Afterpay: a regulator view

The Australian Securities regulator (ASIC) has come out with a long review of buy-now-pay later arrangements in which it has decided to do nothing monitor the companies going forward.

This is perceived by some as very bullish for Afterpay. The stock is up fairly hard as I write this.

Afterpay (ASX:APT) is the big player in this industry and a cult stock and cult product amongst Australian millennials. There are several other players and ASIC's study covered six of them.

ASIC does not have a reputation as an aggressive regulator so that they are monitoring the company going forward is the expected result.

But the ASIC report (available here) does give some insight into Afterpay.

Here are a few extracts:

First an example of underwriting:

Case study 1: Debts on top of further debts 

Vicki was in her early 20s and a mother to three preschool-aged children. She was unemployed but received Centrelink payments. 

Vicki had multiple payday loan debts totalling $4,000 and a $9,000 car loan. Vicki also had a $1,000 debt to Certegy Ezi-Pay that had been referred to a debt collector and several telecommunications and utility debts. 

Vicki explained that she then incurred a $740 debt to Afterpay to buy goods at a butcher and several clothing stores

Note that Afterpay is the last lender here and lent after a previous debt had been referred to a debt collector.

And another underwriting example:

Case study 3: Sold goods that the consumer didn’t need 

John received a carer’s pension. He was cold-called by a merchant who sold him a solar power system financed through Certegy Ezi-Pay. John said he did not have a job at the time and the salesperson said that he would write down John’s last job. 18 months later, he owed over $6,100. John also owed over $7,000 on a loan and $3,000 in other debt.

John said he started using Afterpay in early 2018 and now owes them $960. He said he doesn’t recall being asked about his expenses when he signed up for this arrangement.

Note again Afterpay is the last lender.

And another underwriting example:

Case study 4: No inquiries about the consumer’s financial position 

Ben was unemployed, received a disability support pension, and lived with his father who assisted him as a carer. Ben said he had a shopping addiction. 

Ben reported feeling overwhelmed with debt. He had a $5,000 credit card debt, and he was able to accrue a $1,500 debt with Afterpay, and a $1,000 debt with zipMoney.

In this case Afterpay lent after the consumer was clearly in trouble. But they may not have been the last lender.

Afterpay - the worst lender in the group

Afterpay is considered the gold standard in this sector. It has the most highly valued stock. I have asked several bulls and they all tell me how much better Afterpay is than the competition.

But ASIC have the numbers. Here is a graph of the percentage of Afterpay customers who incur a late fee versus the competition. It sure looks like Afterpay has the worst credit quality.

All I can say is that ASIC have helped out researching a controversial stock.





John

The importance of GE's credit rating

The cover story in Barrons this week is on GE's dim prospects. I confess to being a very minor source for that story. I don't own GE - but there is a price below the current price where I would buy it.

That said, I think there is one last shoe to drop, and it is a doozy. And it wasn't covered in Andrew Bary's excellent article. That is that GE's credit rating - and hence its business - is under threat.

GE's best business (by far) is jet engines where it competes with Rolls Royce (in wide-bodied engines) and a Pratt & Whitney consortium in narrow bodied engines. 

There is a new generation of engines (and planes) now - and the aviation business is booming. Boeing's stock price reflects that.

But GE is no longer the unequivocal engine leader. In wide-bodied (ie planes with two aisles) the current leader is the Airbus A350 powered by a Rolls Royce engine. It is the most fuel efficient long-haul plane on the market (measured in fuel cost per passenger-mile) and the engine is provided exclusively by GE's competitor. GE is playing catch-up - but will probably succeed with the Boeing 777x which (on paper anyway) will take the mantle as the world's most efficient plane.

In narrow-bodied the GE may still be the leader but Pratt & Whitney has caught up a great deal. Picking the competing engines apart is difficult (although at the moment the Pratt & Whitney competition has problems with a knife-edge seal). [I know serious aviation nerds who think the P&W engine is a better product with better prospects - although I think that is a minority view.]

--

The jet-engine business is threatened by GE's current worries. You see jet engines (especially wide-bodied jet engines) are sold with very long-term maintenance contracts. If I order a 777x now it will be a couple of years before the first delivery, maybe 10 years before my delivery and expect to be flying the plane for another 20-25 years after that. I may be ordering 10 planes in which case my last delivery may be 15 years away and I expect to fly that plane for a further 25 years. 

Whoever buys this plane needs to be confident that GE will be around and solvent in 40 years to actually do the maintenance. The GE aviation business is more credit sensitive than almost any business I can think of.

And that is a problem because as Andrew Bary notes GE's debt is already trading as if the credit rating is BBB+, and if you are entering very long maintenance agreements BBB+ is simply not good enough.

If Ahmed bin Saeed Al Maktoum or Akbar Al Baker gets jittery re GE's credit rating then it will threaten GE's ability to sell engines or even Boeing's ability to sell planes (on which GE is the monopoly engine provider). 

Who are these guys you have never heard of? Well Ahmed bin Saeed is the CEO of Emirates airline and Akbar Al Baker is the CEO of Qatar airlines. These are the biggest buyers of long-haul jets in the world. They are GE's most important customers.

--

GE is, I think, a rationally run business - meaning management run it to management's incentives. In the old days that was to buy stock and keep the price high (options) but now it is clearly just for business survival.

And business survival requires that GE maintain its credit rating. 

That is why there will be an equity raise.

--

There are plenty who argue that GE should be broken up. I am not averse to the possibility but it is much harder than it looks. GE has lots of obligations including over 100 billion in debt and 30 billion in pension shortfalls. It also has guaranteed a few (painful) insurance obligations.

If you break up GE those obligations have to go somewhere. And debt holders or the Pension Benefit Guarantee Corporation is not going to accept them being placed against GE's troubled businesses (such as power systems). And Ahmed bin Saeed isn't going to accept them being placed against the aviation business.

