Going Long Leap Wireless: More Than A Leap Of Faith



Seeking Alpha
Churn at the company's core Cricket Wireless business is 3.7%, versus 4.6% for Leap Wireless's overall customer base. While churn at Cricket Wireless rose from 3.5% in Q4 2011, Leap substantially reduced its spending on customer retention, and Jerry ...




At first glance, it may seem odd that we are buying shares of Leap Wireless (
LEAP


). Given our focus on investing in secular growth trends, why would we wish to have exposure to an unprofitable wireless carrier saddled with billions in debt? The answer, however, can be found in one of the strongest secular growth trends of the past few years (and of the years to come): the continued growth in demand for wireless spectrum, something Leap has far more of than it can use. In our view, Leap Wireless is likely to part with a good deal of its spectrum in the intermediate future. That, combined with a slow, but continuing turnaround, should serve to underpin the company's share price, and deliver value to new investors in Leap Wireless. Unless otherwise noted, financial statistics and management commentary used in this article will be sourced from one of three places:


  1. Leap's Q4 2012 earnings release



  2. Leap's Q4 2012 earnings conference call



  3. Leap's 2012 10-K



Q4 2012 Review: Signs of Incremental Progress
Just as was the case with Sprint (
S


), Leap's own turnaround is not something that is occurring in a straight line. Each quarter contains signs of progress, and signs of how much progress must still be made. And Q4 2012 was no different.
Leap posted a loss of 96 cents per share, easily beating
consensus estimates


by 61 cents. Revenue of $755.978 million, however,
missed by almost million


, and Leap Wireless fell sharply on the back of its earnings release, due in large part to the fact that the company lost 337,000 subscribers, versus a loss of 269,000 in Q3 2012. However, buried within Leap's Q4 earnings release were signs of incremental progress. Adjusted OIBDA rose by 9.68% to $148.191 million in Q4 2012, and full-year OIBDA rose by 6.86% to $601.166 million. And although total revenue declined by 1.49% to $755.978 million, gross profits rose by 1.75% due to a 132 basis point expansion in gross margins to 41.43%. ARPU also rose, from $42.09 to $42.73, but this was more than offset by an increase in both costs per gross addition (CPGA), from $238 to $363. However, there are several nuances to the year-over-year increase in CPGA. CFO Perley McBride stated on the company's call that,
"Total subsidy dollars for new customers in the fourth quarter were down $49 million year-over-year and $24 million sequentially. We continue to be prudent with our subsidy spend and will not overspend just to acquire customers. We are focused on acquiring the right customers, those who will stay with us longer. While total acquisition spending was down year-over-year and quarter-over-quarter, CPGA increased due to the lower customer activity in the fourth quarter. In fact, 90% of the year-over-year increase in CPGA was driven by volume. The remaining 10% of the increase was the result of increased dealer compensation as we supported our dealer network through this lower volume period."
Clearly, Leap's turnaround is incomplete. However, the company is aware of the need to continue restructuring. CEO Douglas Hutchenson, whom we have criticized before in large part due to his opposition to merging with MetroPCS (
PCS


