MetroPCS (PCS) is a company with numerous catalysts (M&A, new market launches) and enviable growth prospects (double digit EBITDA/FCF for the foreseeable future).  However, the market discounts these favorable characteristics because of a fundamental misunderstanding of the business model and the company’s growth prospects.  Based on my projections, I think the stock should trade in the low to mid $20 range – assuming no deal with Leap (discussed below), which represents approximately 30-60% upside in the next 12-18 months. 

 

 

PCS is a no contract, pre-paid, unlimited minute wireless carrier that owns its own network.  The company targets a large, underserved portion of the metropolitan U.S. population (lower income, college students, young professionals, etc.) that demands many monthly minutes of wireless talk time at a price (~$40/unlimited minutes/month) far below that charged for typical post-paid wireless service ($90-100/unlimited minutes/month or $60-80/900-1,500 minutes/month). 

 

 

So this begs the question: how can PCS (and for that matter, its rough twin, Leap Wireless) maintain margins as good or better than its national competitors?  How can they compete at all?  Well, there are several reasons, and I think these reasons combined with this chart from PCS’ investor presentation helps to prove the point.

ARPU=Average Revenue Per User per month

CCPU=Cash Cost Per User per month

Churn=Monthly Deactivations/Average Subscribers/Month

CPGA=Cost Per Gross Addition

 

As is shown in the chart, PCS operates with lower revenue per user and lower costs per service than its competitors, resulting in similar cash flow margins.  PCS is able to do this because 1) its equipment is newer/more efficient, and it does not have a high legacy cost structure 2) an unlimited model is cheaper to operate from a customer service perspective (what is there to call and complain about?) 3) it only operates in specific metropolitan areas (limited roaming costs) 4) while its monthly churn is higher (~4.5-5%) versus national carriers (~2-2.5%), its CPGA is significantly lower (~$110 versus $300+).  But not only do national carriers have difficulty competing in this market from a cost perspective – they do not WANT to compete in this market.  To the extent the national carriers have launched prepaid plans it is simply as a channel to convert these prepaid customers to postpaid customers.  If AT&T launches a cheaper product, it may well cannibalize subscribers on the lower end of its ARPU spectrum.  No, the national carriers are quite content to let PCS “bottom feed”.  They are far more focused on increasing the ARPU side than they are cutting on the cost side. 

 

So now that (I hope) I’ve helped establish that the model “works”, what about other investor concerns?  In a recessionary environment, investors worry that PCS’ customers, at the lower-end of the economic spectrum, will struggle to pay for wireless service.  Well, just to throw out some numbers, 85% of PCS’ customers use its phone as their primary phone, and 55% have cut the cord completely.  This is not an “optional” second line of communication - PCS service is oftentimes the only way its customers communicate telephonically.  I believe that in a tough economic environment like we have now, gross additions may well decelerate.  However, I do not believe that churn will get out of control because communication is so essential.  That said, the nature of the prepaid model is that it is very easy for customers to drop off of, and back on to, the PCS network.  So if a customer undergoes some sort of problem that means he can’t afford his bill for a month, he can simply not pay for one month, and start his service back up the next month.  In fact, roughly 1.5% of PCS’ approximately 4.5% churn rate, or roughly 1/3, is related to customers dropping off due to seasonal (summer vacations) or short-term economic factors.  And here it is important to realize that this is a CASH business – NOT a CREDIT business.  Because PCS charges cash upfront, there are no collections or bad debt to worry about like on the postpaid side. 

 

 

PCS’ quarterly numbers are very difficult for investors to sift through.  The business is very seasonal, with numbers looking far better in Q1 and Q4 than in Q2 and Q3.  Again, the nature of the business is that people start up service when they have cash after the holidays, and tend to drop off during the summer months for reasons mentioned earlier.  The company pre-released Q2 08 subscriber figures and investors sold off the stock rapidly.  Investors are concerned that the economic environment is taking its toll and that the company’s legacy, “core” markets are suffering.  However, I think it’s important to recognize that one quarter does not make a trend and historically the company has missed/beat analyst expectations by a wide margin.  One has to examine the company’s results more closely to see that the fundamental business trajectory has remained unchanged over time, and that its growth prospects remain robust and achievable.