So in a break-up a lot of capital needs to be raised. Probably in excess of 50 billion. 

Bluntly I do not think a break-up is realistic. You could get away with under half the raise if you don't break it up. And maybe you could just sell some businesses to strengthen the balance sheet and get away without a raise.

--

Rolls Royce went through this. There was a period where Rolls was problematic - and if you looked at the balance sheet you would have immediately rated it A+. But even then A+ was barely enough - even the threat of a downgrade and Rolls would have had to raise capital to protect their business.

Rolls never raised equity - but it was touch-and-go. 

GE is far more problematic than Rolls at the nadir - simply because there are far more obligations on GE's balance sheet.

I reckon an equity raise is likely. I don't know why they didn't cut the dividend in its entirety (except maybe that wasn't enough). It may be that 20 billion in asset sales is enough - but I have my doubts. I think they will need more to keep the customers satisfied. 

Ahmed bin Saeed Al Maktoum, this one is up to you.

John

POST SCRIPT: I have been asked several times how GE got into this trouble. Here is my very quick summary.

a). GE was left hyped up and overly dependent on finance income and accounting tricks under Welch (who I think is the main culprit here),

b). Immelt did not defuse all the unexploded Welch bombs anything like fast enough. GE would have gone bust on the Welch trajectory, and Immelt got it off the Welch trajectory, but not far enough off the Welch trajectory, and

c). Both Welch and Immelt behaved as if their body odour was perfume. They believed their own hype and bought back stock and stock and more stock. Total shares repurchased were over 100 billion dollars. Just 30 billion of that money now would solve the credit rating problems.

d). Power systems which was once perhaps the golden business fell on hard times. Solar is now cheaper than coal or gas. Renewables are cheap. This is a problem if you are the biggest capital equipment sellers to the old tech. This was exacerbated by spending 10 billion on Alstom just as it all fell apart. Immelt doubled down on dying technology.

The 20 year accounts are here.

Sun Edison - some comments and a way forward

Bronte has taken a long position in Sun Edison. We did this after the first and indeed second stages of the collapse in that stock. The stock decline here is spectacular. First Solar and Solar City have had issues - but nothing like this.

Until about a week ago we were showing (small) profits on the position. Then it took yet another leg down. I know the cliche about trying to catch falling knives - but we think this is a quite good bet - and would be a better bet if the board took decisive action to fix immediate and pressing problems.

Background

Sun Edison develops huge and highly capital intensive solar and wind project where the power is largely pre-sold and where separate financing is developed for each project. These projects are then sold to [“dropped down to”] semi-captive yield companies sold to mostly to yield sensitive investors.

There are several issues. Big solar projects are massively capital intensive – think of utility scale power generation where you have to pay for the next 25 years of fuel upfront. The projects have huge debt but also reliable high margin cash flow.

Secondly there is a pretty obvious conflict of interest in the “yield co” drop-downs. We have successfully shorted a few companies where we think that overpriced assets were being sold to captive vehicles. In the end they these were good shorts - if you can't treat the investors in the drop-down vehicle fairly you will eventually wind up with fewer investors, less access to capital and less underlying profitability.

Thirdly, because of the related parties and the copious amounts of different types of debt these companies have complex and even scary accounts. At Bronte we are quite good at getting to the bottom of complex accounts. But we have a problem with these.

In a meaningful fashion Sun Edison is a “trust me” story.

Whatever, the problems Sun Edison and its yield cos have been smashed. Once fairly obscure solar developers have become a major topic of discussion on Wall Street.

It took us a while to understand why they have fallen so hard. The argument comes down to complex accounts, lots of debt and a peculiar acquisition of door to door marketing company(Vivint).

But there is also more than the usual amount of rumour and innuendo. On Twitter there are arguments we know to be wrong and arguments that are simple fear-mongering (calling Sun Edison “Sun Enron” is one such appeal). Sure the company is highly levered and complex but it is almost certain that the past deals have been good deals. Any solar farm deal you put in place 3-5 years ago has worked out. Both solar panel prices and interest rates are lower than you would have baked into your cash flow models. We would be enormously surprised if the past deals of Sun Edison did not work out.

Whether the future deals work out is however an open question. Low solar panel prices and low interest rates are not exactly a secret – and the funding cost for solar panel farms has risen with this panic. Bluntly we think unless the company repairs its relationship with capital markets it is unlikely to be able to generate good deals in the future and it will wind up in run-off.

There is a deeper problem with the way these companies [yield cos and their parents] see themselves and communicate with investors. That comes down to the fact that many have their roots in semiconductors where operating leverage is everything. You disclose your costs, your variable versus fixed, capacity expansion and so forth because if you make solar modules, wafers or chips that stuff matters a very great deal to your business. Investors use and demand that information because simply put, it matters and drives the profitability of the business.

A yield-co is a completely different business – it is a non-bank financial company.

Non-bank financials “blow up” for one of three reasons, (i) credit risk, (ii) duration mismatches and (iii) and unstable funding. If you want to assess TerraForm Power (Sun Edison’s yield co) you need to assess whether the credit risk on the projects (the counter-party) is okay, how the contract and funding is (eg floating/fixed etc) and all the ways in which project development funding is able
to roll into long-dated funding.

A friend put this to a yieldco and the management balked at providing that level of project detail. My friend's response: “well, are you Northern Rock?”

And that is the guts of the issue and the market fear. We have gone to considerable effort to convince ourselves Sun Edison is not Northern Rock with solar panels. We have talked to several people who have organised funding for these things and it seems okay to us. Specifically all construction finance automatically can be termed out as project finance (over the life of the project and linked to the project) when the construction is done.

If this is true the market fear for this company cannot cause insolvency. Given that the company is priced as if insolvency is likely this stock should produce a good return from here.

