Thursday, October 1, 2009

Leap Wireless (NASDAQ:LEAP) & MetroPCS (NYSE:PCS): Downgraded at JP Morgan

JP Morgan is downgrading shares of Leap Wireless (NASDAQ:LEAP) and MetroPCS (NYSE:PCS):

We are downgrading Leap Wireless and MetroPCS to Neutral from Overweight. We have become increasingly concerned with wireless fundamentals as the industry faces secular challenges, with high penetration and heavy competition causing downward movement on price and increased acquisition costs. We believe Leap and Metro have been forced to operate more and more defensively, and we expect to see additional ARPU erosion over time while long-term margin guidance could be challenging. ˇ

Competitive landscape poses challenges. Recent months have brought a slew of competitive announcements in the wireless industry, particularly at the low end from Tracfone and Sprint’s Boost Unlimited. Leap and MetroPCS, we believe in large part as a reaction to these new competitors, began offering additional features into existing price points in early August, effectively lowering pricing. Metro added to these features just yesterday, more than doubling roaming coverage. We are expecting additional competitors over time as well. For example, AT&T recently noted a prepaid trial it is running in a few markets; though at a large premium, we believe price reductions could come should AT&T see a market opportunity. We could also see T-Mobile, a victim of Leap, Metro, and Boost’s success over the past several quarters, become more aggressive.

Profitability at risk. Both Leap and Metro guide to long-term margins in the mid-40% range. However, we believe the carriers could run into challenges achieving that level of profitability amid recent ARPU compression and further potential pricing pressures. ARPU is now expected to dip below $40 in the near term and could fall further, following recent pricing changes. Both companies have demonstrated an ability to get margins to the 40% level in mature markets thus far; however, that was achieved with ARPU at higher levels. In addition to using price as a lever, Leap and Metro may need to increase acquisition costs to win market share. As a result, we are cautious on both companies' ability to continue scaling effectively over the long-run.

Changes to expectations. We expect seasonal pressures to impact 3Q09 results for Leap and Metro, though new price plans launched in early August could mitigate some of the impact. Nonetheless, we are reducing our net add estimates for both companies given our expectations for seasonality to outweigh new promotions. We believe ARPU will continue to trend downward, dipping below $40, and we expect it could fall further as customers transition to the new plans. Our estimate changes drive modest changes to EBITDA for 3Q09. However, we are making more significant changes to 2010 estimates, reducing our net add estimates as we expect competition to hinder growth.

Potential near-term upside likely to be short-lived. Both companies are entering a seasonally stronger period as 4Q and 1Q results typically benefit from the holiday selling season as well as tax refunds, and we could see shares outperform, although we believe that is a widely held view. Despite potential near-term outperformance, we are very cautious on long-term fundamentals. We are adjusting our price target for MetroPCS to $10 from $11.

Action: While this call contains nothing that's not already known by the market, it is strong enough to generate some selling pressure today. Both stocks are great trading instruments so I would expect traders to jump on board as well, trying to push the shares lower. LEAP & PCS both should be good shorts at the current pre-mkt levels ($19.30 and 9.08, respectively).

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