Is it time to hang up on investments in wireless?

by: Sam Subramanian

During the go-go days of the late 90s, capital was cheap and wireless service providers invested heavily amid ever increasing projections for wireless subscribers. Then the bottom fell off. Brutal price competition and the resulting customer churn took a heavy toll on operating margins as the DJ Wireless index swooned over 90% from March 2000 to October 2002. The industry has been getting its act together on the pricing front for some time. Customer churn rates have moderated. Capital expenditure has been reined in and operating margins have expanded. Low interest rates have enabled debt-laden companies to strengthen their balance sheets. Nextel Communications (NDQ: NXTL), for example, has been able to slash its debt by a whopping $5 billion. The improvement in the operating performance of the wireless technology companies has attracted significant investor attention. Fidelity Select Wireless (NDQ: FWRLX), a mutual fund that concentrates its investments in this sector, has doubled its net asset value since the end of 2002.The obvious question for investors: Is it time to hang up?

We review drivers from an investing perspective to articulate our thoughts on where the wireless sector is headed.

Subscriber Growth in Emerging Markets.

With wire-line connectivity in emerging markets such as China, India, and Russia being low on a per capita basis, wireless technology offers a low cost means for the populace in these counties to get connected while avoiding investments in wire-line infrastructure. With year-over-year revenues and earnings ramping at over 75%, shares of Russian wireless service providers, like Mobile Telesystems (NYSE: MBT) and Vimpel Communications (NYE: VIP) have each soared over 140% in the past 52 weeks. The number of subscribers is nowhere close to saturation yet; as such, we believe there is further room for significant growth in wireless subscribers in these countries. Looking ahead to the 2005-10 time-frame, subscriber growth rate in China is estimated to average 12% annually, a rate nearly 3 times that in mature markets. Such large increases in the subscriber base requires significant investment in wireless infrastructure and companies like Qualcomm (NDQ: QCOM) and LM Ericsson (NDQ: ERICY) stand to be continued beneficiaries of this capital spending. QCOM for example, shipped 32 million phone chips in 1Q2004, a record number, and said demand will increase in 2Q2004 quarter, forcing the company to consider adding production capacity. Shares of QCOM and ERICY have swelled over 100% and 200%, respectively in the past 52 weeks.

Revenue Enhancement Opportunities in Mature Markets.

Subscriber growth in mature markets such as those in the U.S. has ticked up thanks to new phone features like integrated cameras as well as regulations like telephone number portability. We view this acceleration as more of a temporary phenomenon. Longer-term, growth in number of subscribers will decline from current rates as we approach saturation levels. Meanwhile, the nation-wide roll-out of telephone number portability slated for end May will also keep wireless operators on their toes in providing quality services to minimize churn.

Although subscriber growth will eventually slow, growth opportunities from a revenue stand-point continue to be abundant as revenue per customer stands to grow from new high-speed wireless data, wireless Internet access (or Wi-Fi), and wireless information services. Wireless data services and data revenue are forecasted to grow at double digit rates in the years ahead. Looking out to 2006-08, Wi-Max, a new form of high-speed, longer reach wireless networking and Mobile-Fi, the extension of Wi-Fi to moving vehicles, are likely to gain widespread use.

Wireless service providers will have to invest in 3G wireless networking services to go after wireless data service opportunities. 3G wireless networking improves the quality of wireless service while adding a data delivery component. This augurs well not only for well-capitalized wireless service providers like Vodafone (NYSE: VOD) but also for wireless equipment providers like ERICY and Alcatel (NYSE: ALA) as 3G network deployment gains traction in 2005. Research in Motion (NDQ: RIMM), the leading player in wireless messaging, courtesy its Blackberry, is also well positioned for this opportunity.

Fickle Handset Customers.

Sales of handset units are forecasted to grow 10% in 2004 from 2003 levels. New features such as color displays, integrated cameras, short-messaging, and web access capability have driven a strong handset replacement cycle in mature markets while a growing subscriber base continues to spur handset demand in emerging markets. While the total pie has been growing, Nokia (NYSE: NOK), the global handset leader has been at the losing end of the market share game for some time as its handsets have not struck a chord with consumers. Other handset manufacturers like Motorola (NYSE: MOT), South Korea based Samsung Electronics (005930.KS), and SonyEricsson, the London based 50/50 joint venture between Sony and Ericsson, appear to be beneficiaries of NOK's market share decline.

Value Creation through Consolidation.

The pressures from a declining long-distance business as well as economies of scale in the wireless service business make acquisition of wireless assets attractive for major telecom service providers as well as wireless service providers. Wireless represents a growth opportunity for the embattled telecommunication service providers facing the strong headwinds of a declining long distance business. Earlier this year, when AT&T Wireless (NYSE: AWE) put itself up for sale, buying interest was keen from both major telecom carriers as well as wireless service providers. Eventually Cingular, the SBC Communications-Bell South joint venture, was the winning bidder at a price tag of $1,850 per AWE customer. With Cingular leapfrogging to become the nation's largest wireless service provider, we think there is more to come by way of consolidation.

Sprint (NYSE: FON) has recently recombined its 'tracking stocks' FON and PCS potentially making this company a part of consolidation plays. So too are niche wireless providers like U. S. Cellular (ASE: USM). NXTL and Verizon Communications (NYSE: VZ) may also be participants in this industry's consolidation efforts.

In closing, we think the easy money in this sector has been made and share prices in this sector may consolidate for some time. That said, the opportunities for growth in this industry continue to remain attractive and any pull-back will likely be a buying opportunity. At this juncture, we favor wireless infrastructure provider, QCOM. Handset maker, MOT that appears to be on the mend, has added attraction as a restructuring play. Among wireless service providers, we favor NXTL for its strong-hold over construction and manufacturing businesses. Investments in wireless service providers have additional appeal for their potential to create value through consolidation. All said, while the rate of capital appreciation will likely be slower going forward, we believe there are several forces at play here which will likely enable this sector to outperform broader averages like the unmanaged Wilshire 5000 Total Market Index.

Notes: This report is for information purposes only. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice. This report does not have regard to the specific investment objectives, financial situation, and particular needs of any specific person who may receive this report.

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