Where We'd Invest in Wireless

The U.S. wireless industry has had more than its share of ups and downs over the past decade, passing from boom to bust and into a period of steady growth in recent years. A wave of consolidation over the past couple of years has also dramatically changed the investment landscape; of the four largest carriers, only one,  Sprint Nextel , isn't buried within a larger firm. The majority of the wireless market is now in the hands of three players, and we've been saying for some time that we think this should benefit the industry over time. Yet, some carriers have struggled while many have thrived. We think this divergent performance has created an interesting investment opportunity.

The State of the Wireless Industry
We estimate that Sprint Nextel, Verizon Wireless (the joint venture between  Verizon (VZ) and  Vodafone (VOD)), and Cingular/AT&T Wireless (now wholly owned by  AT&T (T)) collectively counted 75% of all U.S. wireless subscribers as their own at the end of 2006, up from 72% the year before. Though Sprint's gain came largely as a result of forced acquisitions of affiliate carriers, each of the three added customers, claiming about 80% of all new wireless subscribers industrywide, absent acquisitions.  Deutsche Telekom's  T-Mobile, the fourth-largest carrier, performed well in 2006, but its share of industrywide growth slipped during the year. The firm remains half the size of Sprint Nextel, the smallest of the big three.

Overall, the number of wireless customers grew by about 10% during 2006, putting penetration at about 76% of the population. While growth slowed for the first time since 2002, we think the wireless industry should be able to reach about 85% penetration over the next few years, the equivalent of about 40 million new customers. We continue to believe that scale brings the ability to efficiently attract new customers, and the 2006 performances from the big three, even with Sprint struggling, lead us to believe that these firms will continue to capture the majority of industry growth over the next few years.

Consolidation also seems to have benefited pricing. After falling steadily for several years, most recently as a result of the introduction of family plans, prices for voice services have stabilized. Data services still represent a fairly small percentage of industry revenues, but their growing popularity has recently created a modest boost to average revenue per customer. Again, the big three carriers have a sizable lead on smaller carriers in upgrading networks and deploying data services. In this pricing environment, profitability across the industry continues to improve.

Value Among the Big Three?
Of the big three, Verizon Wireless was the standout performer during 2006; in fact, we've struggled to find new and different ways to convey this solid performance in our quarterly earnings updates over the past couple of years. The firm added 7.7 million net new customers during the year, a record figure for the industry. With 59 million customers, the firm trails AT&T Wireless slightly, but the quality of Verizon Wireless' base, in our view, is significantly stronger. About 93% of Verizon's customers are on post-paid plans versus about 81% at AT&T, and a much greater percentage of new Verizon customers are taking post-paid services. These customers generate more revenue and are far more loyal on average. Strong customer loyalty, as much as getting new customers in the door, has fueled Verizon's customer growth; churn, the percentage of customers who cancel service, is far below that of its peers. The quality of the firm's customer base shows through in its financial performance: revenue grew by 18% and operating margins expanded to an exceptional 25%.

Unfortunately, we don't believe that Verizon Wireless' stellar performance translates into an investment opportunity. Shares of both Verizon and Vodafone have run up sharply over the past year. Also, an investment in either firm necessarily includes investment in other businesses we aren't as thrilled with, including Verizon's fixed-line phone business and Vodafone's recent acquisition in India.

AT&T Wireless was the most improved firm of 2006, in our view, accelerating growth sharply while expanding margins. The firm is coming to the end of the integration of the "old" AT&T Wireless and Cingular, and it still has room for further margin improvements. AT&T Wireless is adding far more gross new subscribers than any other carrier and has made steady improvements in customer service to build loyalty, which should translate into solid growth in 2007. However, AT&T Wireless is buried in AT&T, a stock we think is currently overvalued.

That brings us to Sprint Nextel, the last remaining of the big three. Sprint's problems during the second half of 2006 have stemmed from difficulty merging the old Sprint and Nextel businesses. The two firms operated on different network standards and targeted different customer segments. Sprint Nextel has tried to largely maintaining two distinct brands and service offerings. In addition to removing some of the benefits of merging, like cost savings, marketing has been confusing and customer service has slipped, especially on the Nextel side. While the number of customers the firm serves has continued to grow, the quality of the base has deteriorated, crimping growth.

We think that Sprint's problems are short term in nature and that the strength of the firm's position in the industry will shine through over time. The first point we'd make is that miscues like these haven't proven fatal in the past. For example, both Cingular and the "old" AT&T Wireless hit very rough patches before their merger in 2004. The firms were able to build around a core group of customers, incrementally improving service to attract and retain more fickle subscribers. We expect Sprint Nextel to do the same, though the intricacies of merging networks and services may drag the process out. The firm has been adding network capacity and expanding data capabilities to better serve customers. New phones that can be used on both of the firm's networks should begin the transition to a single network and set of service offerings. The firm bit the bullet last month, providing expectations of sharply lower profits for 2007 as it invests to put customer service issues behind it once and for all.

Once Sprint Nextel alleviates the problems that have dogged it recently, we think investors' appreciation of this business will grow. The firm's 50 million customers still include some of the most loyal, heaviest users around. It has a deep wireless spectrum position that has allowed it to roll out traditional wireless data services and also give it the opportunity to try out WiMax, a new standard that promises to rival the fixed-line services available to many consumers. Because it isn't tied to a fixed-line phone company, the firm has been a natural partner for the cable industry, and cable companies are starting to add the firm's services to their bundle offerings. We think the stock's current valuation not only leaves a lot of room to run when financial performance begins to more closely match that of its two giant peers, but also provides a big margin of safety even if it falls short.