Alas we could be wrong here. We can’t see all the funding (the disclosure is complex) but the bits we have seen have this character. We checked through several sources and we don't think the company can have a “run on the bank”. The Northern Rock outcome is unlikely.

Now of course we have not seen and understood all of the finance deals. Only the ones we can find. But that is sufficient to know we are probably right. And that is the case for buying. The old projects are good and they should run off at an attractive clip.

The Vivint Acquisition

That said this company does not behave like a financial institution, they have been rash and callous in their treatment of capital markets. This is dumb. Capital (not solar equipment) is the main input in this business. And capital is cheaper if people trust you.

Moreover management did a really foolhardy acquisition and explained it badly.

Vivint (the target) is a door to door marketing scheme selling solar systems. Some suggest multi-level marketing scheme characteristics but I cannot find the contractual terms that indicate it is an MLM. [Contra: friends have done research on the numbers of complaints at State agencies concerning Vivint.]

Moreover the product it is selling door-to-door (financed solar systems) is not a bad deal for customers. Customers put the solar panels on their roof and their power bills go down. Whether the solar system is owned by the household or some corporate structure what is effectively going on is a loan to the householder where the householder will repay the loan by splitting the utility bill saving with the solar company. Things can go wrong in this deal – but those things are not very likely.

That said, there are good reasons why roof top solar is less attractive than utility scale solar farms. The main one is that rooftop solar gets under-priced use of the grid. The grid is essential here – unwanted solar is sold to the grid and the grid provides electricity when the sun doesn’t shine. My business partner was once a utility CEO. He has an instinctive skepticism of rooftop solar. He thinks – correctly – that people with rooftop solar underpay for grid services.

In Northern California this is becoming explicit. Pacific Gas and Electric is proposing changes which explicitly charge households with solar panels more to access the grid. Whilst we have no view on the size of the charge the direction is probably right. This will become a trend and make roof top solar less attractive in the future.

The Vivint acquisition - which looks strange - was poorly explained and was bundled with a few details that indicated that the margins on projects dropped down to the captive yeild-cos are declining caused a run on the stock. Moreover there were lots of hedge funds who had oversized positions in Sun Edison before the collapse. There clearly was a rush to the exits.

And in capital market terms those can be self-fulfilling. The equity and debt cost for Sun Edison has risen substantially and this seriously impedes the economics of the company. Its that strange thing about financials that lower prices for equity and debt reduce the future cash flows.

The current situation and the way forward

Sun Edison has lost about 80 percent of its value without the slightest hint from the management team that there is a problem. The credit default swaps have moved against them and it will be far more difficult to grow whilst the situation is like this.

There really is one issue here. Can they find and develop new solar plants and drop them down into project financed bankruptcy remote vehicles and (a) make a profit and (b) ensure the new owners of those vehicles make enough return to keep them coming back for the next vehicle? [At the moment there is a fairly strong private market for solar projects - people like large pension plans - but the same concern applies to them too. They got to trust you.]

If they can't develop and sell either growth stops dead or the company becomes a ponzi.

Alas with market distrust it becomes unlikely that future projects can meet the required return hurdles. The private market for completed projects will also have the same concerns about the management.

The best case here is that the company has become a melting ice-cube. It is worth something (I think a fair bit more than the current price) but every drip of cash that comes off in the end goes either for debt repayment or is returned to shareholders.

The whole project development team - the raison d'être of the company - ceases to have any use. They should all be fired. Yes - all of them. [If you work for Sun Edison it is your job too. And that will eventually include the board. Them are the stakes. If the current board doesn't do something about this it is eventually your job.]

There is an alternative - an alternative I think the company should take. They should pay their contrition to the market - and give the market what the market wants.

What the market wants here is a clear vision of financial control and responsibility. They want to know that Sun Edison is not Sun Enron.

Stocks don't just fall 80 percent in a vacuum. Someone has to be held responsible - and the board needs to ensure that happens to ensure Sun Edison has a future.

That person is the CEO.

Ahmad R. Chatila

Ahmad R. Chatila (Sun Edison's CEO) is a visionary. Indeed Mr Chatila is the reason for Sun Edison's success to date. I have heard managers describe him in glowing terms - amongst the best CEOs in America.

And I don't disagree.

Except that he should be fired. Pronto. Now.

Sun Edison - through the vision and drive of Mr Chatila has become a financial institution. One with a lot of run-off value. One which I think has improved the world a great deal.

Vision, drive and competence are usually great things for a CEO.

Not in this case.

I am an old fashioned kind of guy. I do not think visionaries should run financial institutions.

Visionaries running financial institutions end in disaster.

Mr Chatila has built an institution for which he is profoundly unsuitable to run. The market has made that abundantly clear.

Pay him out

I have mostly been unsympathetic to firing executives and leaving them with a big payout. Mr Chatila is an exception.

Mr Chatila has not done much that is wrong. He has created - from very little - a worthwhile, valid and large business. He has achieved much.

He has not done very much that is wrong except create a business which he personally is a woefully inadequate CEO for. For this he should be rewarded: as recognition of (a) what he has truly created and (b) for going quietly and constructively.

Calculate his payout, add thirty percent and fire him.

Who to appoint?

There is a core criteria on picking the new CEO.

They need to be boring and from a control culture. The idea CEO would be someone from (say) the risk management department of Goldman Sachs. What you want is a dull suit occupied by someone whose job it is to pull wings off butterflies. Someone whose job it is to ensure - and be seen to ensure - that bad projects are not funded.

The market wants someone who will get on an earnings call and talk about asset liability matching, FX risk mitigation and basically sounds like the CEO of a mortgage REIT, not a semiconductor visionary.

You want risk aversion above all other things.

And you want it for another reason. Mr Chatila has populated the senior ranks of Sun Edison with people like himself. Ambitious go-getters - people who get things done. It is notable that all of the ex Goldman hires at Sun Edison come from the banking and advisory side. They are deal people. Deal people do deals and are not happy if they are not doing deals.

