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In This Issue
bullet Cale's Notes: Merry Cash Flow!
bullet Portfolio Summary: Just the facts, ma'am.
bullet Get To Know Your Company: Thoughts on Leap Wireless.
bullet About the Tarpon Folio: More about our Spoke Fund®.

Letter to Investors
For Nov - Dec 2009 (305) 522-1333             

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Cale's Notes

Cale Smith

Dear Investors,

Somehow the holidays are upon us already. Merry Cash Flow! Considering this update is being delivered in late December, here are a few quick notes before I leave you to your egg nog:
  • As mentioned previously, on January 1st, fees for new investors in the Tarpon and Gecko Folios will increase to 1.25% of assets. The account minimum for each will also increase to $20,000. Please note that if you have opened an account before that deadline, you will continue to receive our 0.90% fee as long as you are an investor with IIM. That applies for new accounts and any contributions you make in the future, too. Consider it my thanks to you for investing with IIM in our first year. And if you're not yet an investor but would like to become one, sign up here .
  • Starting in January, I'll also be making some changes to these letters. You'll still be hearing from me every month, but with some format changes. Investors in Gecko Folio, which is also having a terrific year, have been more than patient in waiting for updates similar to the below. I intend to begin sending those out regularly next quarter, too.
  • Finally, a reminder to please RSVP if you plan to attend the annual meeting on January 30th. I'm happy to say we'll have folks coming in from all over to attend, and I hope you can make it, too.

Happy Holidays!

- Cale

Portfolio Summary

Tarpon Folio - up 97% since inceptionStill on the Nice list. 

Closing In On Triple Digits 

Since inception through yesterday, the Tarpon Folio is up 97.4% and is outperforming the S&P 500 over the same period by 59.2%.

Here are the monthly returns of Tarpon since my last regular update:

  • During the month of October, Tarpon declined 5.4% compared to a drop in the S&P 500 of 2.0%.
  • In November, Tarpon increased 4.5% compared to an increase in the S&P 500 of 5.7%.
  • To date in December, Tarpon has increased 3.8% compared to an increase in the S&P benchmark of 1.7%.

So, our performance lagged the broader market in October and November, soon after taking new positions in the portfolio, but it appears we will outperform again in December. As 2009 ends we are fully invested in 16 companies. Since my last regular update, I sold our shares in Target, which had reached my estimate of full value. While mildly concerned with Target's push into the lower-margin grocery business, that alone was hardly reason to sell. Shares were simply fully valued and I saw better opportunities elsewhere. I redeployed the proceeds into other names in the portfolio - including Leap Wireless.

In the below I elaborated a bit more on Leap than other companies I've previously written about because I received more questions than usual about it. For that reason I've also included links to some of my own notes I made when analyzing the company. I hope both give you a better understanding of why we own this business.

And if you have not read about my expectations for 2010, here's a link to my last letter.

Now, on to Leap...

Get to Know Your Company
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.

About The Tarpon Folio

The Tarpon Folio is an innovative, investor-friendly alternative to the traditional actively managed mutual fund. It's built on a model we call a Spoke Fund®

It is more transparent, takes more concentrated positions and is significantly less expensive than the vast majority of mutual funds. The portfolio is managed for long-term growth using value investing principles. 

Fees are 0.90% of assets annually, assessed on a quarterly basis. Turnover, taxes and trading are minimized in the fund, and investors can customize their accounts in several key ways, including tax preference. Each Tarpon Folio account is also protected by three types of insurance for a maximum of up to $11.5 million

For more information, visit our website.  

Here is our privacy policy, our Form ADV and our Fiduciary Oath.


See our performance disclaimer for more. The historical performance data contained above represent performance results as reported by the portfolio listed. The performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed.

Individual results will vary depending on market conditions and investing may cause capital loss. The S&P 500, used for comparison purposes, is significantly less volatile than the holdings of the funds listed. The performance data is net of all fees reflecting the deduction of advisory fees, brokerage commissions and any other client paid expenses. The performance data includes the reinvestment of capital gains. 

The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.

© Islamorada Investment Management. All rights reserved.

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