Party at Uncle Sam's

The US wireless sector is entering a new phase of growth and consolidation, but players should proceed with caution...

To the global investor, pondering where next to put his cash in 2004, the United States' wireless sector is looking more attractive than it has for nearly four years. US mobile

The American economy is picking up, capital markets are strengthening, and dollar assets are cheap because of favourable exchange rates. Its easy to see why investment banks are eagerly awaiting a flood of investment into American wireless over the next year and beyond.

For one thing, unlike saturated European markets, which have average penetration rates of over 80 per cent, American operators still have a good 40 per cent of the populace to try and entice. The American consumer has been slow to pick up on the mobile craze but, or so most analysts think, she's bound to come around eventually.

A week into January, researchers at Merrill Lynch predicted that this year US mobile companies will post a handsome 8-10 per cent increase in subscriber numbers and that "[earnings] growth in the sector will be robust." American interest in the mobile is speeding up, the analysts thought, and the momentum will continue as the technology gets better and cheaper.

Another reason to expect a good year for US wireless is that America's economy, led by buoyant consumer spending, is looking stronger than at any time since the turn of millennium. Last year's Q3 was the most encouraging - Gross Domestic Product (GDP) grew at a 8.2 per cent annual rate in the quarter, led by a 6.6 per cent jump in consumer spending, after growing at a mere 3.3 per cent pace in Q2. The Conference Board predicts that real GDP will grow 5.7 per cent next year and that consumer spending will rise 4.7 per cent.

With more consumer dollars going on mobile phones, 2004 will see increased spending on wireless equipment, boosting vendor revenues. Wireless capital spending in 2003 totalled $134.5bn, up 7.9 per cent from the previous year but still the slowest growth rate that US vendors have experienced since the rush to start 3G network building in 2000.

Yet according to Telecommunications Industry Association's 2004 Telecommunications Market Review and Forecast, after a year of caution, mobile operator capital spending bottomed out in 2003 and is set to take off again. Wireless equipment vendors can expect "double digit" revenue growth this year, says the report.

TIA also predicts a possible average 9.1 per cent growth over the next 3 years (hitting $190.8bn by 2007), assuming America's economic recovery avoids going into reverse.

But for the global investor there are other reasons for keeping a keen eye on the US wireless industry. Speculation is rife that US mobile operators are about to enter a long overdue merger frenzy that will push share prices to new speculative highs long before they deliver any improvements in the industry's profitability through curbing competition.

Not that there's much to speculate about. With six national carriers overcrowding the wireless space, competition in the US market is fierce and most telecoms experts agree it is unsustainable.

Aware of this, and equally keen to cash in on the usual pre-merger stock surge, shareholders in American wireless are ready to support whatever M&A plans the industry has. But, unusually, management in the US market's big players has been coy about making the first move. Until now.

No one blinked when AT&T Wireless announced on January 22nd that it had suffered a humiliating Q4 loss of $84m while simultaneously confirming that the company is up for sale. The prospect of such a juicy acquisition in a market ripe for consolidation was a perfect opportunity to bury bad news - bad news which included a churn rate of 3.3 per cent, meagre subscriber growth of 128,000 new customers and a 2.2 per cent drop in ARPU to $58.70.

CEO John D. Zeglis was understandably keen to portray the operator's poor performance as a minor blip, but he knew he wasn't going to have to bend over backwards to market AT&T Wireless to prospective buyers, regardless of its recent pitiful performance. As Zeglis put it: "There are so many approaches and the dynamics have lined up so favourably - globally and domestically - we feel it is an opportune time."

Even harsh remarks from Deutsche Bank analysts that AT&T Wireless technical woes and customer service hiccups reflect "deep-seated problems" hasn't been enough to put off potential suitors. At worst, the operator's recent losses will be used by bidders as a lever for forcing down the asking price.

At the time of writing it isn't yet clear which hungry suitor will bag AT&T. Cingular, the Number 2 wireless carrier co-owned by BellSouth and SBC Communications, with an all-cash offer that values AT&T Wireless at about $11 a share, or nearly $30bn, would seem to be the most obvious strategic choice. A marriage of Cingular and AT&T Wireless would leave the combined entity with a colossal 46 million national customers, making it bigger than the current number one, Verizon Wireless.

Taking over AT&T Wireless would also help Cingular get sorely needed airwave licenses and extend its national reach (Cingular operates in only 43 of the largest 50 US wireless markets).

In addition, all of the big players in the industry would benefit as overcapacity is cut down and cut-throat competition is reduced. But Cingular potentially faces competition from Vodafone, rumoured to be willing to sell its 45 per cent stake in Verizon Wireless to clear the way for a bid. Vodafone has been half wanting to get rid of Verizon for some time - it is technically incompatible with the group and has resisted being re-branded as a Vodafone name. One outlandish possibility mooted by researchers at Cazenove is that Vodafone will make an audacious all-out bid for a $100bn controlling stake in Verizon Communications.

NTT DoCoMo, currently with a 17 per cent stake in AT&T, is also supposed to have made an informal offer, though it's recent strategic trajectory has been in the opposite direction and Tokyo analysts doubt its appetite for a takeover. DoCoMo has been unwinding foreign investments at considerable loss. It may retain a nominal interest to help drive up the asking price.

DoCoMo's stake is believed to be on its books at about $5-$6 a share compared to the $11 a share Cingular is reputedly offering.

However it turns out, it all promises to be plenty of work for the big banks. Merrill Lynch&Co have reportedly been retained as advisors to evaluate bids. The banks have been itching to start the anticipated round of mergers and deals in the US mobile sector. As one management consultant from a Boston consulting firm put it: "The bankers have been trying every trick in the book for the last two years to get someone to do anything to uncork this wave of deals, which could yield tens of millions of dollars in fees."

So tempting is the prospect of a merger frenzy to the banks that it seems likely that much of the expected consolidation will be over before the year's out. If successful, AT&T's sale could well be the hair trigger for the industry's biggest M&A boom since 2000.

However rosy the near-future looks, it would be advisable for operators contemplating mergers to proceed with caution. That AT&T could whip up a flurry of interest whilst delivering its worst quarterly results for several years should be a warning sign. Consolidation is needed but only mergers that make strategic sense will in the long run create shareholder value. Sceptical analysts are already warning that a bidding war over AT&T will leave the buyer with a "winner's curse" - an acquisition suffering real problems, losing customers and profit faster than any other company.

Another reason for caution is that America's economy may be more fragile than is generally assumed. 2004 is looking good but it also might be short lived. The lavish party currently being enjoyed by the American consumer is being financed in part by record private borrowing. If these debts are unsustainable, as some more cautious economists think, the American economy could be in for a crushing recession further down the road, which would do considerable damage to wireless operators' revenues.

2004 holds a unique opportunity for the creation of a strong, growing sector on the back of industry consolidation. But the risk of unwise marriages cannot be ignored.