erbert Spencer coined the phrase “survival of the fittest” to describe the process of evolutionary transformation. The wireless industry is going through a transformational change due to consumers’ substantially increased appetite for mobile data and internet services. Due to this transformation, wireless carriers require additional spectrum, network coverage and capacity to meet customer demands.
As the wireless industry evolves it will likely continue to be dominated by several providers who possess the spectrum bandwidth, subscribers, and access to capital to allow them to continue generating strong profits. But there are many ways to look at wireless companies from the perspective of fixed income investors: while some companies may lack the access to capital that can pay for additional spectrum and upgrades to their systems, they may own valuable spectrum that provides more than adequate coverage for outstanding debt.
Investors in this space need to be mindful of various metrics, including companies’ access to wireless spectrum, level of financial leverage, debt maturity profile, access to liquidity, operating profit as well as their respective business models.
Wireless Consumer Revolution
The wireless phone industry in the United States has seen significant growth over the last decade. The number of wireless subscribers has grown from 177 million in 2004 to over 300 million in 2012 (Figure 1). Consumers are increasingly substituting mobile phones for land lines, or “cutting the cord.” This resulted in a 5.9% percent decline in landlines in service over the last year.
More recently, smartphones have begun to displace feature phones as the wireless device of choice for the American consumer. Over half of the mobile phones in the U.S. are now smartphones (Figure 2) and mobile data usage has more than doubled over the last year according to Nielsen. These smart phones are spectrum hogs, using approximately 24 times more bandwidth than regular cell phones: Tablets can use up to 100 times more bandwidth.
Responding to the increase in demand, the wireless industry has invested heavily in infrastructure, including wireless towers, transmission equipment, backhaul networks and handset subsidies. In 2012 alone, wireless carriers spent over $25 billion in capital expenditures related to wireless infrastructure and over the last decade total spending approached $180 billion according to data aggregated by Bloomberg. If we include wireline assets used to support wireless networks, the numbers are even larger. While some of this spending is funded by internally generated funds, much of it is financed by debt, allowing fixed income investors to participate in this growing industry.
The inputs into our evaluation of credit risk include the initial state of a firm, the current operating conditions and how these conditions may evolve, potentially altering the competitive landscape or business models. To do this, we begin with an understanding of air pathways, or wireless spectrum.
Mobile phone communication is transmitted over the air from towers to individual handsets through electromagnetic waves at various frequencies, similar to radio or television broadcasting. There are a number of parts to the wireless transmission equation: spectrum for the calls or data to travel through, towers that bring a signal closer to a user and technology that allows a carrier to deploy the highest level of service. Carriers with access to spectrum, large networks of towers and the latest technology are able to better serve more customers. Without access to unused spectrum, wireless carriers are forced to deploy additional capital to accommodate increases in traffic. Without access to both spectrum and capital, a wireless carrier will be unable to improve its network and may face slow data speeds or dropped calls, resulting in uncompetitive offerings.
The Federal Communications Commission (FCC) regulates and controls wireless spectrum in the United States. Since 1994, the FCC has conducted 87 spectrum auctions to sell the right to use various spectrum frequencies to wireless carriers and other industry participants. Values for wireless spectrum have increased over time as demand for spectrum has increased and the availability of unused spectrum has decreased.
Today, the top four wireless carriers have access to approximately 53% of the U.S. wireless spectrum. In light of forecasts for increasing data demands which (expected to exhaust currently unused spectrum holdings) in 2010 the FCC presented the National Broadband Plan to Congress. This plan called for freeing up an additional 300 megahertz (MHz) of spectrum for wireless broadband use by 2015 followed by an additional 200 MHz by 2020. As it executes this plan, the FCC will need to consider its multiple objectives of fostering competition, meeting consumer demands and ensuring public safety and homeland security.