The people Mr Chatila have hired have got things done. Alas if you are going to have people like this in a financial institution (and Goldman Sachs is full of such people) then you need a counter-balance. Someone who stops you doing silly things and has the intellectual horsepower to work out what is silly and what is not. There are plenty of such people around and if Sunedison can poach deal centric Goldmanites then perhaps it can pick up a few slighly more salty risk managers too.

There is an alternative of course. But that is harder. You could keep Mr Chatila. Have a visionary running your financial institution - but then you need to beef up the risk management culture of the place to an extraordinary degree. You need to sack the CFO, half the board need to resign (and be replaced by hard-headed financial types) and you need to remove about half the go-getters that Mr Chatila has installed.

Easy and difficult routes to dullness

This company has got to become dull and predictable and it has to get there fast. Anything short of dull and predictable will end badly.

There is a fast route to dull and predictable (the one I prefer). Start at the top. Sack Mr Chatila. Appoint someone who will embody the new (and boring) Sun Edison. And this guy is going to give the market the sort of information they need - that is

(a). Power purchase agreements and their counter-parties (the analog of credit risk for a non-bank financial institution),

(b). Contract terms for the above PPAs - eg fixed, floating, renewal terms and also for the debt for the projects (the analog of whether there are mismatches in funding), and

(c). The funding details (to ensure that there are not mismatches in the duration of funding).

There is the second route to dull and predictable. That is to leave Mr Chatila in place but sack half the people around him and replace them with people who will control his ambition. This is - in this case - a worthwhile option as Mr Chatila really is a visionary - someone who really has created value.

Whether you can keep the good parts of Mr Chatila (vision, drive) and also keep the market happy has yet to be seen. I have my doubts.

The third way to dull and predictable - and one which will be forced upon the company shortly if the board does not react sensibly is just to put this into a form of run-off. Fire everyone in project development. Just do it. My guess is that they have to start firing now - but a few is not going to do. In runoff they have to fire all the interesting people, leave a skeleton maintenance staff and send us (now suffering) shareholders lots of cash.

My guess is that the board will settle on the first option or Carl Icahn or some equivalently effective activist investor will buy a big stake and force the third option on them.





John

Hanergy: let there be no doubt

Background: Hanergy is a large cap solar cell manufacturer that has been suspended on the Hong Kong market. The biggest shareholder supposedly lost USD14 billion in one day. 

Now that Hanergy has been suspended I can let these out.

I went to visit Hanergy's main factory in China about a six weeks ago. It was almost entirely silent. There was essentially no production of solar cells at all and the accounts that suggest significant production and sales are entirely fraudulent.

There was some evidence that someone was exploring starting production - and I will get to that - but the factory was almost entirely idle.

Here are a few photos.

This is the plant. There were almost no cars despite a vast car park. All gates except one were locked.

There was a single truck being loaded with solar cells - so there was *some* production. However this truck was being loaded when we arrived and still there when we left two hours later. This plant if it had any production at all had it only a trial basis. The accounts that suggest substantial production are false.

This is another photograph of the main drive to the plant. One car was parked. There was no movement.

This I found particularly bizarre. There were solar cells set up around the plant Some of them were set up in triangle-patterns. This is the only place I have ever seen solar cells set up so that they are not orientated towards the sun.

I walked around the enormous plant. Not a truck went by and the only people we saw except at the side were the gardeners. (There were several of them - and we asked them if it ever got any busier. They confirmed it did not.)

However on the side there was a shaded area with some motorbikes parked - which suggest that the plant is not entirely idle. Just almost.

Strangely two white guys walked out of the plant. I think they were Americans trying to sell some technology - maybe sales guys from AMAT - but I am only guessing. I tried to signal for them to come over but they did not.

There has been much press that compares Hanergy to other solar companies and suggests there may be disruptions in the market for panels. Garbage I say. The right comparison is Sino Forest or Longtop Financial Technology.

Hanergy barely existed.




John

Disclosure that will annoy my clients. Despite sitting on these we were not short Hanergy. Too much squeeze risk for my liking.

Spectrum valuation and a case for Verizon and against wannabe players like Sprint and desperado/promotes like GSAT

This post has been in the back of my mind for a long time. It is also talking my book - long Verizon - big, boring with a *lot* of very high value spectrum and short the spectrum wannabe players like GSAT.

As for timing, the post is prompted by the beginning of GSAT's collapse following the research report by Sahm Adrangi and Kerrisdale Capital.

We have another motivation. For 18 months or so Verizon has been one of our biggest (and sometimes our absolute biggest) long position and it has not worked. We haven't lost money - we just have not kept up with the bull market.

This might be (and I hope it is) just the symptom of a wild bull market where "grandmother-safe" stocks (like Verizon) get left behind. But it might also be because I am wrong.

I sincerely hope for some really knowledgeable spectrum engineers to tell me where I am wrong on this. Comments are appreciated either on the blog or by email.

---

Spectrum usage - the basis for valuation

Imagine we are sitting in the room and I have a purple flashlight. I can transmit information to you using that flashlight - by flashing it.

In the old days I might have used morse-code to do it - and I could probably get this to work at something under typing pace.

As computers have improved - and the light flashes faster and faster - I have been able to get more and more information into my signal. With telephone signals you get about a 10X improvement by going from analog to (2G) digital and get another large lick between 2G and 3G and then 4G. By the time we get to LTE for everything (including voice) this will largely have played itself out.

The purple light is flashing nearly as fast and efficiently as it can now.

Now suppose I have a room full of people and I wanted to flash my purple light to send everyone some information.

One way is that I could "share the channel" by sending a bit of my signal to everyone in the room usually with some kind of program whereby they can pick out their bit of the signal and everything else gets discarded. One example of this was "code division" as in "Code Division Multiple Access" or CDMA.

