Leap provides unlimited flat-rate prepaid wireless services.  Leap has an adjusted enterprise value of $3.6bn and we estimate it will generate $619 million and $716 million of adjusted EBITDA (excluding losses related to new market build-outs and other new initiatives) in 2008 and 2009, respectively.  On this basis, the stock trades at only 5.1x.

 

Price at 8/8/08		45.07		2009E Core EBITDA				424
FD Shares		69		2009E Emerging Markets EBITDA				292
Equity Value		3,119		Total Adjusted EBITDA				716
Net Debt		1,646
Min. Int.		53		Adjusted TEV / EBITDA				5.1x
TEV		4,819
NOL		(200)
Unused Spectrum		(984)
Adj. TEV		3,635

 

In July 2007, Leap shares traded at $98 per share or 17x 2007 EBITDA.  However, a slowdown in second quarter subscriber additions and a slight increase in customer churn caused the shares to fall to $54 in August.  Three weeks later, the shares rebounded to $85 when MetroPCS Communications, another prepaid wireless operator, announced a merger proposal. Leap rejected the proposal, stating that the offer was inadequate, which caused the stock to decline to $74.  In November, Leap announced a minor accounting restatement and pre-released Q307 subscriber numbers slightly below guidance which pushed the stock to as low as $30.  Within five months, Leap had lost $4.5 billion in market capitalization or almost 10 multiple turns of EBITDA.  The stock price has since reached as high as $61 and is now $45. At $45 (5.1x adjusted EBITDA), the stock price ignores the defensive characteristics of the flat rate wireless business, resilience of Leap’s subscribers, and secular growth of the prepaid segment, and offers free options on four high-probability events likely to drive performance over the next 12 months.

 

	National Carriers	Leap	% Variance
Average MOU	952	1,450	52%
Average ARPU	$52	$45	(13%)
Price per Minute to Consumer	$0.05	$0.03	(43%)
Cost per Minute to Carrier (Excl. Acquisition Costs)	$0.03	$0.01	(47%)
% Contribution Margin	38%	43%	4%

 

As the economic slowdown continues, Leap’s targeted budget-conscious consumer base grows, and landline displacement accelerates. This has been demonstrated historically by Metro: in Metro’s Detroit market, where the local economy slowed ahead of the rest of the country, the company achieved 5% penetration in its first 12 months of operation vs. 3% in a typical market.

 

In retail and other industries, the market has rewarded “best value” companies for their defensive characteristics. We anticipate that as Leap’s defensiveness is recognized its stock price will more appropriately reflect the nature of its business.

 

Company	YTD Price Change		Company	YTD Price Change
Big Lots Inc	110%		Leap Wireless Intl Inc	(3%)
Rent-A-Center Inc	62%		Metropcs Communications Inc	(8%)
Dollar Tree Inc	59%
Fred's Inc-Class A	58%
Overstock.com Inc	29%
Family Dollar Stores	33%
Wal-Mart Stores Inc	24%
			Average	(5%)
Average	54%		Variance vs. Other "Best Value" Companies	(59%)

 

2. Unique Low-Cost Business Model Creates Economic Moat: Leap has an inherent cost advantage due to efficiencies in nearly every line item. These result from the simplicity of the flat rate model (eg. simplified billing, minimal customer service requirements, word-of-mouth marketing, etc.), and its targeted footprint, which excludes low-density rural areas. Although the national carriers have recently launched competitive “unlimited” plans, they are priced at $90-$100 per month, more than double Leap’s ARPU. National carriers’ are unlikely to compete more aggressively on “unlimited” pricing because their operating costs per minute are nearly as high as Leap’s revenue per minute, and for fear of cannibalizing their high-paying subscriber base and driving excessive call volume over their networks. In fact, Sprint-owned Boost Unlimited, the only significant unlimited competitor in Leap’s footprint, is experiencing 7% monthly churn (implying the entire customer base turns over in 14 months!), is unprofitable, and recently raised prices. Our recent diligence suggests Sprint may wind down the Boost offering in the near future, making an estimated 1 million subscribers available to Leap.

