LEAP WIRELESS COMES TUMBLING DOWN

Leap Wireless International's need for new funding took a desperate turn last week as the company revealed it is in violation of its credit facility agreements and could face delisting from NASDAQ after it issued extra shares without shareholder approval to comply with an arbitration ruling. Moreover, the company is facing increased skepticism about its business plan, once the envy of the wireless industry.

Mounting debt, weakening demand, fraud and an unfavorable arbitrator ruling have all contributed to Leap's default. The company has since turned to UBS Warburg to explore new sources of financing and a restructuring of its debt. Susan Swenson, Leap's president and COO, said in a press release last month that “Leap has dedicated a team to work with UBS Warburg to complete this task as quickly as possible.”

Already, some lenders under Leap's credit facilities have stopped funding new loan requests, including loan proceeds for interest that had previously been paid through draws under the credit facilities. Leap said late last week that it has chosen not to pay interest on the loans.

Separately, Telephony has learned that Mark Kelley, vice president and chief technology officer, left the company on Friday.

“The world for Leap has changed 180 degrees in the last few months,” said Ned Zachar, partner with Thomas Weisel Partners, which recently stopped covering the stock. “I thought they would have an easier time selling the benefits of their product into the marketplace. The wireless slowdown has got them.”

LEAP'S FALL

Feb. 11: Announces it will concentrate on growing its existing 40 markets and not expand its territory

March 28: Company amends vendor financing agreements to remain in compliance with lending covenants

April 1: Stock jumps 19% on renegotiated deals

April 24: Reports first-quarter results and reveals fraud problems

May 2: Eliminates 50 positions in cash-saving move

May 6: Sells its stake in Mexican operator Pegaso to Telefonica

July 24: Reports slower subscriber growth. Slashes full year subscriber estimates

August 8: loses arbitration with MCG PCS over price of certain PCS licenses. Ordered to pay $41  million

August 29: Announces intent to find additional financing and possible NASDAQ delisting

Sept. 6: Announces violation of credit facility agreements

Source: Leap Wireless

Just a year ago, Leap was adding subscribers faster, keeping operating costs lower and reaching positive EBITDA more rapidly than any wireless operator. It did so with a unique no-frills, all-you-can-talk service plan for around $30 a month within a limited service area. That plan attracted more than 1.5 million customers, many of them new to wireless.

But Wall Street became concerned over Leap's debt load earlier this year when analysts realized the carrier may miss certain EBITDA thresholds from the third quarter of 2002 through the first quarter of 2003, putting Leap in default of its vendor loans. Piled on top of that concern was a jump in fraud at the end of the first quarter.

In June, company executives said they were confident that Leap would remain in compliance with its vendor covenants, which were amended three times (Telephony, June 10, page 14). Late last month, however, Leap — whose stock was trading at 29 cents at press time — revealed that it would not comply with vendor credit loans primarily because of an arbitration court ruling that forced it to pay 21 million shares to MCG PCS, priced at $1.894, as an adjustment price for two New York PCS licenses Leap purchased from MCG. That, and a challenging wireless market, sent Leap running to UBS Warburg.

Leap executives refused to discuss the current financial situation, though Jim Seines, Leap's director of investor relations, said, “Management carefully considered both options, whether payment to MCG would be done in cash or stock.” “They have some tight covenants,” said Ben Abramovitz, wireless analyst with Jefferies & Co. “The principal is coming due, and the vendors are in trouble. They may look to pull back that money.”

At the end of the second quarter, Leap's net debt was about $2 billion, with $1.46 billion of that amount being vendor financing — a substantial load for a mid-sized operator. At the end of the first quarter, Leap said it needed to raise about $225 million and would use $200 million to pay down vendor debts.

Ericsson, one of Leap's principal vendors, said its exposure stands at about $118 million. In addition, Ericsson has $365 million in undrawn commitments to Leap.

“While Leap has stated its intention to continue its operations in an uninterrupted fashion, the outcome of the process publicly announced and communicated to Ericsson…is uncertain,” Ericsson said in a statement.

Leap's other vendors, Lucent Technologies and Nortel Networks, would not say how much they are exposed to Leap. “We value them as a customer and have been working with them on their business plans as they are refined,” said a Nortel spokeswoman. “We do not have a material exposure.”

Leap's third-quarter results may go a long way in determining its vendors' willingness to renegotiate. If Leap shows it can continue adding a substantial number of customers, improve its churn levels and control customer acquisition costs, vendors could relax these covenants, said Zachar.

Most analysts who cover Leap's stock, however, are concerned about the third quarter, which is historically the worst-performing quarter for the wireless industry.

“Leap has faced difficulty in controlling churn, difficulty with inadvertent fraud and difficulty on the level of penetrating the entire wireless subscriber arena,” said John Bright, senior research analyst with Johnson Rice, who recently reiterated a sell rating on Leap shares. “The business plan was created around assumptions that have now changed.”

The company has little room to maneuver, though, in part because its all-you-can-talk pricing plans. Restricting coverage within the city limits of any given market initially yielded cost savings on infrastructure, licenses, marketing and distribution. Leap's cost per gross add, however, increased in the second quarter to $316 from $246 in the first quarter because of higher marketing expenses, lower customer additions, price competition and fraud. Meanwhile, Leap's churn runs higher than the 3% industry average.

Indeed, many question whether Leap's business plan — conceived when wireless competition was less fierce — is still applicable. “It's still a model that is unproven,” Bright said.

Leap began as a Qualcomm spinoff, recruiting successful industry executives, including 22-year telecom veteran Swenson, and filling a niche of providing basic wireless services to the masses when it began crafting its business plan in 1998.

Harvey White, Leap's chairman and CEO, has always been adamant that Leap's business plan is a sustainable model. “It works. It's not a test. It's a real business. We're part of a trend,” he told Telephony last year.

White was correct, and in fact, other operators have caught on, dramatically reducing their pricing plans to the $30 to $40 level and offering thousands of minutes along with free long-distance and roaming.

“Mobile offerings from mainstream carriers offer essentially the same thing Leap does,” said Ken Hyers, senior analyst with In-Stat/MDR. “It's tough to make an argument for Leap in a limited geographic area.”

At the same time, regional operators like Sprint PCS' affiliates are beginning to put more emphasis on competitive local pricing. Leap recently reacted by introducing unlimited plans with 500 long-distance minutes for $40 per month, sending its pricing up while competitors are slashing prices.

“All along Leap has been saying they weren't seeing competition,” said John Byrne, wireless analyst with Kagan World Media. “Now, with a new long-distance offering, they are, for the first time, catering to what others are offering.”

Still, Dennis Spickler, vice president and chief financial officer with MetroPCS — an operator with a business plan similar to Leap's — said there is value in all-you-can-talk local pricing.

“I'm not sure that the bigger bundles offer the same value,” said Spickler, whose company offers such plans for $35 in Atlanta, Miami and Sacramento. “They tend to be offerings that are 300 to 500 anytime minutes, with the bulk of the minutes being nights and weekends. There is some differentiation.”

And Leap, which operates in 40 markets, has become the leader in wireline displacement, recently announcing that 26% of its customers have cut the cord, choosing to use Leap's service as their only phone. On average, Leap's customers use their phone 1200 minutes per month.

Should Leap manage to get its financing costs down, several carriers might be interested in buying the spectrum-rich company, or at least its valuable assets. But that's not likely to happen right away in light of the poor economic climate, said Tim O'Neil, an independent wireless analyst.

“There aren't too many carriers out there with lots of cash and who want to increase their debt load right now,” he said.