Subject: [NEXTEL-1] Nextel Is DONE: With expenses set to soar, Nextel's earnings could be at a peak

From: [email-masked]
Date: Sat, 24 Jul 2004 17:54:10 -0400

Nextel Is DONE: With expenses set to soar, Nextel's earnings could be at
a 
peak 

By Jacqueline Doherty 

26 July 2004
Barron's
18
English

In just two years, Nextel Communications has gone from the brink of 
bankruptcy to an industry darling. The wireless company's shares, 
which changed hands at 2.78 in July 2002, closed Friday at 23.59. 
Those who bet on the company's ability to pay down its substantial 
debt and survive the market downturn have been duly rewarded. 

But now investors may have grown overly optimistic. Nextel needs to 
spend billions of dollars over the next few years to upgrade its 
systems. At the same time, deep-pocketed competitors have figured 
out how to offer walkie-talkie service on a cellphone, which has 
been Nextel's main attraction to users, and those rivals have 
Nextel's high-profit-margin customers in their sights. Costs from 
higher taxes, option expenses and higher marketing costs also could 
start to bite. As a result, this year may mark the peak in earnings, 
which could subsequently disappoint. 

"There are many red flags with Nextel," warns Susan Kalla, a senior 
telecom analyst at Friedman Billings Ramsey Group. "Cap ex is a 
problem and push-to-talk will no longer differentiate them. If they 
lose their uniqueness, they'll get dragged into price competition." 
Kalla recently dropped coverage of the company after downgrading her 
rating on the stock this spring to Market Perform. 

Nextel, with 14.5 million customers the sixth-largest wireless 
carrier, is known for its push-to-talk service that lets its 
cellphones double as walkie-talkies. The service originally caught 
on among construction workers and the like, but now it's also 
considered cool by the masses. Historically, the walkie-talkie 
feature has allowed Nextel to distance itself from the competition, 
attracting customers who spend more and stick around longer. 

The Reston, Va.-based company last week reported average revenue per 
handset of $70 in its second quarter, much higher than the industry 
average of $56. Customer churn, or the percentage of customers who 
disconnect their service, was 1.6%, below the average of 2.6%. 

As a result, revenues soared 29% to $3.3 billion in the second 
quarter, and Nextel reported earnings of $1.3 billion, or $1.17 
cents a share. Results got a boost in the quarter from a tax benefit 
of $726 million, or 65 cents a share. But even after the elimination 
of extraordinary items, the company earned 55 cents a share, well 
above the consensus estimate of 51, and far ahead of last year's 28 
cents. 

Nextel also is on sounder financial footing. At the quarter's end, 
it had $2.1 billion of cash, and long-term debt was down to $9.6 
billion, from $14.7 billion in 2001. 

Chief Executive Tim Donahue reaffirmed Nextel's pledge to deliver at 
least $2 a share in earnings this year, up 42% from $1.41 last year. 
That would give the company a price-earnings multiple of only 12, 
well below the 16 P/E on the Standard & Poor's 500, which isn't 
showing earnings increases as rapidly as the wireless provider. Yet 
despite the strong results and modest multiple, the shares have been 
stuck below 30, a level the stock approached in January but has yet 
to breach. 

Investors may be deterred by trends outlined in a report by Morgan 
Stanley's telecom analyst Simon Flannery, who has a price target of 
19. He forecasts a peak in Nextel's earnings this year with gradual 
subsequent declines, as laid out in a nearby chart. Revenue growth, 
in his forecast, will slow from more than 20% in '03 and '04 to more 
sedate levels below 10%. At the same time, expenses will jump. One 
cost that will increase is taxes. For years, Nextel has used net 
operating losses to eliminate tax payments; that's apt to end. In 
addition, accounting rules may change next year to require companies 
to expense stock options. In that event, earnings would be trimmed 
by 15 cents a share. 

Revenue growth could come under pressure from the saturation of the 
wireless market and from rising competition. About 57% of potential 
individual subscribers in the U.S. already have cellphones, and 
Yankee Group, a research and consulting firm, believes that number 
will top out at 75%. So far, the growth in the number of subscribers 
has more than offset the decline in the price of wireless service. 
But as subscriber growth slows, so, too, will revenue growth. U.S. 
wireless revenues, including data services, rose by 13% in 2002 and 
11% last year, but Yankee Group projects that gains will tail off to 
an average of 6.5% over the next four years. By 2008 growth is 
expected to slow to a mere 0.5%. 

"The wireless industry is in the process of maturing and all 
subscribers with good credit already have a cellphone," says Roger 
Entner, director of wireless-service practice at Yankee Group. 

Nextel's chief financial officer, Paul Saleh, disagrees. The 
industry will continue its healthy growth as first-time subscribers 
sign up, as customers continue to switch more of their calls from 
land lines to cellphones and as the delivery of data provides 
another area of growth, he says. 

Yet revenues could come under pressure on another front, as Sprint 
and Verizon Wireless, with walkie-talkie offerings of their own, go 
after Nextel's business. It was the specter of rising competition 
that prompted Barron's skepticism of the company's prospects last 
year ("Juicy Target," May 26, 2003), which has so far proven to be 
off the mark. The initial complaint about the competition's push-to-
talk service was the noticeable lag between when a call was sent and 
when it was received. But both carriers are expected to solve these 
problems, and the pause should be rendered less discernable by 
upgrades over the next year. 