The tables below illustrate the risk cannibalization represents to the national carriers if they were to introduce low-priced unlimited plans to compete directly for Leap and Metro customers.  There is a base of over 200 million post-paid subscribers. Given our expectations that Leap/Metro will gain an estimated 2 million subscribers in 2008, it would be illogical for the large national carriers to offer low-priced unlimited plans and encourage their existing subscriber base, of which >50% can re-price in any given year (i.e., 2-year contracts), to trade down. Note also that the other prepaid providers are primarily pay-as-you-go and charge significantly more on a per minute basis than Leap/Metro. Their subscribers are often the first to switch to Leap/Metro when they enter a new market and represent a significant opportunity for Leap.

 

Postpaid Subscribers		Mar-08		Prepaid Subscribers		Mar-08
Verizon Wireless		62		TracFone		10
AT&T Wireless		56		AT&T Wireless		6
Sprint Nextel		40		Virgin Mobile		5
T-Mobile		26		T-Mobile		5
Alltel		11		MetroPCS		4
US Cellular		5		Sprint Nextel / Boost		4
Rural Cellular		1		Leap		3
Centennial		1		Verizon Wireless		3
Cincinatti Bell		0		Alltel		1
NTELOS		0
Sub-Total Postpaid		202		Sub-Total No Contract		42
Total		244

 

3. Resilient Customer Base: Leap’s customers have shown resilience in the face of increasing gas prices, a weak economy, and more recently, the sub-prime credit crunch.  In each case, the impact has been temporary, as customers adjusted to new conditions.  This is because, unlike the customers of other wireless providers, Leap customers are highly dependent on the service: over 90% of Leap customers use Leap as their primary phone and 65% use Leap as their only phone.  In addition, 70% of Leap’s customers are renters. Because 30% of average household spending is on rent vs. only 16% on food and energy combined, Leap customers will likely benefit from declining rents more than offsetting the impact of commodities inflation on their budgets. Finally, while other carriers’ (eg. Sprint) historical results may have been inflated by relaxed credit standards on postpaid contracts, Leap’s results are undistorted because payment for services is made in advance. This also eliminates exposure to future bad debt expenses.

 

4. Prepaid Subscribers to Grow at 8x the Rate of Postpaid: Prepaid is historically the last portion of a wireless market to mature, and at ~80% penetration the US market is poised for a share shift to prepaid. The tables below provide third party estimates of the evolution of the US wireless market between 2007-2010, and the prepaid/postpaid split of international wireless markets. This data suggests that Leap’s addressable market will grow by nearly 73% between now and 2012 as No Contract market share increases from 16.5% to 24.1% of total wireless subscribers.

 

		2007	2008	2009	2010	2011	2012			Italy	UK	Spain	Germany	France	Average
Wireless Penetration		80%	84%	86%	88%	90%	91%		Pre-Paid	88%	67%	55%	51%	39%	60%
									Post-Paid	12%	33%	45%	49%	61%	40%
No Contract		40	46	52	57	63	69
Contract		202	209	212	215	216	217		Penetration	>100%	>100%	>100%	~95%	~80%
US Wireless Customers		242	255	264	272	279	286
No Contract Market Share		16.5%	18.0%	19.7%	21.0%	22.6%	24.1%
No Contract % Growth		-	15.0%	13.0%	9.6%	10.5%	9.5%

 

5. Free Option #1 – Upside to Current Core Market Penetration: Leap’s core markets are currently penetrated ~7%, vs. Metro’s ~11%. Street analysts assume this is because Leap’s markets are fundamentally weaker than Metro’s. However, much of this gap is explained by Leap’s underinvestment in its local coverage areas and distribution network. Leap is currently adding approximately 600 cell sites to the ~2,400 currently deployed in its core markets, covering an incremental 4mm-5mm POPs and filling in the gaps in its coverage. Early results indicate 20% improvement in revenue and reduced churn in augmented markets. On its Q208 earnings call, the company confirmed that it expects terminal penetration in its core markets to reach up to 9% within two years based on this exercise. Narrowing the penetration gap vs. Metro by only 2% could be worth $21 per share. We believe the impact of augmentation will become apparent in 2H08 results.

