Their upgrade is based on 2 key factors:
1. Higher estimates for subscribers, service revenue and EBITDA due to the success of PCS’ new all-inclusive calling plans, which are having a more positive impact on gross adds, churn and ARPU than we had initially expected; and
2. Attractive valuation as PCS is now trading at the lowest multiple in the group – 3.7x 2011 EBITDA vs. 3.7x to 5.8x for its peers – despite having one of the more robust growth outlooks.
Deutche notes they do not believe that investors should put too much weight on an assumption that PCS will exhibit seasonal weakness in its stock over the next six months. While this has been the historical pattern for PCS following the company’s seasonally strong first quarter results, they consider this a risky trading strategy for 2 reasons. First, the fundamental momentum in the business is much stronger than they have seen coming out of the last few 1Qs, as evidenced by PCS’ material beats on key 1Q10 metrics such as net adds, churn and ARPU. Second, the firm believes that this seasonal trading pattern is sufficiently understood by now that it no longer offers any meaningful advantage.
PCS’ 1Q10 subscriber results were not merely ahead of expectations; they were substantially ahead of expectations. For example, net adds of 692k were more than 2x consensus of 330k and churn of 3.5% was 150 bp lower than consensus of 5.0%. Other results were impressive as well: ARPU of $39.83 beat consensus of $39.17 despite new plans that represented price reductions of 0-10%; gross adds of 1.47 million exceeded consensus of 1.35 million despite lower than expected advertising spending; and EBITDA of $224 million beat consensus of $220 million despite the beat in gross adds, which usually drives higher acquisition costs.
In Deutsche's view, these material beats were driven by forces much more substantial than typical seasonal strength. Instead, they believe they reflect the well-timed collision of PCS’ new allinclusive rate plans with the emergence of prepaid as they key driver of industry retail subscriber growth.
Deutsche is increasing their2010 net add estimate to 1.4 million from 950k and their 2011 net add estimate to 800k from 500k. Their improved outlook is partly due to higher gross add forecasts and partly due to lower churn estimates. For example, for 2010-2011 they have increased their gross add forecasts by a total of 366k, which is a little under 49% of the increase in their net add estimates. The other 51% is from lower estimated churn as the firm is reducing their 2010 churn forecast to 3.9% from 4.3% and 2011 estimate to 3.8% from 4.2%.
Firm is increasing 2010 service revenue estimate to $3.6 billion from $3.5 billion and their 2011 estimate to $4.0 billion from $3.7 billion. They believe these revisions are conservative as they still assume that ARPU trends deteriorate as we move into 2H10.
Attractive Valuation PCS is now Trading at the Lowest Valuation in the Sector
Based on their revised estimates, PCS is currently trading at 3.7x 2011 EBITDA. This represents the lowest valuation within the US telecom service sector where valuations currently range from 3.7x to 5.8x (among the 8 telecom services carriers under Deutsche coverage). In their view, this represents an attractive entry point as they believe that PCS has one of the strongest growth profiles in the sector, especially among wireless peers.
Based on their improved outlook for PCS, they are increasing are targeted valuation range from 4.5 to 5.0x forward-year (2011E) EBITDA to 5.0x to 5.5x. Deutsche's new price target of $14.00 is based on the mid-point (see Figure 7). In their view, this range is conservative as it values the shares in-line with its peer group despite a generally stronger growth profile. But, as highlighted in Figure above, they believe that even within this targeted range the shares have considerable upside potential. For example, at their new price target they estimate potential upside of nearly 80%. In fact, Deutsche estimates that the shares are so undervalued that even if the stock merely traded in-line with LEAP, its closest peer, the potential upside is 40%.
Notablecalls: This is a fairly powerful call from Deutsche's Telecom services team. The prepaid space has been a no-go zone for many institutional players as they have gotten their heads handed to them several times before.
I spoke to a tier-1 firm internal hedge fund desk some weeks ago and their message was fairly simple - they needed to see real improvement in fundamentals to get long. They considered PCS really cheap but acknowledged the fact other people had been burned before and would need to see significant improvement before getting back into the name.
We got that improvement last week as PCS blew away subscriber estimates (net adds were DOUBLE of Deutsche's estimate).
The stock got sold on heels of general market turmoil but with Deutche out with an almost 100% price target on the name, people will take note.
Deutsche estimates that prepaid captured >90% of retail net adds in 1Q10 and will represent >70% in 2010 as lower-end post paid subs migrate to prepaid. I think several of the private equity players know that as well and may be looking to join the party. So, PCS is really a PE takeover candidate here as well.
All, in all I think the stock will trade up nicely today. I expect it to be up 5-7% putting $8.25- $8.40 range in play.