Churning Points

Here’s a newsflash for you, Dan Rather: The U.S. wireless services market is no longer a zero sum game. Although the two clear winners in the wireless services arena are Verizon Wireless and Nextel Communications, each of which is blowing away the competition, the entire industry has found itself on steady ground as the economy has improved.

The total net adds for the sector have climbed steadily during the last six months, aided and abetted by the powerful wireline substitution trend. I suppose at this point it’s conceivable that wireless penetration could rise to 75% in this country, which means that, assuming some estimates that put the current rate at 60% are accurate, we’ve got many millions more users to tap for growth.

The net growth of the sector will offset some of the negatives, but I do expect churn to spike rather dramatically in the first six months or so of WNP implementation. Verizon and Nextel both had strikingly low churn rates this quarter at less than 2%, but those numbers should be taken with a big chunk of salt. Plenty of subs are ready and waiting to switch carriers once WNP kicks in.

Using the example of Hong Kong, which saw its churn rates skyrocket about five-fold following WNP, I expect that we’ll see churn at the weaker carriers such as Sprint PCS and Cingular Wireless rise to 6% to 7% while stronger carriers like Verizon and Nextel rise to 4% to 5%. AT&T Wireless and T-Mobile will likely be somewhere in between. With customer acquisition costs upwards of $300 to $400, operators’ profitability and cash flow will suffer. Further, it will be very tough for those carriers with higher churn trends to keep their net adds positive, as they have to more than offset that churn with new customers.

Further offsetting some of the intra-sector churn will be the potential of wireline-to-wireless portability, which could result in a further acceleration of wireless substitution for traditional wireline services. I’m less than convinced that the ability to transfer a landline to a cell phone will spur mass movement, as it’s likely most of those talkers who would want to do such a thing have done so already, but it certainly will help the net add growth for the wireless service providers.

The sector and each company in it has a lot of moving parts and cross-currents that will make it a tumultuous place to work and invest over the next year or so. With Verizon and Sprint both trying to get into the walkie-talkie business that has propelled Nextel to such singular success, and the promise of 2.5 and 3G still around the corner, there’s a lot to juggle here.

But as we have emerged from our teleconomic depression as well as from the macroeconomic recession, and with the carriers’ ability to access capital again, the outlook is better today than at any time in the last four years. That valuations of the sector are still quite reasonable, what with Nextel trading at just over ten times next year’s projected earnings, is also a net positive. The bubblicious prices of the late 1990s as well as the depressed prices of late last year were both equally destructive to long-term prosperity--which is really what all of us in this industry are shooting for anyway.

Cody Willard is a hedge fund manager and commentator on RealMoney.com.