 

Existing POPs		25.9		Capex/POP		26		Value Created		1,566
x Incremental Penetration		2.0%		x POPs		5		- Investment		(130)
= Incremental Subscribers		0.5		= Total Investment		130		= Net Value Creation		1,436
x Est. CCPU x 12 (1)		31.50
= EBITDA Contribution		196		ROI		12x		Value Per Share		$20.75
8x TEV / EBITDA Multiple		8x
Valuation Impact		1,566
(1) Assumes 70% flow through on $45 ARPU for incremental subscribers.

 

6. Free Option #2 – Inflection Point in Emerging Markets: Leap’s business demonstrates high positive operating leverage.  The following tables show granular operating results for Fresno, California based on consultant estimates. The top table shows that Fresno becomes cash-flow break-even at a penetration rate of 3.22% when gross profits fully absorb fixed operating costs and maintenance capex.  We extended the above analysis and found that as Leap adds customers beyond 3% penetration, 70% of incremental revenue flows through to EBITDA.  Positive operating leverage helps EBITDA margins rise from 13% in Year 1 to 45% in Year 4, and in absolute terms EBITDA grows eight-fold from Year 1 to Year 4. These results are consistent with Leap’s Q2 results which reflected $18 normalized monthly contribution per user in the existing markets, over 40% margin on $44 ARPU, at a combined penetration of approximately 6%.

				Annual
Average Revenue Per User ("ARPU")				$504.00
Variable Costs:
Long distance (per sub / yr)				$15.00
Interconnect cost				$18.00
Billing (per sub / yr)				$24.00
Customer care (per sub / yr)				$60.00
Marketing (per gross add)				$40.00
Total Variable Cost / Sub				$157.00
Contribution Margin Per Sub				$347.00
Fixed Costs:
Tower rent / Utilities / Techs				2,111,400
T-1 lines				1,435,500
Switches / Utilities / Techs				390,000
Software Maintainence				60,000
Store Rent / Payroll / Property tax				1,719,996
Ads, utilities, security other				1,188,000
Monthly G&A				600,000
Total Fixed Costs				7,504,896
Corporate Allocation				1,800,000
Total Expenses				9,304,896
Capex				3,000,000
Total Expenses + Maint. Capex				12,304,896
EBITDA - Capex after corp Break-Even				35,461
Penetration %				3.22%

 

 

	6 Weeks		6 Months		Year 1		Year 1.5		Year 2		Year 3		Year 4
Penetration	1.0%		2.0%		3.0%		4.0%		5.0%		6.0%		7.0%
Fresno Subs	11,000		22,000		33,000		44,000		55,000		66,000		77,000
Service Rev	5.5		11.1		16.6		22.2		27.7		33.3		38.8
Less: Var. Costs	1.7		3.5		5.2		6.9		8.6		10.4		12.1
Gross Profit	3.8		7.6		11.5		15.3		19.1		22.9		26.7
Margin %	69%		69%		69%		69%		69%		69%		69%
Less: Fixed Costs	7.5		7.5		7.5		7.5		7.5		7.5		7.5
Less: Corporate	1.8		1.8		1.8		1.8		1.8		1.8		1.8
EBITDA	-5.5		-1.7		2.1		6.0		9.8		13.6		17.4
Margin %	-99%		-15%		13%		27%		35%		41%		45%
Less: Capex	3.0		3.0		3.0		3.0		3.0		3.0		3.0
Unlevered FCF	-8.5		-4.7		-0.9		3.0		6.8		10.6		14.4

 

From 2006-2007 Leap launched service to 27mm covered POPs (“Emerging Markets”) in addition to the 26mm covered POPs in its core markets. We estimate Leap’s Emerging Markets were 4.7% penetrated in Q208, implying nearly 15% EBITDA margin expansion remains. Projections for core and Emerging Markets EBITDA are below, excluding the impact of Leap’s new initiatives (including Auction 66 build-out and broadband).