The problem is that as I share the channel everyone's gets their information a bit slower. I need to wait whilst information is sent to everyone else.

And if I try to do it too much I just cram up the signal.

I could try a different approach - which is to use multiple purple flashlights and flash signal at full pace to everyone separately but I will have another problem.

The room will be flooded with purple light.

And that purple light will degrade everyone else's signal.

That degradation has a name: "interference". Too much interference and the speed at which I can get information slows down - often dramatically.

There are a few solutions to the interference problem.

One solution is that instead of having a big tower flashing purple light to everyone I have lots of tiny little towers that flash a low powered purple lights that has an effective transmission distance of a few metres. In an ideal world everyone has their localised purple light which gives them information and does not interfere with their neighbours.

Alas that idealised solution requires lots of capital expenditure (you have to build a tower every few metres).

Another solution is to make the purple light into a beam and beam it at every individual person - so they all get their own signal. This has a name - "beam forming" and it the basis of many proposed 5G phone systems.

Another solution is to use the mathematics of interference to my advantage - design my system so that only my signal survives - and everyone elses' is cancelled as white noise.  There are variants on that - but the most famous is MIMO and it winds up being very computer intensive. However you can reasonably get another half order of magnitude of wireless efficiency via this method. It is also the basis of Steve Perlman's wireless technology. I am deeply skeptical of Steve Perlman's project - but I am sure there are people out there more knowledgeable than me.

Another solution is to encase my purple light in glass and send it individually to each person. You can get a vast amount of information this way (fibre-optics) but you lose mobility.

By far the cheapest solution though is to just use another colour.

So I flash in red, violet, indigo, yellow and a bunch of colours you can't see (but are still really colours).

Flashing my signal in multiple colours is an alternative to building more towers. This is a pretty direct trade-off. If I am allowed to use many colours I can get much more information out of a single tower.

When somebody buys "spectrum" what they are really buying is the right to flash light in a different colour. These colours are radio frequencies (say 700 MHZ) rather than visible light (say 700 THZ for the colour purple).

The right to flash information in a different frequency (that is a different colour) is an alternative to the practical obligation to build more towers.

As towers have an identifiable capital and running cost (a cost structure well known to phone companies) spectrum has a definable value - defined by avoided cost.

The point here is that if you know the cost of the phone company and the amount of capital expenditure avoided you can work out the value of the spectrum to a phone company. The phone company can either buy more spectrum or build more towers. [To work this out accurately you would need a map of the US, demographic and phone usage data by small region and try to work out how you would serve them.]

If you have a lot of information to transmit you can save a lot of money buying spectrum rather than building towers - and hence your spectrum is worth a lot of money. It is worth more if (a) the people are difficult to serve or (b) there is a lot of people willing to pay for speed or reliability.

This is where the value of spectrum in billions of dollars comes from. It comes from avoided cost.

--

A phone company with a good spectrum position will be able to avoid a lot of costs and still provide a very good service. This will make it profitable. It will be able to charge more (as it has reliable coverage) and will not have to build a lot of towers.

A company with a bad spectrum position will have a cost structure that - well frankly - sucks. It will be competed away.

When we think about the value of spectrum we have to think about the amount of cost that it avoids.

If it avoids lots of costs it is worth a lot.

If it avoids very little cost it is worth very little.

--

The rise of smart phones has increased demand for information a lot. Okay a huge amount. We all have the internet in our pocket these days.

And that has obliged phone companies to spend lots of money to keep up with demand. If they don't spend all that money their phone system will break down. [Lots of readers will remember AT&Ts problems in 2009 and if you do not here is Jon Stewart to remind you.] After the iPhone was introduced demand for data went through the roof (especially at AT&T who had a monopoly on iPhones). AT&T capital expenditure in the last five years has been roughly $100 billion - mostly on fixing this problem. These are not small sums and as spectrum is an alternative to capital expenditure AT&T most certainly wishes they had more of it.

The rise of smart-phones has driven up the capital expenditure requirements of the carriers - and as spectrum is an alternative to capital expenditure it has driven up the value of spectrum.

That rise in the value of spectrum (which really has been quite extreme) is the main reason for owning Verizon. They have lots of good spectrum which means good coverage at low costs and that means big profits. My view is simple here. The trend will continue and is Verizon's friend. Profits will be *much* higher in five years. The stock starts at a low teens PE ratio with a 4.4 percent yield and it is only going to get better.

Verizon wireless grows revenue at about 7 percent and will grow earnings faster.

--

What sort of spectrum avoids costs?

Spectrum has value because it allows you coverage and capacity at lower costs.

But not all spectrum is equal.

There is really good spectrum. That comes at low frequency and with very few restrictions as to the power output.

And there is poor spectrum which is either very high frequency or has restrictions as to the power output or both.

Low frequency spectrum is good because it propagates really well. It can go through buildings so you can use your iPhone whilst sitting on the toilet in the centre of your concrete office block. It can travel decent distances with limited regard to obstacles. In the wireless world low frequency tends to mean 600-900 MHZ.

In every country in the world there was a big block of this "beach front real estate" taken by the TV channels. Why? Because when they were allocating spectrum in the 1950s there were not many demands and the TV stations asked for and got the best bit.

In every country in the Western World the TV channels are being forced to go digital and their extra spectrum is being sold off. That sell-off has been the basis of most of the big spectrum auctions that have taken place.

In the last auction AT&T and Verizon were the big purchasers - and those blocks are where the LTE/4G networks have been rolled out.

However this is not just "low frequency" spectrum but it also has very few restrictions as to the power of transmitter allowed. Typically Verizon is allowed a tower hundreds of feet high on which they can put a 1000 watt transmitter. This allows Verizon the ability to cover a large amount of area (often hundreds of square kilometres) from a single transmitter. The most valuable spectrum at the last big auction covered the affluent suburbs of Chicago - middling population density and thick insulating walls meant that low frequency spectrum was required. Affluence meant that people would pay for the premium service.