 

 

In September of 2007, PCS made a stock for stock (2.75 ratio) offer to merge with Leap Wireless (LEAP), implying a 65.4%/34.6% ownership split.  Leap operates a very similar prepaid, unlimited minutes model, but targets less urban areas.  Investors immediately bid up the shares of both companies and took the ratio to 3.30x+, believing PCS to give up a larger number of shares.  However, as both companies are in the midst of launching new markets (discussed below) and Leap was about to restate some financial results, merger discussions fell through.  It is my estimation that a merger will NOT take place in the near term (i.e., the next 1-2 months).  Rather, I believe both companies have every incentive to finish their respective new market build outs to try and jockey for a bigger share of the pie.  The merger undeniably makes a tremendous amount of sense, as there are clear synergies between the two companies (PCS conservatively estimated approximately there would be $2.5 billion NPV of synergies on account of nearly identical business models, contiguous but not overlapping operating regions, etc.), but timing is a real concern for investors.  A great deal of the trading of these stocks over the past few months has been on merger speculation.  Currently, however, the share ratio between the two companies has collapsed to below 2.60x, implying investors do not see a merger taking place in the very near term.  I think this suggests that buyers at these levels are purchasing a cheap option on a very accretive merger deal if it happens sooner than investors expect. 

 

 

PCS divides its business into “core” markets, which it has been operating since 2002, and “expansion” markets, which it began to launch in 2005.  It is these expansion market launches that drive my projections – NOT aggressive metric assumptions.  The company currently has approximately 60 million Covered POPs (the number of people in a particular region that the company’s network serves) as of the end of Q1 2008.  I project this will increase to just over 70 mm by the end of 2008 and to nearly 100 mm by the end of 2009.  Here is a rough schedule of major projected market launches.  Through my discussions with management and other related industry professionals, I think there is a potential for the company to launch New York and Boston early, providing upside potential to current analyst expectations.  In addition, due to their densely populated footprints, I believe that penetration (Ending Subscribers/Covered POPs) of these markets could exceed historical growth patterns of those found in legacy, core markets.

 

Since it is difficult to post entire models on VIC, I will try and lay out my primary operating metric assumptions, which I believe to be conservative, so that fellow VICers can decide for themselves.

 

ARPU: I project flattish to very slight growth going forward, reflecting competition and modest price inflation.

CCPU:  I project CCPU to remain at the mid $18 level for the next two years or so as the company completes its market build-outs.  Then I project it will begin to decline to the mid $15 range (current CCPU in more established core markets is at ~$15).

Churn: I project churn to remain elevated in the current economic environment and as the company launches new markets, eventually reaching a steady state of ~4.5%.

CPGA: I project modest growth in CPGA costs, again, as the company builds out its markets. 

Penetration/Subscriber Growth: I project approximately 50 bps of incremental, annual penetration for the next several years in the core markets, tapering off to 25 bps and capping total market penetration at 14-15% (from ~10.5-11% currently)

Historically the company has experienced penetration rates of 5% in less than 12 months in every new market it has launched.  I have tried to haircut this assumption slightly, and then track penetration on a curve similar to that of historical growth rates in core markets. 

CapEx: Consistent with company projections, I assume that it costs approximately $20.00 per Covered POP to build out a market (though I caution investors to look at historical statements, as some of these costs, even those of New York, Boston, etc. have already been spent).

 

The company projects EBITDA to be between $750-850 mm for 2008.  Consensus is for $800 mm in 2008, $1,000 mm in 2009, and 1,500 mm in 2010. 

 

For reference, my own projections are roughly in-line with consensus for the next several years, but I think the thing that investors are missing here is that it does not take Herculean effort, or aggressive assumptions, for PCS to achieve this level of growth.  I encourage investors to build a simple model to test what happens when you grow Covered POPs from 60 mm to over 100 mm in less than 24 months, rather than simply look at the implied 2008 EBITDA multiple and say “A wireless carrier in a recessionary environment trading at 9x 2008 EBITDA?  I’ll pass.”  Once PCS has built out its markets, and begun to normalize its spending, the company will easily be throwing off well over $1,500-2,500 billion of EBITDA, with real room to grow, and investors have a cheap option on a very accretive M&A transaction. 

 

Finally, one valid question is: Why PCS and not Leap, given their similar business models and the M&A opportunity for Leap?  In the past I had reservations about Leap’s capital position vis a vis its build out plans, but Leap has since successfully raise debt to fully finance itself.  I’ve spent a long time looking at both companies, and go back and forth deciding which one I like better.  However, I’ve decided that it is better to debate the overall opportunity rather than the relative merits of each company, though I’m happy to do so on the forums here.  The real question is: Is a low-cost, prepaid, unlimited wireless model a sustainable one?  Here I hope I’ve helped to make the answer more clear.