Why
We Own Leap Wireless
Before I get too far into the discussion of our
holdings in Leap Wireless (NASDAQ: LEAP), I'd like to share a quote
from the famous investor Sir John Templeton that I was recently
reminded of:
"It is impossible to produce superior performance
unless you do something different from the majority."
Leap Wireless is a relatively new position for us.
I initially began buying shares when they traded near $20. I believe
shares should trade in the mid-$30 range. The majority currently see it
differently however, as shares have recently traded down to $12, the
lowest they have ever been since the company went public in 2004,
before climbing back recently to $17. I averaged down in Leap along the
way, meaning I bought more shares as the price declined, so for
investors in Tarpon since September, our average cost is $16 per share.
But there is no denying we've seen some significant short-term paper
losses on Leap, one of 16 companies we own, until fairly recently.
What follows are the highlights of my
justification for buying more shares as they have fallen. Leap is also
an instructive example of how value investing usually works. We've all
been a bit spoiled over the last year in that I rarely needed to
average down. I don't anticipate that will be the case as often looking
ahead.
A year ago, we did something different from the
majority by investing in a handful of competitively-advantaged
companies which had shares that were being sold off out of fear and
uncertainty. Now I'm doing the same with Leap, which was also being
sold
off recently for reasons that appeared overblown.
Background on Leap
Leap Wireless provides wireless voice and data
service in 35 states under the "Cricket" brand. The company offers
unlimited service for a flat monthly rate without a contract of any
sort under a "prepaid" billing model. Due to an industry leading cost
structure, Leap can provide wireless service to its customers at a
significantly lower cost than most competitors, selling its wireless
minutes for less than it costs other carriers to produce theirs. Leap's
costs are low due to a distinctly different corporate strategy centered
around local economies of scale and the efficiency of the company's
network, built from the ground up to deliver high capacity and high
quality at a low cost. Leap also focuses its operations exclusively in
areas with high concentrations of customers.
Leap is a growth company trading like it's going
out of business. Revenues at Leap have grown at over 20% per year for
the last five years, yet in a little over two years, Leap shares have
gone from almost $95 per share to $12 - for no truly fundamental
reasons except changes in expectations and overblown fears of increased
competition.
I say Leap is cheap now based on my own estimates
and a handful of independent benchmarks. In 2006, for instance, Leap
paid $984 million to purchase spectrum, or airwave licenses. Today the
market believes the entire net worth of the company to be less than the
value of just that spectrum it bought three years ago. I'd say it's as
if purchasers of Leap shares today were buying slices of spectrum with
a company thrown in for free - except you can't exactly make a sandwich
out of those slices even if you did own them. More relevant, perhaps,
is that in September of 2007, a sophisticated corporate buyer - prepaid
operator MetroPCS - offered to buy Leap for $78 a share. Leap turned
them down.
Leap is probably the most misunderstood company in
our portfolio, and it certainly is not without flaws. The moat around
its business is not as apparent as that around some of our other
companies. There is a higher than average degree of uncertainty about
the true valuation of Leap - both in the market and in my own
valuations. That said, at prices like those of today, that uncertainty
can still be accounted for through a margin of safety. It may be hard
to tell exactly what the per share value of Leap really is, but even
the low end of a wide range of approximate intrinsic values for the
company is considerably higher than where shares currently trade.
About The Industry
In order to explain why we own Leap, a little
background on the wireless telecom industry is in order. Some time ago,
I spent a few years working in telecommunications, first at an internet
service provider and then at a radio frequency (RF) engineering firm
that provided wireless consulting services to the big operators like
Nextel and AT&T. While far from an expert, I did learn quite a
bit and had some pretty unique experiences, from food poisoning in
Azerbaijan to dodging sleepy bulls in St. Maarten. Good times.
I ultimately came to two hard-earned insights
about the wireless telecom industry:
1. These people are nuts.
Not just company executives, but customers,
venture capitalists and vendors, too.
2. Mobile phone services are a commodity.
Back then, in the long-distance calling business,
people could see revenues collapsing before their eyes. In the core
backbones of the internet, you could also sense that all those routers
were on their way to becoming glorified toasters as the number of
router companies boomed. But in the wireless world, nobody wanted to
admit that cell phone service was becoming a commodity, too.
To date, mobile telecom still defies the laws of
basic economics. The vast majority of businesses on the planet, for
instance, give customers who buy more product discounts.
Not so among cell phone companies.
And consumers in most other industries would see
through a pricing change that lowered an upfront price while increasing
monthly fees. Not so in cell phone land. When the iPhone was originally
launched, pricing started at $399 for the phone plus $20 a month. Sales
didn't really take off, however, until after the phone price dropped to
$199 and the monthly charge increased to $30. In other words, it was
only after the total cost of owning an iPhone over a two-year contract increased
that sales shot up.