You would never use the spectrum that way in Manhattan. There is simply too much demand for it. However you can still use smaller, lower towers and get good coverage inside buildings.

The two things that make this spectrum value is frequency (low) and power restrictions (very few).

High frequency spectrum is less good generally. It doesn't propagate as well. At very high frequencies (say 2500 MHZ) it can't get into a building and so you lose coverage as you go into elevators or behind trees. You certainly lose coverage when you go into the concrete core of your building (ie the toilet) and try to use the phone.

High frequency spectrum does however have one big advantage.

There is more of it. Much more of it.

And so it gets extensively used for capacity when you really need to move a lot of data.

If you are going to build a wireless network in Tokyo or Seoul or New York you are going to need a lot of spectrum (because the density of use is high) and some of that will need to be high frequency (simply because there is not much low-frequency spectrum and there is a lot of high frequency spectrum).

The poor propagation of high frequency spectrum can be used to your advantage. High frequency spectrum has a hard time getting into a building resulting in poor indoor coverage. A solution is to "light" the building from the inside - putting a transmitter say in the air conditioning duct. This makes for very good internal coverage.

Moreover as the high frequency spectrum can't normally get into the building in this case it can't get out of the building. This means the spectrum used in the building does not interfere (much) with the spectrum used outside the building allowing reuse of spectrum.

Very high frequency spectrum (say upper-band WiFi at frequencies of around 5000 MHZ) can stay inside individual rooms of a home. Low interference is good and means the WiFi never gets congested. The downside is low propagation even within your home. [If you try using your iPad in bed on the other side of the house you will understand the problem.]

Verizon's spectrum mix (unequivocally the best in America) consists mostly of low frequency 700 MHZ "beach front" property with another amount of high-frequency spectrum (the so-called AWS bands) which are used primarily for urban infill. They have some frequency at higher levels too however they have not traditionally had any interest in very high frequency spectrum (eg 2500 MHZ).

Power restrictions

Driving in the country at night you know that a big city radio station (even one a very long way away) can drown out a country station. Radio - especially AM radio - is very low frequency (say 0.6 MHZ) and can propagate a long way (hundreds or sometimes thousands of kilometres).

There is not much spectrum this far down the dial so you can't have a lot of stations. And they interfere with each other a great deal. The big city station has a power output that will simply dwarf a regional station.

Not everyone will be allowed to broadcast with high power because something with high power will (badly) interfere with something at lower power a little way up or down the dial.

All rights to use spectrum come with a power restriction. That power restriction can be for a trivial amount of power or can allow you to use 1600 watts from a 300 metre high antenna.

Obviously being able to pump out a large amount of power from a high tower with a great line of sight will be cheaper than putting a smaller transmitter every 50 meters.

The higher the amount of power you can pump out the higher the value of spectrum.

Lightsquared and power restrictions

Power restrictions can completely neuter the value of your spectrum. LightSquared had some spectrum that was originally designated for satellites. Phil Falcone bet his hedge fund and his reputation on the possibility of getting that spectrum approved for terrestrial use. If he could it was very valuable.

The only problem: that spectrum was near (in frequency) to the spectrum used for the economically important GPS satellite system.

The Federal Communications Commission (FCC) said that was fine so long as independent tests verified that there was no interference.

Phil Falcone took that as the go-ahead - the right to use the spectrum.

Alas the independent tests came back nasty - a phone tower interfered with an aircraft navigation system 20 kilometres away. Approval was denied.

Now I am going to make the obvious point. GPS signal is broadcast by a satellite running on solar energy and batteries hundreds of kilometres away. A phone signal comes from a large tower hooked to mains power.

There are 11 orders of magnitude difference of power between the GPS signal and the phone signal. If the colours were not very different (say a slightly different shade of purple) then there is simply no way that the GPS signal could be seen. The way to think about it: try spotting a 1 watt LED versus the entire power load of a nuclear power station converted to light when the light is a similar colour. It can't be done.

LightSquared demonstrated one thing: Phil Falcone is so egotistical he thought his will could out override the laws of physics. It cost him his fund and his reputation. It cost his clients an awful lot of money.

Alas this seems common enough on Wall Street. I have seen the most absurd things being said about spectrum as if power restrictions do not matter. Power restrictions absolutely determine the value of the spectrum holding.

Quick summary as to what is valuable and what is not

Low frequency spectrum with limited power restrictions is hugely valuable.

High frequency spectrum with only modest power restrictions is less valuable - but is very good for urban infill. Once you have covered most the nation with low frequency spectrum you need to do mid-range or high frequency infill. This is the stage Verizon is now at - using AWS spectrum for infill.

High frequency spectrum with dramatic power restrictions is worthless. A high frequency spectrum with a binding power restriction can't get into a building and can't go very far and you simply can't cost-effectively build a network using that stuff. Besides it competes with WiFi - and WiFi is free - and competing against free is difficult.

WiFi

 There is a lot of WiFi spectrum, some at 2400 MHZ but most around 5000 MHZ. It is unlicensed and anyone can use it. It is high frequency spectrum which makes transmission through the walls of your home difficult (as anyone who has tried can attest).

There are some rules for using it - concerning how you are meant to share channels. The most important rule however is a power restriction. Power restrictions on WiFi are binding and a WiFi signal has an effective range of about 70 meters. [The range will depend on how many walls you have and also on other WiFi signals and how good your antenna is.] Whatever - it is useless over long ranges.

The power restriction is absolutely critical to WiFi. The reason why everyone in a street manages to use WiFi in their home without causing critical interference is that everyone abides by a power-restriction. [You cannot legally sell a WiFi access point that does not abide by the power restriction.]