), struck a different tone on the company's Q4 earnings call, noting the transformation that Leap is undertaking. The company is putting more and more emphasis on selling smartphones, and while this effort will yield long-term benefits, namely in the form of higher ARPU rates and longer customer lifetimes, it is pressuring gross subscriber additions in the near term. However, there are already signs of progress. Churn at the company's core Cricket Wireless business is 3.7%, versus 4.6% for Leap Wireless's overall customer base. While churn at Cricket Wireless rose from 3.5% in Q4 2011, Leap substantially reduced its spending on customer retention, and Jerry Elliot, Leap's COO, stated on the earnings call that churn would have been 50-60 basis points lower in Q4 2012 if Leap had been more aggressive in its customer retention. However, such a move would negatively impact the company's financial performance, and it is a trade-off that we believe is worth making. Leap is striking a balance between merely seeking as many gross customer additions as possible and ensuring that it acquires long-term profitable customers. COO Jerry Elliot stated on the call that 66% of Leap's gross additions in Q4 2012 came from other postpaid carriers; these gross additions were driven by continued improvements in Leap's device portfolio, and Leap expects to continue to improve its device financing programs to continue to attract postpaid customers to the company.
Leap forecast improving free cash flow through 2013, something that has been a key priority for the company. While Leap has positive operating cash flow, the company's free cash flow has been negative for some time, as required investments in its network outstrip its ability to monetize its customer base. CPGA is expected to decline sequentially in Q1 2013, and Leap forecast capital expenditures of $300 million for 2013 at the midpoint of guidance, down from $434 million in 2012 capital expenditures. Leap is set to spend $100 million in 2013 on its LTE networks, and CFO Perley McBride stated that the company has become more disciplined in its capital expenditures, with capital expenditures undergoing a strict internal review process. Achieving positive free cash flow is a key goal for Leap Wireless. But, we do not believe that investors need not fret about Leap's financial condition, or its ability to operate its business. We believe that Leap will either continue making incremental progress in its turnaround efforts, or that the company's wireless spectrum will render the issue moot.
The Hidden Value of Leap's Spectrum
Like all wireless carriers, Leap's business cannot function without wireless spectrum. However, in an industry scrambling for spectrum, Leap is awash in it, and much of the spectrum is going unused.
30%


of the spectrum that Leap holds is outside of its present markets, and even in markets that it operates in, Leap
is utilizing


just 40% of that spectrum. Both CEO Douglas Hutcheson and CFO Perley McBride spoke of the value embedded within Leap's spectrum. They noted the company has completed four spectrum exchange transactions since the start of 2010. These transactions have raised $120 million for Leap, and boosted the depth of its spectrum holdings to 23 MHz, up from 16 MHz, and CEO Douglas Hutcheson stated openly that, "our spectrum also has substantial value as we consider our alternatives."
As we have stated in previous articles on Leap, we believe that the company is discussing various options related to its spectrum, with an eye towards arriving at a strategic solution, something more meaningful than a mere spectrum swap or sale. As expected, analysts pressured Leap's management team on this front, trying to gain insight as to what sort of discussions the company has had regarding its assets. And while COO Jerry Elliot declined to give specific details, he did leave the door open to a meaningful spectrum deal, stating that "in terms of the kind of strategic activity level, the asset value, I think obviously, we've all seen a fair amount of strategic activity in the third quarter and now, even just recently, if you look at the asset values, I think it's fair to say that the prices -- the observed prices in the marketplace in the last few weeks continue to increase pretty significantly and so, that's encouraging. I obviously, can't really comment on specific conversations but in terms of an appreciating asset, I think there were some pretty recent reconfirmations that the asset does continue to increase in value and until we get to a place where we want to do something on the strategic side, as we've been trying to talk about for a while, driving free cash flow out of the business is first and foremost on our list of priorities."
Leap's spectrum is currently being valued at $1.947333 billion on its balance sheet, a year-over-year increase of 8.85%. And while Leap carries a substantial debt burden, there are two factors that serve to blunt the risk of this to Leap's shareholders.

  1. Leap trades at a slight discount to book value: Leaps' book value stood at $433.132 million at the end of 2012, giving the company a book value per share of $5.47 (based on 79,134,930 shares outstanding). Shares of Leap closed at $5.26 on March 1, 2013, meaning Leap trades at a price/book value of 0.962x.
  2. Leap's debt maturities are manageable: Leap's total debt load stood at $3.302463 billion at the end of 2012. However, only $4 million of this is due within the next 12 months. $258 million in debt is due in 2014 and 2015, $1.108 billion is due in 2016 and 2017, and $1.98 billion is due in 2020 and beyond. Leap has ample room to fortify its balance sheet, and with $674.976 million in cash & investments, the company has, for the time being, enough capital to continue investing in its turnaround and drive positive free cash flow. In addition, Leap is in the process of
    syndicating


    a new term loan facility to refinance its 2014 and 2016 debt, which will further ease the medium-term pressure on Leap's balance sheet.

