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.
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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.
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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.
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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.
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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