WiFi carries a lot of data and it carries it by the mechanism of giving everyone a very low powered purple light which they put right next to them. But instead of just purple it has about twenty colours (known as channels). You can carry a *lot* of information by WiFi - multiple high-definition TV channels even - but you can't carry it very far. And for the most part the consumer pays for the infrastructure [ie the little purple light] which is nice for the carriers.

Point here: low-powered high-frequency spectrum competes with WiFi and you can't do that very effectively because WiFi spectrum is fairly abundant (caveat in the next section) and free.

The caveat: WiFi in the Superbowl Stadium versus WiFi in Times Square

There are about twenty useable WiFi channels and it is not often that twenty people want to be downloading something simultaneously within say a 100 foot radius.

When this happens you run the risk of WiFi congestion.

There are prominent places when far more than twenty people want to use the same spectrum simultaneously. The Superbowl stadium at half time has 70 thousand people in it all wanting to film, take pictures and upload the stuff to the internet. The Superbowl stadium at half-time is probably the most congested spectrum in the world.

The WiFi (and phone systems) in the last Superbowl worked. [It had to work - it was sponsored by Verizon. Verizon would have had very bad press if it had not worked.]

In Times Square at the queue for half-priced tickets everyone seems to want to download theatre reviews (as much as anything to see what to see).

WiFi does not work. I know. I have tried it.

It is worth explaining why.

Even though there are rules unlicensed spectrum suffers from the problem of the commons. Too many people in an uncontrolled fashion want to get onto it. The commons however are not very big (a couple of hundred feet radius mostly) and most commons (say the one in my suburban street) have a limited number of people who want to share. So "commons" is not a big problem.

In Times Square "commons" is a big problem. Way too many people fit into my small radius and the network is congested.

At the Superbowl that is also true - but for one thing. There is only one party managing the network in the Superbowl stadium. Signal from outside the stadium can't get in. (The walls are too thick!)

So within the stadium the unlicensed spectrum behaves as if it were licensed spectrum. Sophsiticated WiFi equipment (such as Meraki) include "rogue network detection" as as standard feature. If you were setting up a wireless network for (say) Stanford University where there were a gazillion devices you would want to ensure that rogue networks were prohibited and to ensure you own the spectrum in those places. Rogue devices are jammed and "deauthorized".

The FCC has recently pronounced against jamming rogue networks - at least if you want to charge for an alternative network. The FCC recently fined Marriott Hotels $600 thousand for jamming a rogue WiFi hotspot and then forcing people to pay for hotel-provided WiFi.

My guess is that jamming remains legal (it is certainly supported by equipment manufacturers) but it is only legal if you give away the WiFi signal on your controlled network.

GSAT

GSAT - the latest victim of Sahm Adrangi's precision analysis - is the owner of two blocks of spectrum - both originally allocated as satellite spectrum.

One lot is clearly worthless as it even closer to GPS spectrum than the Lightsquared spectrum. Interference is a given. There is no way they will be allowed to operate at any meaningful power level.

The other lot of spectrum is adjacent WiFi and will never be allowed by the FCC to be substantially more powerful than WiFi spectrum for fear of drowning out WiFi. GSAT proposes using their spectrum with a 4 watt power limit. [Verizon spectrum is low frequency and often has a 1000 watt power limit.] This will mean it has a range commensurate with WiFi.

What GSAT are proposing is a private WiFi channel.

But for the most part there is enough WiFi channels.

In football stadiums or Grand Central where rogue networks can be removed there is plenty of WiFi capacity. [This was demonstrated by the fact that your phone worked during the last Superbowl.]

This applies in hotels too (provided hotels give up charging for WiFi and hence don't fall foul of the Marriott ruling).

In places where rogue networks can't be excluded like Times Square another WiFi channel will be nice. But there are not that many such places. Moreover one channel will get congested for sure in those places... after all if just two people want it you have a difficulty...

Simple summary: GSAT has nothing in the spectrum game. High frequency spectrum with a binding power restriction is worth something near zero. It is a non-starter.

It is hard to see what capital costs GSAT's spectrum helps a carrier avoid. And if it doesn't help them avoid costs then the spectrum is worthless. [Sorry guys.]

That said there are plenty of hedge fund managers who hold GSAT on some vague notion that spectrum is scarce and hence valuable.

I know you read this blog. I suggest you start your next letter as follows:

Dear Limited Partner 

As you know we hold GSAT even though their spectrum is restricted to low power output and is of a high frequency and hence will not have a range of more than a few hundred feet. It also competes with WiFi spectrum within that range. 

We however think that the laws of physics do not apply to us because...

Low frequency spectrum - and the incredible value it offers

AT&T and Verizon have the lion's share of low frequency spectrum in the US. [Both Sprint and T-Mobile have narrow slices.]

These large holdings of low-frequency spectrum mean that Verizon and AT&T can offer better coverage at lower capital cost than their competitors.

The low frequency spectrum however still has limited capacity. If you want lots of capacity you have to use high frequency spectrum (simply because there is much more of it).

If you have low frequency spectrum you advertise yourself on network reliability ("Can you hear me now") but you offer limited and often small data plans.

If you have a high-frequency network your reliability is going to suck (sorry Sprint) but you can offer very large (even unlimited) data plans.

To the extent that you can charge for reliability and you do not have to carry huge amounts of data you should have pricing power AND more modest capital expenditures. You should make pots of money.

We have almost pure comparison between a high-frequency player and a low frequency player in the US - an that is between Verizon Wireless and Sprint.

