CELL SERVICE--PROFITS, PROFITS AND MORE PROFITS!

A friend just had a frustrating cell phone experience; what's new?! The industry has experienced dramatic growth and constant change for many years. Growth is always hard to manage. Common sense says that running the same little business year after year is nowhere near the complication of running a business that is constantly merging with new or competing technologies. The cell phone business is highly competitive and highly profitable except that every few years the companies must spend billions on new technology just to stay even. To constantly recruit new customers, the companies must offer complicated come-on marketing techniques. They must offer aggressive promotions while being careful not to give away the store. Therefore, they make a lot of rules that the store personnel must follow.

My friend's phone was damaged about 1 year into a 2 year contract. The phone company was willing to sell a new customer a certain phone for $30. The same phone would cost my friend $290! The pricing seemed to be a rip off to my friend and was enough to make him very mad.

The key to the cell phone business is the very high profit margin on the phone service. Once billions have been spent on spectrum and hardware, the cost of providing a one minute call is almost nothing. (By the way, the operating leverage in this business is similar to the airline business so be careful). The phone companies want and need new customers so badly that they are willing to give give away free service for about 22 months in order to make a profit the next 2 months. If you have purchased a PDA with some of the same features as today's phones you understand that the PDA or cell phone cost far more than $30. Indeed the fair price of the phone my friend wanted probably is about $290 (about the same as a PDA). The phone companies service including over-head may cost them $25.00. The customer signs a contract to pay $39 per month for two years and the phone company sells them a phone at $260 below costs. The extra $14 per month for the next 24 months is $336 so by the end of the contract the company recovers the $260 loss plus a "profit" of $76. In my friends case, the phone company had not recovered their loss on his last phone when he wanted to in effect cancel the first contract.

During the 90's the phone companies pushed very hard and borrowed billions to build net works in the hopes of being one of the big survivors. Several almost imploded with debt. When I purchased NXTL about three years ago, the balance sheet was an absolute mess. The company literally had a negative net worth. What a difference three years can make in a highly profitable business?

The next round of capital spending has already started. VZ has installed high speed data service in 18 major metropolitan areas and the service is very good. Folks are browsing the internet at close to broadband speeds on the VZ network, Cingular networks and T-Mobile networks. The service cost an extra $44 per month through VZ and is being adopted rapidly.

Prior to the NXTL agreement, Sprint announced plans to spend $4.0 to $4.2 Billion on high speed (EVO) service. NXTL studied alternative technologies and eventually approached Sprint. Clearly it makes sense for FON and NXTL to jointly spend $4 to $6 Billion on a common network rather than $4 Billion each on separate networks.

Now that the merger has been announced as a tax free stock swap, it is tempting for investors to go find more exciting prey. However, there are still big events to come. One very important thing to note about the merger is that Sprint will spin off its land-line business! Very important!
Contrast the Sprint spin off to the actions of the three largest companies that own cell phone networks. VZ, SBC, and BLS are not spinning off their land lines but are spending 10s of Billions to upgrade them to fiber optic cable. Yes, these companies plan to go head-to-head with Comcast, TWX, Cox and all the other cable TV companies. The cable companies are at the same time selling phone service over cable like never before. If Sprint can avoid the need to build its own high speed land line network, it can be in a cat-birds seat. If it does not work this way, then the firm can later buy AT&T or MCI?

Both cable and phone companies are selling package deals that in effect offer deep discounts on the other guys service. For example, the phone companies have not offered to cut the price on their very profitable and very high margin home phone service but instead offer to add TV service for much less than the price of cable through the cable company.

Oops, the cable packages do not include cell phone service but the phone packages do! The cable companies desperately need to be able to include cell phone service in their package! Did you read my previous missives about Virtual Phone Networks? In case you missed it, several firms including ESPN, AT&T and Quest are now offering cell phone service via the Sprint network. They buy the minutes wholesale. In particular, I expect ESPN to be successful in offering short sports videos over their new phone network. Yes, I think Disney has made it over several humps and is a good stock to own.

Anyway, so far, none of the cable companies have offered cell phone service. They have engaged in talks with Sprint and others and they have even discussed the idea of starting a whole new joint venture.

I can't tell you that Sprint has a lock on a deal with the phone companies. I can say that Comcast or Time Warner are not likely to do a deal with VZ or Cingular! But, there are other alternatives.

QCOM has already started piecing together a separate network. The announced purpose is to offer media feeds to cell companies. Also T-mobile now stands as the last remaining sister at the ball. T-mobile is a nationwide player. Its network is built to the same standard as Cingular which may be an important consideration. The next two big regional players, All-Tel and the name escapes my feeble mind, use the same system as VZ and Sprint. These two could be purchased by the cable companies and made into a national player. T-mobile was not far behind AWE or NXTL but is now very small relative to Cingular or Sprint. T-Mobil has a strong network of WIFI hot spots. The fact that it is a sub of the big German phone company may hurt its chances of doing a joint deal with the cable companies but they might just buy the whole network.

I respect the managers of Comcast, Sprint and NXTL and the cable/Sprint fit is the best, easiest and most profitable. Each cable company could do its own deal but VZ and Cingular are big enough that the FCC would probably let the cable companies band together. Sprint has offered a deal several times in the past few years but conditions were not ripe.

Holding on-to companies that need to spend billions on networks is not a comfortable position in a rising interest rate environment. However, it is comforting that Sprint will not be spending the billions on fiber optic cables. It is also re-assuring to know that the memory of the last down-turn in this industry was not so long ago. The merger of Sprint and Nextel perhaps shows it best that the players are not willing to spend billions alone which would put them at risk. The combination of Sprint and Nextel is big enough to give them the chance at being the biggest of all in this industry. Folks as knowledgeable as John Malone, (Liberty Media Chair) have questioned the wisdom of VZ's decision to spend extra billions to take fiber all the way to each home.

My bottom line is that FON/NXTL is a profitable business with solid growth plans. I plan to hold on-to this bucking bronco with all my strength. At the first sign that the economy is too strong, I plan to reduce my equity exposure (yes there is a risk that the economy will continue to slow but I believe the bigger risk is that the economy will get too strong). I am hopeful that a deal will be made with one or more cable companies well before it is time to be extra defensive. In recent weeks, I have had the tendency to add mostly big cap value stocks.

The other good news is that revenues will grow substantially as data and media services become even bigger than voice. There are so many new services coming that it is impossible to know all the possibilities. For example, Motorola and Apple have been working together for some time on an i-pod combo phone. It should be on the market soon but no one can buy a tune over the phone unless they pay for a service over and above their voice service.

Any businessman, who has dreamed a little, must view these new services with excitement. Suppose you think about owning a big jukebox that has wireless nodes. People everywhere can access the jukebox and play a song. Everytime they do so there is an electronic deposit of a nickel in your jukebox! Wow! PROFITS, PROFITS AND MORE PROFITS.