Capital Markets

Capital Projects: Wireless Market Hits a Speed Bump

Why are wireless firms struggling to raise money?
Joseph RadiganOctober 26, 2000

What did Verizon Communications’ decision to cancel the initial public offering for its wireless division tell us?

Was it a.) a sign that the wireless telecom sector is a victim of its own success?

Was it b.) the direct result of the market turmoil that has plagued investors and issuers alike for the past six months?

Or was it c.) a combination of the two?

If you picked c.), you’re on to something. For several years, the wireless sector’s growth in the U.S. has been on steroids, working furiously to narrow the huge lead held by Europe and Japan, where cell phones are virtually ubiquitous.

In fact, growth since 1998 has been so rapid that by the end of this year, market penetration is projected to approach 40%. The problem is, growth has been so heated, it’s almost been inevitable that it would cool off.

During the time that this torrid growth was taking place, cell phone carriers and equipment providers were shelling out approximately $60 billion in capital expenditures 1998 and another $72 billion in 1999 to build the wireless infrastructure, according to Meggan Walsh, the senior portfolio manager for several funds with stakes in wireless and telecom stocks at AIM Advisors in Houston. Wireless carriers are projected to spend at least as much this year as they did last year, and there’s no end in sight to the huge bills.

The heavy spending prompted wireless carriers to tap the public markets to help them foot the costs. For example, earlier this year, AT&T Wireless’ $10.6 billion initial public offering was the largest such equity offering in U.S. history. But AT&T Wireless’ offering came just as the IPO market was running out of steam, and the shares made a poor connection with investors.

The weak performance of AT&T Wireless’ stock set a poor omen for the Verizon offering. It didn’t help that, as Walsh said, there’s a supply-demand imbalance in the market for the securities of wireless companies. The capital markets simply can’t absorb all the issues that are hitting them.

“There’s too much paper both on the debt and the equity side,” Walsh said. “We have to work through that.”

Keep in mind that the Verizon stock offering hasn’t been cancelled permanently, only delayed. The company is expected to return to the IPO market in 2001. If it were simply a matter of waiting an extra six months, that would be one thing, but as Mike Eggly, co- manager of the Northern Technology Fund and Northern Global Communications Fund in Chicago, said, at least three other huge IPOs are waiting in the on deck circle.

Deutsche Telekom, France Telecom and Telefonica are all planning stock offerings for their wireless businesses, and while the international nature of the offerings underscores the global scope of the wireless business, their timing so close together exceeds the appetite of international investors to absorb all of them at once.

The glut of offerings is compounded by growth forecasts that, while still rapid by conventional standards, are somewhat lower than the peak growth of the past two or three years.

“We will not see growth that meets Wall Street expectations,” said Eggly. “A lot of the easy growth has been found. But not everybody can spend $75 per month on their cell phone. There still is growth. It’s just a question of how much growth is left.”

The market’s unease can also be traced to investors’ displeasure with some of the business fundamentals at wireless firms.

Subscriber growth is still strong, but Walsh said it hasn’t matched the bullish forecasts bandied about earlier in the year. “Some drivers have not come through,” she said.

If investors had only to contend with disappointments in subscriber growth that would be one thing, but almost all the metrics used by investors to value these stocks are giving them cause to worry.

For example, revenue per user per minute, or RPUs is projected to decline from $0.18 this year to $0.09 by 2005.

Wireless companies are betting that extra services, particularly with the advent of third generation, or 3G, wireless, which is another name for the mobile Internet, will keep the RPUs from falling further, and may even drive the number back up. But the services aren’t available yet, and in the meantime, analysts and investors have to value these stocks based on the services that are already commercially available.

That said, market penetration is strong and getting stronger. Walsh notes that five years ago, market research called for a wireless sector that would penetrate 55% of the customer base by 2010. The actual performance has exceeded the most bullish of those forecasts.

Walsh cited figures from the Cellular Telecommunications Industry Association that said there would be 214 million cellular handsets in use by 2005 compared to 107 million at the end of this year.

Growth was so fast in 1998 and 1999 that it’s now expected that wireless penetration will grow from its current level of 38% of the market to 75% by 2005. Unfortunately, the wireless market is a victim of its own success. The explosive growth of last year and the year before can’t be sustained, and while the growth is still tremendous by most traditional measures, the rate of its acceleration is tailing off.

Walsh said investors are also concerned by a churn rate of 2% per month. That is, 2% of the total subscriber base switches carriers each month. Until 3G services come on line, or wireless carriers get more creative with products making use of current technology, the churn rate is going to remain uncomfortably high.

“The stickiness of extra services haven’t come through yet,” Walsh said. “The expectations are that stickiness will improve.”

Perhaps the most nettlesome issue is the huge capital expenditures the industry is confronted with, not only for new equipment but also for government auctions of 3G spectrum both in the U.S. and overseas. On Monday, Italy’s government raised 12.5 billion euros in a spectrum auction.

While wireless carriers only shelled out half the amount that had been projected in the Italian auction, Walsh said investors have been afraid that cellular companies will overbid for the spectrum as they did in European auctions earlier in the year.

That said, the markets were somewhat relieved when Verizon pulled its IPO last week.

“I would say the market is looking that and saying, ‘At least they’re being prudent not trying to raise capital at any cost’,” she said.

“The market is not expecting cap ex to drop off ,” Walsh said. “But in this environment, when you have weak psychology, at some point you want to get paid, and these companies are all spending and spending. If this were a positive psychology market, you’d look at these stocks and say that’s good that these companies are spending on the infrastructure.”

With the market’s current psychology anything but positive and the equity markets largely closed, that begs the question as to how the sector will fund its capital needs.

Marcus Jones, a high yield analyst with Moody’s Investors Services, said given the recent turmoil in the junk bond market, that spigot is largely turned off, too. Until the equity and debt return to health, the best alternative for telecom carriers may well be the syndicated loan market.

But even here, borrowers will need to be creative. Some, may find the doors open to them, and Jones cited Western Wireless as an example of a carrier that may find doors still open, but at a price.

The chief executive of the Bellevue, Wash. company is John Stanton, who is also CEO of VoiceStream. Before VoiceStream, he had been a senior executive with McCaw Cellular until it was bought by AT&T. Given his track record, lenders are a likely to be a little more flexible with Western than they’ll be with other borrowers.

Moody’s rates Western Wireless BA2, which Jones said is the higher end of the non- investment grade range. But he feels that the lack of an investment grade rating won’t prevent the company from tapping its lenders again.

In March, Western borrowed $2 billion in a syndicated deal led by Toronto Dominion. That was roughly the same time that AT&T Wireless had its IPO.

“People will lend John Stanton money because they know who he is,” Jones said.

But Jones said this is an investors market, in that they can dictate terms to issuers. Borrowers in syndicated offerings may have to spread their non-credit business – – such as treasury and cash management, stock transfer and bond trusteeship – – around with various members of the syndicate if they want a deal to go through.

“Typically, those bigger investment grade guys have more non cash business to toss around,” Jones said.

So how long will the static interfere with the wireless market? Eggly of Northern Funds said the problems could persist for two quarters or two years.

“My view is that the estimates will largely not be met in the coming quarters, although they’ll be close,” Eggly said. The sector won’t return to favor until new applications bring more customers into the market willing to spend a few extra dollars a month on wireless services.

Until then, you can expect to hear a lot of static in the wireless market.