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JANUARY 9, 2004 • Editions: N. America / Europe / Asia / Edition Preference

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By Kenneth Leon

Better Connections for AT&T Wireless
After the No. 2 wireless carrier's rough patch, S&P sees more promise for it as it sheds costs and improves operations

After hitting a 52-week high of $9.10 on Sep. 8, AT&T Wireless (AWE ) shares fell around 20% as software and network glitches disturbed customer billing and support services. These problems received a great deal of attention and hurt the stock price. Meanwhile, the Federal Communications Commission rule on number portability went into effect on Nov. 24 and should increase competition.


In the last few weeks, however, AT&T Wireless shares have edged higher, to around $8.15 on Jan. 9, and we at S&P believe the wireless carrier may show signs of better execution in the year ahead. One recent news story that helped lift the stock said that Cingular Wireless, a partnership between SBC Communications (SBC ) and BellSouth (BLS ), is interested in merging with or acquiring AT&T Wireless (see BW Online, 1/8/04, "Cellular Stocks: This Year, Tread with Care").

Looking out 12 months, we believe AT&T Wireless and the industry will remain attractive as growing EBITDA (earnings before interest, taxes, depreciation, and amortization) and earnings support high multiples, bolstered by key industry drivers.

In part based on the findings of our Dec. 11 study on local number portability, Standard & Poor's Equity Research sees wireless substitution from landline as a major long-term opportunity. We believe that carrier loyalty may be challenged as consumers turn to price and convenience. We expect aggressive bundling strategies from carriers, particularly landline and wireless services under one plan, as they try to reduce customer churn. We believe wireless-services pricing may hit a speed bump with number portability and then stabilize by mid-2004 or sooner.

TIGHTER SHIP. To most investors, AT&T Wireless is a "show me" story. With the focus on recent software and network glitches, we believe they may be overlooking significant cost reductions that are under way. During 2003's second quarter, AT&T Wireless launched a companywide initiative called "Project Pinnacle" to improve operating efficiency and reach its goal of industry-leading margins in 2005. It's eliminating 1,900 employees as it consolidates national corporate functions in Redmond, Wash., and northern New Jersey.

With the launch of number portability, some wireless carriers are extending weekend calling rates to Friday, while others are increasing handset subsidies. AT&T Wireless had some operational problems in porting phone numbers to other carriers. While this is an embarrassment that may hurt its reputation, we don't think customer volumes tied to number portability are material.

We believe that AT&T Wireless, the second-largest U.S. provider of wireless personal-communications services in terms of revenues, can regain its competitive position in the market, mitigate any further market-share loss, and drive profits higher with its cost-cutting. It's not positioned to take advantage of bundling like most of its competitors with affiliate wireline operations in local, long-distance, and Internet services. In our view, AT&T Wireless' No. 1 objective is to strive for stronger execution so that it can be recognized as a wireless industry leader in network quality and innovation in customer services and support capability.

BETTER METRICS. AT&T Wireless provides wireless voice and data services over two separate, overlapping networks. One uses time division multiple access, or TDMA, as its signal transmission technology. The other uses technology known as global system for mobile communications, or GSM, and general packet radio service, or GPRS.

As of Sept. 30, AT&T Wireless' two networks within its consolidated markets covered an aggregate population of approximately 224 million customers, or 77% of the U.S. population, and operated in 87 of the 100 largest U.S. metropolitan areas. By the end of 2003, we believe its ability to run both its TDMA and GSM/GPRS networks will be less of a drag on earnings as it migrates more of its subscribers to the GSM/GPRS network and the new 2.5G handsets. The network upgrade to GSM/GPRS is mostly complete. In our view, this may show up in widening EBITDA margins.

In 2004, we think AT&T Wireless should show material improvement in many operating and financial metrics. We expect it to show quality growth with higher average revenue per user (ARPU) from enhanced data services and wireless substitution of landline services. EBITDA service margins may plateau during the early months of number portability and then expand in the second half of 2004. Finally, AT&T Wireless is improving its balance sheet and driving free cash flow.

TARGET: BIG SPENDERS. We expect service revenues to grow 8% in 2004, to $17 billion, assuming a $61 to $62 ARPU with pricing stabilizing after the initial six-month period of number portability. Among its 21.8 million customers (as of Sept. 30), AT&T Wireless is intent on pruning some of its low-usage, unprofitable subscribers. Its focus is on expanding the more profitable high-end home and business subscribers. We believe its EBITDA service margins will remain in the 29% range, as marketing expenses may move higher during the first six months of local number portability.

AT&T Wireless finished the September quarter with $4.3 billion in cash and generated $1 billion in free cash flow. Our 12-month target stock price is $9, based on forward price-to-sales, price-to-book value, and enterprise-value-to-EBITDA analyses. With the shares trading at a discount to peers on forward price-to-sales, we would recommend that investors accumulate AT&T Wireless, based on our view of a profitable outlook.

We see it striving for network quality and reach, as well as improving customer billing and support in the next 6 to 12 months. Maximizing profitability and free cash flow are important financial objectives, followed by strong net subscriber additions, in our opinion. The challenge for AT&T Wireless, we believe, is that price competition will continue to be a key factor when customers are deciding whether to switch to another carrier.

Note: Kenneth Leon has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Analyst Leon follows wireless telecommunications stocks for Standard & Poor's Equity Research
Edited by Karyn McCormack

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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