Like I said - nutty.
In industries with an abundance of irrationality,
stock prices sometimes get out of whack. The promise of wireless
telecom is that anything electronic can become a communications device,
and this can be very exciting to people who dream about refrigerators
ordering take-out. Stock prices of wireless companies swing too low on
the downside, as well.
Most wireless operators, aided by handset
manufacturers, go to great lengths to convince customers that their
services are anything but ordinary. Shiny new phones, family plans,
rollover minutes, favored caller plans, free calls to similar customers
and a slew of other bells and whistles are routinely trotted out to
emphasis the uniqueness of each service.
But while the phones may differ, wireless service
is closer than ever to becoming a commodity. There are still varying
levels of call and coverage quality among companies, mind you, but the
differences are narrowing every day. And in any industry with
undifferentiated products or services, an efficiently run, low-cost
provider has a competitive advantage.
Here are three other truths of the cell phone
industry:
1 - Operators do not have a good way
to measure their true costs.
AT&T has no idea what it costs them when I
call my aunt in Mississippi from here in Islamorada. Sure, the company
knows approximately how much profit it will make off me in an average
month, but that's an entirely different animal then knowing exactly how
many fractional pennies per second the company earns in profit each
time I hold my iPhone next to my noggin.
I also find it remarkable that cell phone
companies continue to provide flat rate pricing for unlimited use of
their data networks. These companies spend a ton to enable consumers to
surf the web on their handsets, yet unlike with voice traffic, they
don't meter it. It's a bit like putting out lobster tails and filet
mignon at the $7 all-you-can-eat buffet - great for the customer, but
it doesn't make much sense for the restaurant.
2 - Telecom investors obsess about
metrics that can obscure operating performance.
Managing a wireless operator is highly
challenging. Revenues are driven by two wildly changing variables -
usage and pricing - and a slew of other factors influence the costs of
calls. As a result, the industry has become obsessed with metrics
labeled with acronyms like ARPU, CCPU, and CPGA. While the averages of
each metric are important, quarterly trends in each are not
particularly insightful to long-term business owners. Because of what I
outlined in #1 above, however, these metrics seem to take on extra
significance.
The problem is that these traditional metrics can
be pretty opaque, and none really gauge a company's economic
efficiency. Take that first metric, ARPU, which is short for Average
Revenue Per User and of great significance inside the industry. In
general, high ARPU is good - except when it's bad. More specifically,
maintaining a high ARPU can drive customers away, creating higher
"churn" or turnover, which means the firm then has to spend more to
acquire new customers.
In addition, there is no common metric that
indicates the success that cost-cutting efforts have in the face of
lower prices - a pretty important measure in so competitive an
industry. To gauge that, you've got to create your own metric. It's not
hard, mind you (ARPU - CCPU = AMPU or average margin per user), but the
point is that much of what traditionally goes on in analyzing wireless
telecom companies is spuriously precise - and it may be measuring the
wrong things these days.
Why the obsession with those metrics? Among other
reasons, to make business appear more predictable than it really is -
an absolute must when needing to frequently raise money for network
expansions. But in reality, there is no growth without volatility in
telecommunications.
3 - Carriers hate subsidizing
handsets.
A cell phone is a bright shiny lure that a
wireless firm subsidizes in order to make them affordable enough to win
a monthly recurring revenue stream. Due to the success of higher-priced
smartphones like the iPhone, the subsidies that mobile operators pay to
lower the cost of these lures to consumers will continue to be
significant. This really chaps cell phone service providers in the U.S.
- particularly because in most of the rest of the world, customers pay
full price for their phones.
What does all the above mean?
Despite a ton of chatter about a looming price war
lately, I believe the current consensus on Wall Street about the
prepaid cell phone industry is wrong. There will not be a serious,
long-term price war in the prepaid space.
Let me be clear: the number of competitors in the
prepaid space is unequivocally increasing, and some firms are backed by
the biggest operators in the industry. But a critical distinction
should be made between a price war and an increase in competition. I am
not buying shares in Leap under the presumption they will have no
competition. My belief is that while competitors may attempt to offer
relatively lower priced plans, they still will not be able to
underprice Leap for any length of time without eroding or destroying
their own franchises.
I believe the Big Four wireless carriers -
AT&T, Verizon, Sprint and T-Mobile - want to avoid a price war
like the plague. This desire to avoid a price war is not new, however.
It's a strategic choice. Since 2004, in fact, the basic rate for the
lowest-priced wireless plan at the largest carriers has stayed steady
at $40 for 450 minutes. The executives who run these companies are very
familiar with the carnage wrought upon the long-distance industry
during those vicious price battles of a decade ago. I believe those
companies' recent interest in the prepaid market represents a misguided
attempt to channel prepaid customers to postpaid contracts.