 

						Penetration Rate				EBITDA				Adj. TEV / EBITDA(1)
		POPs	Penetration	Subs		2008	2009	2010		2008	2009	2010		2008	2009	2010
Core Markets		26	7.3%	1.9		7.3%	7.3%	7.3%		424	424	424		8.6x	8.6x	8.6x
Emerging Mkts		27	4.7%	1.3		5.0%	6.0%	7.3%		195	292	419
Total		53	6.0%	3.1		6.1%	6.6%	7.3%		619	716	843		5.9x	5.1x	4.3x
(1) Based on $45 stock price and balance sheet data as of Q208. Enterprise value adjusted for $1bn unused spectrum and $200mm unused NOL value.

 

7. Free Option #3: New Markets: Leap has begun building out new markets acquired in FCC Auction #66. These markets, including Chicago, Philadelphia, Baltimore, and Washington, DC, are larger, more ethnically diverse and higher density than Leap’s existing markets, suggesting higher ultimate penetration potential and a faster initial penetration ramp. In Q208 Leap launched service to 8.5mm covered POPs in Las Vegas, Oklahoma City, St. Louis and Southern Texas. By 1H09 Leap will launch on 36mm POPs and by 2010 on 50mm. This expansion may contribute $133 per share over the next 5-7 years as penetration ramps up. In addition, as new market launches expand Leap’s national footprint and reduce roaming areas, core market penetration potential will increase as more customers who currently roam in Auction 66 markets choose Leap over national carriers.

 

A66 Covered POPs (2010)			50
Potential Penetration			12%
Incremental Subscribers			6
Est. Mature Mkt. Contribution per User			20
Incremental EBITDA			1,440
TEV/EBITDA			8.0x
TEV			11,520
Less: Spectrum Value			(984)
Less: Cum. Investment(1)			(1,350)
Equity Value			9,186
Per Share			$133
(1) Assumes $25/POP capex, $6/POP opex. Net of $200mm estimated capex already spent as of Q208.

 

Leap reported Q208 earnings on August 5. The results reflected the extremely high potential of the new A66 markets. Whereas historically new markets have ramped to 1.5% penetration over the first 90 days, these ramped to 2.4% penetration within 60 days in competitive markets, where awareness of the unlimited offering is higher, and 1.6% penetration in uncompetitive markets. Total net adds were 171,000 versus street consensus of approximately 115,000.

 

Historically, Leap’s POP growth has been directly correlated with its stock price as the market recognized the future penetration potential of newly covered POPs. Between 2004 and Q207, Leap’s stock price more than tripled as the company doubled covered POPs. Between now and 2010, Leap will launch twice as many POPs as it did between 2004-2007, and will again double covered POPs.

 

				2005					2006					2007
		2004		Q1	Q2	Q3	Q4		Q1	Q2	Q3	Q4		Q1	Q2
Stock Price		$27.00		$26.05	$27.75	$35.20	$37.88		$43.59	$47.45	$48.49	$59.47		$65.98	$84.50
Cumulative % Growth		-		(3.5%)	2.8%	30.4%	40.3%		61.4%	75.7%	79.6%	120.3%		144.4%	213.0%
Covered POPs		26		26	26	27	28		31	37	40	48		49	51
Cumulative % Growth				-	-	3.9%	7.7%		19.3%	44.0%	55.2%	85.3%		89.2%	96.5%
Subscribers		1.6		1.6	1.6	1.6	1.7		1.8	1.8	2.0	2.2		2.5	2.7
% Penetration		6.1%		6.2%	6.2%	6.0%	6.0%		5.8%	4.9%	4.9%	4.6%		5.2%	5.3%
Cumulative % Growth		-		2.9%	3.1%	3.4%	6.3%		13.3%	17.0%	25.4%	42.1%		62.4%	70.4%
Net Adds				45,575	2,736	4,816	45,767		110,411	57,686	130,979	262,457		318,346	126,791
% YoY Growth				-	-	-	-		142%	2,008%	2,620%	473%		188%	120%

 

