PCS’s customer base would be disproportionately affected by an economic slowdown. Analyst estimates were revised downwards. I believe this is incorrect. In addition to the reasons listed above, the launch of new markets (Las Vegas, Los Angeles, etc.) typically coincides with high gross adds and high churn.
Instead, Q2 showed low churn and lower-than-expected gross adds. This was likely due to the Tax Relief Check hitting consumer wallets in Q1, which artificially increased Q1 performance and created difficult Q2 comps.
Now, with estimates revised downwards, PCS looks poised to beat projections on both gross adds and churn. Clearly, this will be mitigated to a certain extent by the macroeconomic challenges facing the company, but I believe this risk is already priced in.
6. Downside is limited by asset value
MetroPCS holds significant PCS and AWS spectrum assets and network assets.
PCS auctions over the past 10 years have yielded average prices of about $1.25 per MHz-POP for large metropolitan environments (1-2 million) and $2.75 per MHz-POP for urban environments (2+ million). This implies a value of $2.5 billion for MetroPCS’s PCS spectrum.
AWS auctions over the past 10 years have yielded average prices of about $0.33 per MHz-POP for large metropolitan environments (1-2 million) and $0.65 per MHz-POP for urban environments (2+ million). The January 2008 AWS auction is a good benchmark. This implies a value of about $660 million for MetroPCS’s AWS spectrum.
By my calculations, MetroPCS’s spectrum assets are worth north of $3 billion (however, MetroPCS carries them at $2.4 billion on its balance sheet). Add this to $1.1 billion in cash, $2.3 billion in network equipment and other PP&E, and $300 million in other short- and long-term assets, and MetroPCS is trading close to book value.
1. iPhone could change the game
It is hard to ignore the recent success of converged mobile devices, most prominently the iPhone. If consumer demand shifts significantly towards these, MetroPCS will be in trouble. The company does not offer feature-rich smart phones, and its network is not optimized for them (though its current customers have very high MOUs).
2. Significant debt burden
MetroPCS is financed with $3 billion in debt, and requires a substantial amount of leverage to continue growth. This primarily consists of $1.4 billion in 9.25% Senior Notes due in 2014, a $1.6 billion Senior Secured Credit Facility at an annual rate of 7.17% through 2011. The interest burden from these was $109 million in the first half of 2008.
With $1.1 billion in cash, liquidity is not a concern, yet access to capital could impact ability to sustain growth. This concern will be accelerated if the company decides to purchase significant new spectrum.
3. New network builds consume all free cash flow
PCS is in an aggressive expansion phase. Until the major builds in New York and Boston are completed, expansion capex will consume most of the company’s free cash flow. Additional purchases of spectrum will also consume cash.
In the first six months of 2008, PCS generated $331 million of operating cash flow, and spent $389 million on PP&E.
Still, maintenance capex is relatively low after the initial 18 month network build, leading to attractive long term cash flow characteristics.
MetroPCS competes with major national carriers such as Verizon, AT&T, Sprint and T-Mobile, and regional carriers such as Leap Wireless (Cricket) and Pocket Communications.
However, MetroPCS’s service offerings are sufficiently differentiated from national carriers by price point, service offering, billing method and contractual commitment that it faces little direct competition in its low-end segment. Regional carriers often do not attempt to compete directly due to significant first-mover advantages and far higher ROI’s in non-competitive markets.
5. Core market growth may be slowing
Almost all of recent subscriber adds have come from MetroPCS’s expansion markets, suggesting that additional penetration into core markets may be limited. Out-year estimates from the Street do not suggest significant expansion in these markets, but would still cause downside pressure on long-term projections. However, growth in expansion markets has been ahead of expectations. This suggests the attractiveness of the PCS offering in a difficult market, which will provide support if issues within the core markets persist.
Simply put, MetroPCS is cheap.
At Friday’s closing price of $13.90, the company trades at 8.6x and 6.5x consensus 2008 and 2009 EBITDA, respectively, while growing EBITDA by over 30% (if you believe Street estimates). Leap Wireless, the best public comparable, trades at 10.4x and 8.0x, respectively, while growing EBITDA at a slightly slower pace (LEAP also has worse unit economics). Verizon and AT&T trade at an average of 5.4x and 5.0x respectively, while growing EBITDA at an average of 7.7% (and dealing with difficulties in wireline and triple-play).
A conservative discounted cash flow analysis using a 15% discount rate yields values of $20.29 to $24.96, implying upside of 46% to 79.6%.
Disclosure: I am long MetroPCS.