Description

Leap Wireless is a growth company with event driven catalysts that is trading like a distressed situation.  Shares of LEAP have collapsed from $37.75 in May 2009 where LEAP sold 7 million shares in a follow-on public offering to around $14 today on declining estimates for forward EBITDA and multiple contraction.  I believe LEAP can more than double from here on proving its' ability to continue to grow EBITDA, despite competition, as competition proves to be less aggressive and damaging than feared because of an inability to continue lowering price, as the decline is existing market subscribers proves to be partially seasonal and cyclical rather than entirely secular and as LEAP and Metro PCS eventually consummate a much awaited merger.

LEAP provides unlimited flat rate prepaid wireless services regionally covering approximately 92 million POPs.  LEAP has an estimated enterprise value of approximately $3.1 billion and consensus estimates for 2010 EBITDA of $683 million for an EV/EBITDA valuation of 4.6x.  While emerging competition is a serious concern rarely do you see such a valuation for the low cost provider in business with secular growth and no near term debt maturity issues.

LEAP shares have collapsed on a competition scare as Sprint has achieved success with its Boost offering, Tracfone (a subsidiary of Carlos Slim's America Movil) has launched a competing offering through Wal-Mart using Verizon's network, and the market has worried about the aggressiveness other national carriers such as AT&T and T-Mobile.

Certainly, Sprint was very successful in 2009 with its Boost offering attracting over 2.5 million net pre-paid subscribers on it's iDEN network.  Sprint's advantage in adding prepaid subscribers is based on its superior brand, national network, and broader distribution network.  However, Sprint's rational for its aggressive Boost initiative was the excess capacity on its iDEN network at the end of 2008.  I estimate that Sprint will is approaching full capacity in its iDEN network and should reach full capacity absent capital expenditures by Q1 2010.  As such incremental Boost subscribers will be less attractive from a contribution perspective as Sprint would have to deploy capital to support growth in the business limiting it's ability to justify further price decreases.

Tracfone's Straighttalk initiative which was in trial at over 200 Wal-MARTs in Q3 is being deployed nationally starting in Q4 this year.  Tracfone should have some success with Straighttalk as the offering is similar at only a slightly higher price point and the market knows that the service is being offering over Verizon's high quality network.  However, Tracfone, similar to Sprint will have limited ability to continue to lower prices as they are purchasing minutes based on variable cost pricing from Verizon at a rate that likely makes their current offering of limited profitability or actually unprofitable.  Verizon is unlikely to lower pricing for Tracfone and is anticipating only approximately 300,000 net additional subscribers on this offering annually.

Furthermore, the market has been terrified by the damage AT&T's and T-Mobile's new prepaid offering will cause, with LEAP and PCS stocks falling on the AT&T pricing announcement and anticipation of the T-Mobile pricing announcement.   However, the announcements of both their pricing updates have resulted in offerings that are 50% more expensive than what LEAP and PCS are offering and LEAP and PCS rallied when T-Mobile's offering finally became public.  With the recent stock market decline, LEAP and PCS are below these levels.

EBITDA Better than it looks

LEAP consolidated EBITDA in Q2 was $138 million, however, existing market (non new market) EBITDA alone was $192 million.  The difference is the losses LEAP is incurring in it's expansion markets where penetration is very low and still expected, even by the bears, to grow.  If you valued LEAP today on Existing market runrate EBITDA and expansion markets at zero value, the company is trading at 3.9x EV/EBITDA.

Expectations are Very Low

Sell Side expectations have come down dramatically in the last six months...from close to 900 million of EBITDA to $680 million in EBITDA, setting the bar to a much more realistic and beatable level.

Seasonality is an issue for LEAP's valuation

Last year LEAPs achieved 43% of its net subscriber guidance by Q2.  This year they have achieved 46% of their guidance.  Q2 and Q3 are typically the weakest seasonally and investors typically worry that the weak subscriber additions reflect changes in the secular trend.  The stock has typically tracked this lack of confidence and has performed better going into Q4 and after Q1 than after Q2 and into Q3.

LEAP is trading below Book Value

Leap is currently trading below it's tangible book value of $17.27 per share and stated book of $23.18 per share.  Liquidation analyses on the street vary in their assessment of the value of LEAP's spectrum and inplace network equipment, however, pessimistic liquidation valuations put the value of the assets in the range of $12 per share.

Potential for significant value creation and premium from M&A transaction

PCS offered 2.75 shares for each LEAP share in 2007 to combine the companies.  The rational was to create a national prepaid wireless payer which would result in revenue and cost synergies.  The companies currently comprise almost mirror networks withoverlap in only 8 million POPs out of LEAP's 92 million POPs and PCS's 104 million POPs.  The revenue synergies would have resulted from a reduction in churn as customers moving from one's carrier's coverage area to another would not deactivate and lower customer acquisition costs/higher net adds as the combined companies would be able to promise a nationwide network rather than a regional one.  The cost synergies would come from traditional sources such as corporate overhead, purchasing, billing, etc.  At the time PCS estimated the NPV of the synergies was $2.5 billion.  LEAP rejected the transaction at the time because PCS was only offering LEAP some 35% of the synergies and LEAP wanted 50% of the total economics because of the opportunity in it's expansion markets.  Some of these synergies have probably already been achieved due to the Roaming agreement between the two companies however, the value of offering a nationwide network is clear when your primary competitors (Boost and Tracfone) are offering a national network.  The street is admitting to cost synergies around $135 million and not admitting to any revenue synergies.  Still should the combined companies be able to achieve $200 to $250 million of total synergies, the value to the combined company should be $1 billion to $1.25 billion.  At the previously rejected 2.75  share ratio should result in a share price for LEAP around $22 per share or a 50% premium to today's stock price.

Yesterday an interesting development occurred. LEAP named three additional board members to the company's board.  I view this as positive as LEAP's board at 5 people was probably too small and not independent enough to approve a deal with PCS given that the chairman of LEAP is also a major shareholder of PCS.   Furthermore, one of the new board members, John Chapple who is the former CEO of Nextel Partners is a wireless industry heavy weight and has a overlapping board relationship with James Perry of Madison Dearborn Partners.  Madison Dearborn is the largest shareholder of PCS with almost an 11% stake.

Catalyst

1.  Reduction/Rationalization of guidance

2.  Entering strong season for net adds and stock performance

3.  End of Mutual Fund tax loss selling after October 30th

4.  Becoming FCF positive

5.  Ceasation of negative newsflow about competitor pricing as Sprint Boost reaches network capacity and Tracfone limits losses

5.  Potential M&A transaction with PCS