As per those three industry truths mentioned
above, each of the Big Four has fuzzy cost structures today. Because of
their all-you-can-eat approach to data, they may have already missed
the chance to capitalize on tiered-rate data plans. They also have a
slew of pricier, data-centric handsets coming down the pike that
they'll have to subsidize to put in the hands of subscribers. And a
price war would immediately impact several of the key metrics the
analysts on Wall Street obsess about, potentially jeopardizing the
companies' abilities to raise money.
Additional potential threats include other prepaid
providers, but again, Leap has a cost-based advantage in all but one
case. Prepaid providers that lease others' networks can't compete on
costs. Those prepaid operators owned by the Big Four but doing business
under a different brand will either ultimately be hampered by the
higher costs of those old legacy networks, or they'll start to
cannibalize the existing postpaid business. So they're in a box.
The one exception to the above is MetroPCS, a
prepaid provider built and run quite similar to Leap, with economics
and a strategy that look quite similar. Metro operates in different
markets than Leap, however, so there is even less of a competitive
threat from that company. Some of you may have noticed that I'd
actually bought a few shares in MetroPCS the same time I started buying
shares in Leap. Once Leap started dropping in price, though, I sold
those shares of PCS to begin averaging down in Leap. I am a big fan of
the business model of both companies, but after more reading, found I
preferred Leap's economics a little more.
All of which brings us to Leap.
If you don't really know your true costs, have
conditioned investors to focus on certain imperfect metrics, and have
to subsidize phones to get customers, who's the last guy you'd want to
meet in a dark alley?
I'd argue it's someone whose strengths are your
weaknesses - a company obsessed with keeping a low cost structure,
unafraid of lumpy results and which doesn't have to give away expensive
phones in order to get customers.
Now we're talking.
Why Is This a Great Business?
To be clear, wireless operators are not great
businesses, but Leap has some attributes that make it better than most.
These companies consume considerable amounts of capital to grow.
Combined with the fact that they provide a commodity service, many
businesses in the industry run a real risk of destroying value through
growth, rather than creating it.
Leap requires an amount of capital equal to a
mid-teens percentage of its service revenue to maintain its existing
business. While that is more than I'd like to see in the ideal
business, the company still earns more on its capital than it costs the
company to raise it, so growth is creating value.
I view the capital intensity of the business as
outweighed by Leap's positives - specifically, an under-appreciated
moat, continued fast growth, a very large distribution network,
cost-focused management, and underserved customers with no credit risk
- now all trading near an all-time low.
The Model
Leap competes in a different segment of the
market, focusing exclusively on prepaid customers. Historically, cell
phone companies in the U.S. have preferred contract subscriptions to
prepaid or pay-as-you-go plans. Leap customers aren't required to sign
a contract, however, and instead pay ahead of time for the minutes they
will use. That's not simply a subtle change in billing, however - it's
a completely different business model than the Big Four.
Efficiencies in everything from pricing plans to
network design to advertising lead to better returns on capital for
Leap than much bigger competitors. It also means that to compete,
traditional carriers risk cannibalizing their own customer base,
creating brand confusion, and/or increasing their already challenging
customer service issues. Those challenges only grow more daunting when
confronted with the chronic inability to match Leaps' long-term margins.
The Misunderstanding
Prepaid operators typically serve lower income
customers. Half of Leap's customer base earns less than $35,000 a year,
and 55% are younger than 35 years old.
If Leap sold cars or condominiums, the income
level of typical customer might give us some pause. Because Leap's
services are paid for upfront, however, there is no credit risk to the
company in serving lower income customers.
Leap's Cricket service is also extremely valuable
to its customers. Over 90% of Leap's customers use Cricket as their
primary phone, and more than 75% use Cricket as their only phone. So
Leap is focused on an underserved part of the market that is in dire
need of cheap cell phone service. The company serves that market while
assuming zero credit risk and with customer turnover comparable to that
of traditional operators.
In addition, the market for prepaid cell phone
service is the last area of growth among wireless carriers. With the
country saturated with traditional cell phone plans, strong growth in
prepaid customers represents an attractive opportunity for an operator
with the right strategy.
The Moat
Leap's moat gets no respect.
Here are links to three tables that explain why I
believe the company has a considerable competitive advantage, however.
(Again, the following are links to my own internal notes, as opposed to
being designed for general public display, but email me if you want or
need any explanations of anything in them.)
This
link will take you to the first table, which demonstrates
among other things that even at a price point approximately 20% below
its competitors, Leap achieves similar profitability as its much bigger
competitors.
