The U.S. Wireless Industry Study: Connecting to Free Cash Flow
Chris Diceman, CFA; Rory Buchalter, CFA/416-593-5577 ext. 2242, ext. 2268/cdiceman@dbrs.com
In a newly released study, DBRS notes that for the first time in the 20-year history of the U.S. wireless industry, this year will be a turning point, with wireless companies now in a position to generate free cash flow. DBRS estimates five of the top eight carriers will generate free cash flow for the first time this year, with the remainder achieving this goal by 2005. The eight wireless carriers included in the study account for nearly 90% of the market, which was approaching 150 million subscribers at June 30, 2003. These include: (1) Verizon Wireless (25% market share); (2) Cingular Wireless LLC (15%); (3) AT&T Wireless (15%); (4) Sprint PCS (10%); (5) Nextel Communications (8%); (6) T-Mobile USA (8%); (7) ALLTEL Corporation (5%); and (8) United States Cellular Corporation (3%).
In this study, DBRS concludes that the U.S. wireless industry falls into in the BBB range, supported by its strong operating results and improving free cash flow. However, the industry remains below the “A” range, due to intense competition. The “A” range is typically where the incumbent wireline telcos fall. Individual wireless company ratings can vary from the BBB level depending on their specific circumstances. For example, some companies have operational and financial support from an incumbent wireline operator, or have achieved size and scale, that can support ratings in the “A” range.
The industry is clearly undergoing a strategic shift as it matures. This is forcing it to change its focus from growing market share at all costs, towards subscriber retention and profitability, albeit with slower subscriber growth. This will ultimately lead to improved free cash flow. This change in focus has modified previous industry aspirations of achieving wireless penetration levels in the 75%-80% range, down to more modest expectation of about 65% by 2008. This assumes prepaid levels remain near 5%-8% and a gradual 3G roll-out.
Future cash flow growth will be driven, in large part, by two factors: (1) continued operating cash flow growth; and (2) reduced capex levels. Operating cash flow growth is expected to remain strong, driven by four key areas: (1) subscriber growth; (2) relatively stable ARPU levels supported by growth in usage; (3) an increased focus on subscriber retention; and (4) lower operating costs as networks become more efficient. However, potentially pressuring this growth is expected to be: (1) higher churn levels initially with wireless number portability being implemented in November 2003; and (2) no significant reduction in subscriber acquisition costs (CPGA) with most carriers continuing to focus on luring high-value postpaid subscribers.
Capex levels are expected to decline for most carriers going forward with the completion of footprint expansions and 2.5G network upgrades. As a result, capital intensity will fall to below 20% of revenue for all of the carriers. However, over time, these lower capital spending levels will need to include the costs for new spectrum, which could be significant and require new funding.
Overall, free cash flow for the U.S. wireless carriers should grow significantly over the next five years. This growth in free cash flow will be important, if companies are to improve their financial strength prior to large spectrum acquisitions and network build requirements for 3G roll-outs. In addition, the carriers may revisit consolidation strategies during this period, given: (a) lower subscriber growth rates going forward; and (2) improved valuations. Ultimately, the carriers will need to consider potential partnerships to provide greater scale and efficiencies prior to the large, national roll-out of high-speed 3G data network overlays expected over the next five years.
Dominion Bond Rating Service Limited (DBRS) has published a study that provides additional analytical detail. To see this study, please click on http://www.dbrs.com/web/sentry?COMP=2900&DocId=130181. If you do not have access to this study, please contact us at info@dbrs.com.