In addition to spectrum, wireless companies’ business models and business fundamentals are determined by capital structure and access to liquidity. Despite the telecom industry’s reputation for being relatively stable and defensive, a number of wireless companies are in a position of weakness due to their lack of spectrum. Subscribers and spectrum holdings are concentrated amongst a few wireless players in the U.S. The four largest national carriers hold over half of the available wireless spectrum and almost 70% of the higher quality spectrum. The same four carriers account for over 90% of all U.S. subscribers. There are 11 U.S. wireless companies that issue debt securities and all but three of them are high yield issuers, leaving these companies at a potential disadvantage should they need to raise more capital to acquire additional spectrum.
That said, a fundamental analysis of wireless companies also includes rigorous analysis of all of the companies’ assets, including spectrum, particularly for companies at risk of going into bankruptcy.
Telecom companies have historically gone through stages of upgrading infrastructure broadening spectrum portfolios.
Many U.S. consumers just recently purchased their first smartphone, but the battle for airwaves utilized by these phones has been brewing for years. The newest smartphones use a technology called 4G LTE, or Long Term Evolution, which offers faster speeds and more efficient network utilization. Wireless carriers in the U.S. are scrambling to upgrade their networks to LTE to be able to offer competitive services and market their broad LTE coverage. The rise of smart phones, tablets and wireless data enabled laptops has put additional demands on wireless networks.
The larger, well capitalized telecom companies have for the most part upgraded their networks to enable them to handle newer technologies, but these companies continue to look to acquire spectrum. On the other hand many of the smaller, lower-rated wireless companies and those with over-leveraged balance sheets may find themselves at a competitive disadvantage; some have altered their business models and given up on being a nationwide carrier either by signing roaming agreements or by engaging in spectrum swaps to enhance their competitive positions in their niche markets.
Spectrum positioning, network coverage and capacity, capital structure, access to liquidity and business model characteristics are all inputs in the determination of a company’s churn-adjusted cash profit per user (CACP). CACP is calculated using average revenue per user (ARPU), cost per gross addition (CPGA), churn and cash cost per user (CCU).
CACP when combined with an analysis of the capital spending required to sustain those profits is a key determinant of lifetime subscriber value, which is in turn an important indicator of a company’s ability to grow profitably.
Over the past decade, the churn adjusted monthly cash profit per user has declined for all wireless carriers. Recently, for the largest U.S. wireless carriers, this trend has subsided. Smaller, newer U.S. wireless carriers are in a more strenuous and defensive position in today’s dynamic, competitive environment.
Companies that are unable to adapt to consumer demands and who are highly levered will have a greater risk of economic failure. In such cases, investors will need to determine the effect of a potential bankruptcy filing on a company’s business as well as its rights to retain spectrum licenses granted to it in previous auctions or transferred via spectrum swaps. Recently, several bankruptcy courts have come to different conclusions when addressing the issue of the validity of liens on the proceeds of FCC spectrum licenses. This uncertainty could cloud the value of collateral packages within the communication sector, making financing potentially more challenging. As with any investments in high yield issuers, it is important to assess the value and ownership of company assets from all angles including how a bankruptcy is likely to play out in the courts and what is likely to be returned to bondholders.
Consumer Revolution Driving Wireless Evolution
Recently, investors have witnessed another consolidation phase amongst U.S. wireless carriers. These combinations are a by-product of the consumer revolution; wireless companies, to better cope with consumer demands and to maintain a competitive advantage, are increasingly considering the benefits of strategic positioning and scale (which may include superior spectrum positions and network capacity as well as cost synergy benefits). The evolution of wireless business models may drive further combinations and partnerships. In addition, emerging entrants will need to consider spectrum and network efficiencies in a more complex setting.
It is also important to identify the beneficiaries of wireless network upgrades, namely the wireless tower industry, other suppliers of wireless network infrastructure, and ultimately the end user – the consumer.
Given the technological and competitive risks faced by companies in the wireless communications industry, we believe it is prudent for bondholders to identify companies that have access to ample wireless spectrum and that have the financial flexibility to effectively utilize that spectrum with LTE technology. Finally, bondholders must ensure that they are being adequately compensated for the risk that a company gets left behind as the industry evolves.