The
second table can be found here, which shows that on both a
quarterly and annual basis, declines in Leap's average revenue per user
are being more than offset by improvements in cost control. In other
words, the economic efficiency of Leap is improving over time.
And here
is a link to the third table, which provides a quick snapshot
of several of Leap's key cost metrics compared to industry averages.
(They're significantly lower.)
I believe the metrics highlighted in these tables,
as opposed to those traditionally relied on in the telecom industry,
are the most relevant.
Leap's network technology, CDMA2000, also provides
the company with high quality, high capacity, low cost service in
concentrated areas. In other words, the company's technology
complements the strategy of providing cheap service in crowded areas.
Leap isn't trying to blanket the entire country with cell phone
coverage like the Big Four. Leap has been able to deploy unlimited
voice and broadband data service using only small slivers of spectrum
(10MHz) in most of its markets, a notable feat in the world of radio
frequency engineering.
That said, Leap has no proprietary technological
advantage. Other firms use CMDA networks, too. What makes Leap
different from the vast majority of its competitors, however, is that
its technology enables it to achieve local economies of scale.
In telecom, those firms earning the highest
returns on capital have historically been those operating in defined,
limited geographies. Leap is no exception. It has built a loose network
of local pockets of wireless coverage in or near urban areas. As a
result, it can blanket an area with low cost advertising, usually in
the form of radio ads, and when combined with thousands of distribution
points in that area, Leap can acquire new customers at a lower cost
than competitors. (You can see this in the firm's "CPGA," or cost per
gross customer acquisition.)
As the first provider of prepaid services in most
of its markets, Leap also has an advantage over the largest
competitors. The Big Four have clear advantages on the national level
in terms of economies of scale. Those advantages don't necessarily
translate when it comes to launching new products in smaller markets,
however. A company with scale advantages still has to steal market
share from an existing local incumbent in order to gain enough share
that it can get the scale it needs. Until that point, the new entrant
will incur economic losses - with no guarantee of ever reaching the
point where its national scale will matter.
Growth at a competitive disadvantage destroys
value. I believe direct competition by the Big Four in the prepaid
market will destroy the advantages those carriers have. Economies of
scale will be too costly to achieve in Leap's local markets.
Futhermore, to truly compete with Leap means the established operators
would have to abandon the strategy of customer captivity that a service
contract represents. While the cost of that stickiness comes with a
price tag - the subsidy traditional operators pay on each phone bought
- the Big Four nonetheless cannot abandon their contract-based approach
without seeing subscribers leave.
So Leap has a cost-based advantage in its local
markets, and that makes all the difference.
Why Is It Cheap?
Leap is cheap for a variety of reasons, ranging
from analyst downgrades to missed earnings targets to reduced
subscriber growth expectations for 2009. While notable, none of these
developments truly concern me in the long-term. They each are
understandable given the impact of the recession on low-income
customers.
The most apparent reason shares declined this fall
was because of the fear of an erosion in Leap's business due to an
expected increase in competition. More specifically, Leap's shares fell
precipitously this fall due to rumors surrounding a secretive "Project
Black" being launched by T-Mobile and new, low-price plans due out from
AT&T Mobility. Both new wireless services were purportedly to
launch with pricing plans competitive with those of Leap. As it turned
out, however, neither new plans were competitive - both were still 50%
above Leap's pricing - and Leap stock has bounced back in the interim.
Is It Cheap For Temporary Reasons?
Yes. At some point the market will realize that
the rumors of Leap's demise have been greatly exaggerated.
What Is It Worth?
I believe Leap shares should be trading in the
mid-$30 range. As I said earlier, though, there is a wider than normal
range of possible intrinsic values for Leap.
Despite a lot of different looks at valuing Leap,
a simple discounted cash flow model (DCF) was ultimately just as
enlightening as attempting to model ARPU, churn and/or market
penetration. All DCFs can be notoriously sensitive, but for companies
with recurring revenue models and high initial capital costs, these
models represent one of the only ways to gauge value during the early
years.
DCFs are most useful when growth, prices and
margins are relatively steady, and as you may have gathered above,
Leaps' business lacks some of those characteristics. For instance, we
can generally expect new sales activity for Leap to be highest in the
first and fourth quarters, and customer turnover, or churn, to be
highest in the third quarter and lowest in the first quarter.
In any case, here is a
simplified DCF that should be transparent enough for you
to see at least some support for the above-mentioned value for Leap. It
is relatively simple but still makes the point that even if the
assumptions are off quite a bit, shares are still cheap. Again, don't
take that DCF value as an accurate point estimate - it is a hint, not
an answer.
And as usual, please email me if
you have any questions.
|
Cale's
Notes: 
Still on the Nice
list.