CFO Saleh believes applications tailored by Nextel to different 
industries give the company a competitive edge. Police can download 
a suspect's image or a service provider can scan inventory or credit 
cards with attachments to their phones. "We don't compete on price. 
We provide value to our customers," he says. 

Nextel's entry into the prepaid calling-card market, however, could 
put an added squeeze on margins. So far, of Nextel's total 14.5 
million customers, 605,000 are part of the calling-card program, 
called Boost. 

Launched in California and Nevada, Boost targets younger customers, 
and Nextel plans to roll it out to seven new markets. The prepaid 
market will bolster revenues and increase the use of Nextel's 
network during off-peak time periods, when Boost users make about 
40% of their calls. But Nextel will need to get the cost per user 
down sharply if it hopes to make Boost customers as profitable as 
its existing business clients. The average revenue per unit for a 
Boost customer is in the mid-$30 range. So Boost customers, which 
generate only 2% of total revenues, brought down the average revenue 
per unit by $1 in the second quarter to $69. 

The toughest issue Nextel faces is one of technology. The problem 
dates back to the company's early years, when it purchased slivers 
of spectrum used by radio dispatchers across the country. That 
bandwidth, while sufficient for existing voice services and some 
minimal data service, can't currently deliver broadband data. Nextel 
uses a proprietary technology dubbed iDEN, or Integrated Digital 
Enhanced Network, developed by Motorola to weave together the slices 
of 700- and 800-megahertz spectrum Nextel owns. Other carriers bid 
on wider swaths of spectrum sold in government auctions, and they'll 
be upgrading systems to offer broadband over the next year or so. 
Verizon Wireless will roll out broadband in major U.S. markets by 
year end. 

One piece of the technology problem may soon be solved. Nextel's 
cellular service has long interfered with the radios used by public 
employees, such as police and fire fighters, because both use 800-
megahertz spectrum. After the Sept. 11 terrorist attacks, Nextel 
proposed a plan to swap its 800-megahertz spectrum for 1.9-gigahertz 
spectrum held by the federal government. That would solve a public-
safety problem, and, because the spectrum is nationwide and 
contiguous, it would be sufficient for broadband services. 

But competitors argued that the spectrum was going to Nextel at 
below-market prices and that it should be auctioned to determine its 
fair value. 

After two years of intensive lobbying and haggling, the Federal 
Communications Commission announced a compromise. Nextel would 
receive the new spectrum, valued by the FCC at $4.8 billion. In 
return, Nextel would return spectrum it owns, valued at $1.6 
billion. And the company would pay up to $3.2 billion to relocate 
affected users. If that cost were less than $3.2 billion, Nextel 
would pay the difference to the government. 

"Our focus was on public safety," says John Muleta, chief of the 
FCC's wireless- telecommunications bureau. "We feel we have made the 
right decision for the public interest and the wireless carriers." 
Verizon and the wireless industry's association disagree, contending 
the government is undervaluing the spectrum by billions of dollars. 
It's likely the matter will head to the courts. Nextel has declined 
to comment on the matter until the FCC publishes a formal order with 
all the details of the swap. The order is expected in the next few 
weeks. 

Besides spending on the spectrum swap, Nextel will have to deploy 
technology over the new frequencies to allow for broadband 
capabilities. Right now it's working with a number of companies. 
That includes Flarion Technologies, in which Nextel has an equity 
stake. Flarion's proprietary technology is expected to cost $2 
billion or so to deploy and would give Nextel the ability to offer 
consumers broadband access over their phones and laptops, at home or 
anywhere. And it would allow Nextel to compete with cable or DSL for 
Internet access. If the technology is successful, it could be a home 
run. If it isn't, the company may have to turn to alternatives that 
could cost more than $10 billion to deploy. "We're not testing your 
average technology, we're testing a disruptive technology," says 
Saleh. 

(MORE) 

Free cash flow -- operating cash flow minus capital outlays -- has 
been prodigious over the past year; it ran $1.2 billion in 2003 
alone and the company projects $1.7 billion this year. But it, too, 
could fade quickly as capital expenditures pick up. In the most 
recent quarter, free cash flow dropped to $73 million from $507 
million in the previous quarter as capital expenditures rose 42% to 
$583 million. The big spending, moreover, is in front of Nextel, not 
behind it. 

Nextel's CEO certainly isn't signaling his confidence in the stock 
price, having sold almost $20 million worth of stock in the past 
three months. CFO Saleh avers Donahue hadn't sold shares in a number 
of years and wanted to diversify his holdings: "The sales are not a 
reflection of his views on the company." That said, Donahue, who 
still owns more than 1.4 million shares directly, sold 100,000 
shares at $25.93 a share for proceeds of $2.59 million on July 6. He 
put an additional 333,334 shares on the market at $26.41 each for 
proceeds of $8.8 million on July 1, and on June 7, he disposed of 
100,000 shares at $24.02 each for a total of $2.4 million. He again 
sold 250,000 shares at 24.05 on May 12 for proceeds of $6 million. 

Investors might be advised to follow his lead. 

http://online.wsj.com/barrons/article/0,,SB109063295403372752-search,00.html?collection=barrons%2F30day&vql_string=DONE+With+expenses+set+to+soar%3Cin%3E%28article%2Dbody%29

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