A Note on iPhone Inventory
In its 10-K, Leap noted that it has sold fewer iPhones than it expected to in 2012, and that by June 2013, the company could end up with $100 million in additional iPhone inventory [if Apple (
AAPL


) enforces the terms of the contract], which would add further pressure to Leap's balance sheet. Because Leap sells the iPhone without a subsidy, it is harder for Leap to sell the device than it is for traditional carriers such as AT&T (
T


) and Verizon (
VZ


). However, we do not believe that this will be a long-term issue for Leap. The company
notes


that the terms of its contract with Apple allow it to lower the sale price of the iPhone, and COO Jerry Elliot stated on Leap's Q4 call that Leap will be able to meet its iPhone commitments without an adverse impact to its balance sheet. Leap has also
said


that, "the demand [for the iPhone] is there…it's our out-the-door price that needs to be addressed." The company's expanded device financing program is expected to increase iPhone sales, and the company
stated


that it is working with Apple to increase the effectiveness of its iPhone promotions and advertising. We expect more color on iPhone trends when Leap reports its Q1 2013 results.
Hedging the Risk of Leap with LEAPS
In our view, Leap offers more long-term upside potential than peers such as AT&T and Verizon. But with increased upside comes increased risk. Our thesis for Leap is predicated around the continuation of its turnaround, which is not something that will happen in one quarter, or even one year, and it will take time to unlock the value of its spectrum. That is why risk-averse investors should consider hedging an investment in Leap using LEAPS options.
Investors can buy Leap's January 18, 2014 options to create a collar around Leap's shares, thereby limiting their downside risk (but also capping potential upside). Prices shown below are accurate as of the close of trading on March 4, 2013.
Leap Wireless Collars
$5 Put & $10 Call $5 Put & $7 Call $7 Put & $10 Call
Share Price $5.26 $5.26 $5.26
Cost of Put $1.19 $1.19 $2.50
Sale of Covered Call -$0.22 -$0.65 -$0.22
Net Cost $6.23 $5.80 $7.54
Maximum Profit -19.74% -13.79% +32.63%
Maximum Loss +60.51% +20.69% -7.16%
% Change Needed to Break Even +18.44% +10.27% +43.34%
All three of the potential collars shown above have positive and negative aspects. For example, while the $5 put/$10 call collar allows for up to 60.51% profit, investor losses are capped only near 20%, a level some may find too high. The $5 put/$7 call collar requires a move of just over 10% to be profitable, but caps profits at under 21%, a level that some investors may deem too small to bother with. And the $7 put/$10 call collar requires a move of over 43% just to break even, but caps losses at just over 7%.
Conclusions
Investors looking for stability and income in the telecommunications sector should look beyond Leap Wireless. But for investors with a tolerance for risk, we believe that shares of Leap Wireless could be a good addition to their portfolio. Leap Wireless is making progress on its turnaround, and while there is a good deal left to accomplish, we believe that in 2013, Leap will continue to make incremental progress in accomplishing its turnaround. And Leap has far more spectrum than it needs to operate its day-to-day business, and its management team has consistently hinted that it is exploring ways to monetize that spectrum. With Clearwire (
CLWR


) set to be taken over by Sprint [or DISH (
DISH


) if it is able to outmaneuver Sprint], Leap Wireless is one of the last remaining standalone sources of wireless spectrum. And with
almost 19%


of Leap Wireless's float sold short, any news of tangible progress relating to Leap's turnaround or the monetization of its spectrum is likely to spark a rally in the company's share price. We believe that Leap will be able to turn itself around and deliver value to new investors, and that risk tolerant investors should consider adding to or initiating positions in Leap Wireless.