Verizon Wireless was a separately reporting subsidiary until the end of 2012 and reported its data (courtesy CapitalIQ) can be found here. You can see it did something like $76 billion in revenue in 2012 and the capital expenditure was 8.8 billion (which was its all time high). The capital expenditure was the all-time-high because of the roll-out of the LTE network. Since then Verizon Wireless revenue has risen. Here is wireless revenue by quarter:

								(dollars in millions)
	2012		2013				2014
Unaudited	3Q	4Q	1Q	2Q	3Q	4Q	1Q	2Q
Operating Revenues
Retail service	$ 15,538	$ 15,786	$ 16,169	$ 16,422	$ 16,776	$ 16,967	$ 17,246	$ 17,288
Other service	616	607	559	656	740	744	741	790
Service	16,154	16,393	16,728	17,078	17,516	17,711	17,987	18,078
Equipment	1,858	2,559	1,813	1,953	1,924	2,421	1,870	2,387
Other	1,012	1,042	982	945	959	993	1,022	1,018
Total Operating Revenues	19,024	19,994	19,523	19,976	20,399	21,125	20,879	21,483

You can find the original here.

The growth rate is about 7 percent. It is pretty good.

Operating income for wireless is growing faster because there is relatively fixed costs - and thus operational leverage. Operating income for wireless is now running over 7 billion per quarter and the growth rate was 14 percent in the first quarter but only 7 percent in the second quarter. [There were some unusual expense shifts - my guess is the growth rate is about 10 percent.]

Capital expenditure for wireless is currently running a little over 10 billion per year (it has gone up - all that urban infill is not cheap). They are guiding it down in a couple of years which makes sense (but I guess has to be seen to be utterly believed).

By contrast here are Sprint's numbers. [Again you can find the original courtesy of CapitalIQ.]

Revenue is only 35 billion per year - less than half Verizon - and it does not grow very much.

More importantly capital expenditure is running at roughly 6 billion per year. Again they are guiding for it to fall somewhat - but it can't fall much because of the lack of coverage. What we have is less than half the revenue, roughly 60 percent of the capital expenditure and a lack of growth. It is not pretty.

Capital expenditure has been SUBSTANTIALLY larger than operating cash flow for many years. By contrast Verizon Wireless has substantial operating cash flow after capital expenditure. The spectrum holdings of Verizon have avoided vast capital expenditures and provided better service and pricing power.

Sprint by contrast has large and increasing funding needs. They needed a huge capital injection from Softbank. My guess is that they will need another one.

T-Mobile whose spectrum position is similar to Srpint also has capital expenditure substantially larger than operating cash flow. Alas their parent is not as rich. My guess is that contrary to the popular perception Sprint and not T-Mobile is the ultimate survivor - but only because Sprint is controlled by Softbank and Masa Son will decide at some point he prefers owning a solvent number three phone company than owning a large stake in Alibaba.

Some people (and guidance) think that T-Mobile becomes cash flow positive (after capital expenditure) when it finally turns off old 2G networks. I do not believe it as I think their unlimited buckets now will force them to infill for a very long time. [The 2G network thing will also apply to Verizon.]

The Verizon question

Verizon wireless grows revenue at about 7 percent, income at about 10 percent and according to management is likely to drop its capital expenditure.

It is priced at a teens PE ratio.

Of course it includes a wireline business but that is no longer shrinking. Why? Mainly because it is the opposite end of all those WiFi access points.

What is is worth?

My guess is a *lot* more than the current price. I can't see any reason why the demand for bandwidth will not be a lot higher in a decade and the ability to solve problems by digital compression (ie 4G over analog) is nearing an end. There is likely going to be a true crunch and that crunch will provide pricing power.

But bluntly you don't need that. All you need is the revenue growth to continue at 4-7 percent for half a dozen years, profit growth is thus 8-14 percent and the free cash is overwhelming. Verizon is very cheap it continues. It starts with an almost 4.5 percent dividend. If it gets better at that rate for half a dozen years (still an open question) Verizon is really cheap. In order for Verizon not to be good value that revenue growth needs to stop or the capital expenditure requirements need to blow out.

Some people state the revenue growth will stop because there is a price war going on in US telephony. I have spent a lot of time looking at it and think it is mostly a phoney war (forgive the pun) but it is clearly impacting Sprint whose revenue is stationary but whose customers

I would love (off-the-blog) a decent conversation with anyone who has a decent idea on how to value Verizon's spectrum. I have a list by county of the US of their spectrum holdings (its a 25 megabyte file).

Is there any more spectrum?

It is worth asking whether this can be solved by making more spectrum available. Are there great "fallow fields" of spectrum?

The short answer is no.

The long answer is a little more complicated.

The available low-frequency spectrum has by-and-large come from freeing up the spectrum previously used for TV. In most countries (though not America) all the auctions have happened.

In America there are two major releases of that spectrum. The first was in January 2008 - and the second will be in 2015 (the so-called incentive auction).

The 2008 auction was bid just after the introduction of the iPhone (announced 29 June 2007, introduced a little later). The bidding prices were not high. Spectrum demand and prices have gone up massively since the introduction of smart-phones.

The 2015 auction will be the last auction of high-value low frequency spectrum in my lifetime. There are no more huge blocks to be had. The FCC has reserved 30 MHZ for minor players (not AT&T or Verizon). That reservation is a huge gift from taxpayers to the minor carriers and will allow at least one of Sprint or T-Mobile (or maybe Dish) to prosper. For the minor players the 2015 auction is their last chance to get some high-powered low-frequency spectrum. It is do-or-die.

Because Sprint has a richer parent (Softbank) my guess is the winner will be Sprint.

At high frequency there is not really a shortage of spectrum. There is a lot of WiFi spectrum if you want to build a very dense network (at very high cost). But more realistically Sprint owns (courtesy of Clearwire) huge swathes of very high frequency spectrum with much more realistic power limits than WiFi. Sprint is able to offer a lot of capacity - but as the spectrum is high frequency they might have trouble offering it over a broad market.

Future research

I am seeking anyone who can help me value Verizon's spectrum. I want to develop a physics-based model of Verizon's competitive advantage. Hope dear readers that you can help.



John