Wednesday, August 10, 2011

Smartphones could solve prepaid carrier problems

MetroPCS and Leap Wireless reported disappointing earnings last week. MetroPCS stock plummeted after missing analyst estimates by 20%, dragging down Leap with it.

MetroPCS has been a hot stock. It’s the fifth largest cellular network operator — only MVNO TracFone and the Big Four are larger — and has the fastest growing network. It’s been aggressively advertising in its local markets, and through a roaming agreement with Leap claims to provide (voice) coverage for 90% of the US population.

Its Q2 results were not all bad — with 19% YoY increase in subscribers, and an “adjusted” EBITDA up 11% over Q1.

With the bad news, the stock has lost its high-flying multiple. Since the Aug. 2 bad news, it’s dropped almost 50% below where it traded since May.

Some were quick to announce MetroPCS’s impending doom. In Fortune Scott Woolley wrote:
The question now is, can the company's stock claw its way back? Yesterday's tumble reflects increasingly visible cracks in the budget provider's armor.
Certainly costs per subscriber are rising faster than ARPU.

At least MetroPCS is showing a profit. The shares of Leap (operator of the Cricket network) fell 32% after its quarterly loss more than doubled compared to a year ago. The stock had already fallen 20% due to fears raised by the MetroPCS disappointment.

Why are the two discount prepaid carriers facing such problems now? One factor mentioned is that they are facing increased competition from #3 carrier Sprint. Certainly its Virgin and Boost brands are aggressively competing with unlimited service plans in the $40-60 range that directly target the two prepaid carriers. (Interestingly, all three are CDMA carriers, and of course Leap is a Qualcomm spinoff).

I see a different problem. Thanks to the iPhone success, almost every man, woman and child wants a smartphone, which in the US today means either the real thing or the Android substitute.

While the iPhone remains exclusive to the Big Two, Virgin has a good range of (slightly delayed) Sprint Android phones which has enabled it to grow rapidly. From my own brief experience as a MetroPCS customer last week, its Android offerings do not yet measure up.

It’s clear that MetroPCS knows that Android is crucial to its near-term success. Both CEO Roger Linquist and COO Thomas Keys talked extensively about Android phones during its earnings call last week. So if this is only a temporary problem — with “good enough” phones coming down the road — then subscriber growth and earnings may turn around.

Meanwhile, for more than a year Leap has needed the scale that its larger and faster-growing rival could provide by acquiring it. With its smaller subscriber base and incompatible data strategy, it will have even a harder time getting the latest Android phones.

Both MetroPCS and Leap are beneficiaries and victims of commoditization: they are using price to compete, but need acceptable quality commodity (i.e. Android) smartphones to be attractive to prospective subscribers. The decision of the Big Two to end unlimited data plans creates an opening for both if they have the right products.

The collapse of the MetroPCS stock makes it less likely that the long-fought merger will happen. For antitrust reasons, I think it unlikely that Verizon would be allowed to buy either carrier, and so far Sprint has been too sickly to consider further acquisitions.

I believe the next 18 months are crucial for both companies: if their offerings are considered comparable to the (non-iPhone) offerings of the Big Four, then their subscriber and ARPU growth will continue. Otherwise, they may become cheap enough for even Sprint to afford them.

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