8. Free Option #4 – Merger with MetroPCS: At its June 2007 analyst day, Leap discussed the opportunity to enhance core market penetration. In response, Metro rushed to make a hostile, public offer in September 2007, in an attempt to sidestep Leap management and capture this “low hanging fruit” for Metro shareholders. Leap rejected the offer as inadequate and opportunistic, but both companies continue to express interest in a merger. The logic behind this merger is extremely compelling. Currently Leap/Metro offer much cheaper service than national carriers but within limited footprints. Leap and Metro’s footprints are highly complementary, with very limited overlap in existing markets. Combined, the companies would cover nearly 200 million POPs when fully-built out, including 20 of the top 25 markets, and could offer much more extensive roaming while maintaining their cost advantage. We estimate a combination of Leap and Metro could generate up to $500mm per year in EBITDA synergies including $300mm revenue accretion from a nationwide price plan, $150mm from eliminating redundant overhead, and $50mm from lower purchasing costs. Based on its 2.75:1 stock-for-stock offer, Metro was allocating only 35% of these synergies to Leap shareholders. Leap’s Chairman, Mark Rachesky, is a hedge fund manager and highly economically motivated. His reasons for allowing Leap to reject the offer are clear: by closing the penetration gap vs. Metro and demonstrating the potential of its A66 markets, Leap will be in a position to negotiate a larger share of the combined company. Leap CEO Doug Hutcheson has a proverbial gun to his head to quickly demonstrate successful market launches and improving core penetration because for every 12 month’s delay, approximately $2.50 of synergies value per Leap share (at 2.75:1 ratio) is lost. Further increasing the likelihood of a deal, Mark Rachesky bought 13.6mm shares of Metro in Q1 (nearly $250mm at current prices). At 8x EBITDA, a merger would generate $20 per Leap share of incremental value.  

 

9. Poised to Beat Q3 Estimates: Leap is poised to again exceed analyst expectations in Q3. Despite the evidence of Q2, street estimates continue to ignore the impact new market initial penetration, market augmentation and growing broadband uptake will have on net subscriber additions. These factors, in combination with moderating churn vs. 2007 from the aging of the emerging market subscriber base and the tailwind provided by tax rebate spending will again offset negative seasonality and drive strong Q3 subscriber additions.

 

			Q308 Incremental
		POPs (mm)	Penetration	Net Adds (000s)
Core (Excl. Augmentation Impact)		26	0.05%	13
Augmented Markets		29	0.03%	10
Emerging (A58)		27	0.15%	40
A66 - Q2 Launches		9	1.00%	85
A66 - Q3 Launches		1	1.50%	15
Broadband		42	0.10%	43
Total Net Adds				206
Consensus				100
% Beat				106%

 

We value Leap based on a sum-of-the-parts analysis. The core business alone, net of debt and after adjusting for unused spectrum value and NOLs, is worth $42 per share based on 8x 2008 EBITDA. This assumes zero growth from 2007 in core EBITDA. Free options 1-4 represent incremental upside of $152 per share, including the entire emerging markets segment which in 2008 will contribute nearly $200mm of EBITDA. We value this segment (Free Option # 2) at 10x 2008 EBITDA (6.7x 2009 EBITDA). After applying 65%, 60% and 60% probabilities to options 1, 3, and 4, respectively, we arrive at our target price of $145.

 

		2008E						% of
		EBITDA	Multiple	Value	Per Share	Prob	Adj. Value	Current Px
Core Markets		424	8x	3,392	49.01	-	49.01	109%
Net Debt				(1,700)	(24.56)	-	(24.56)	(54%)
NOL Value				200	2.89	-	2.89	6%
Unused Spectrum				984	14.22	-	14.22	32%
Core Business Equity Value				2,876	41.56		41.56	92%
Free Option #1: Incremental Penetration of Core Markets				1,436	20.75	65%	13.49	30%
Free Option #2: Emerging Markets		195	10x	1,950	28.18	100%	28.18	63%
Free Option #3: A66 Markets (Discounted 5 years at 10%)				5,704	82.41	60%	49.45	110%
Free Option #4: PCS Merger Synergies at 2.75:1 Ratio				1,400	20.23	60%	12.14	27%
Total Short-Term Options				10,490	151.57		103.25	229%
Total Potential Value				13,367	193.13		144.81	321%