Wednesday, October 9, 2013

Leap Wireless International, Inc. (LEAP): Best Way To Gain Upside From Lower 700 Block A Spectrum

Recent industry developments have cleared a path to unlocking the value of the previously impaired Lower 700 A Block Spectrum. The biggest issue, device support, has been addressed and should lead to widespread device availability for use within this spectrum.

License holders are pushing the FCC to resolve the remaining issue in the near term - Channel 51 interference. Even if the FCC doesn't act, the 600 MHz auction in late 2014/1H2015 should resolve channel 51 interference.

The best way to play the increasing value of the Lower 700 Block A Spectrum is through the purchase of Leap Wireless International, Inc. (NASDAQ:LEAP) stock now in order to own the remaining stub after the rest of the LEAP's assets are acquired by AT&T, Inc. (NYSE:T) for $15 a share.

"After the expected deal closes in 1Q2014, the remaining Leap stub will be a non-transferable equity interest in this Lower 700 Block A Spectrum license. Stub holders will be paid when the spectrum is sold to a third party, which we think will happen in the next two years," BMO Capital Markets analyst Kevin Manning wrote in a note to clients.

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In July, AT&T agreed to acquire all of Leap Wireless except for the lower 700 MHz A Block Spectrum that Leap owned in Chicago. This structure was used as AT&T did not want to own the spectrum because of the potential inference issues, it didn't support the spectrum at the time, and Leap was unable to find a buyer at the price Leap wanted.

Leap bought this spectrum from Verizon Communications, Inc. (NYSE:VZ) last year as part of a transaction in which Leap largely sold AWS spectrum to Verizon.

Following the close of the deal with AT&T, current Leap shareholders will hold a proportionate share in a contingent valuation right (CVR) in the spectrum. The 700 MHz license will be transferred to a licenseco, and a stockholders' repres! entative has been formed with three current Leap board members serving on the board.

The board will include Mark Rachesky, who is currently Leap's chairman and largest shareholder, as well as the current CEO and another current director.

"We believe it's in Mr. Rachesky's best interest to maximize the price received for the CVR as he likely will be the largest shareholder in the CVR," Manning said.

The stockholders' representative has two years to enter into an agreement to sell the spectrum and can incur up to $10 million in expenses before requiring approval from AT&T. If the stockholders' representative has not entered into a sales agreement within two years, AT&T will be allowed to sell the spectrum with proceeds distributed to the CVR holders.

Distributable proceeds of the sale of the spectrum, whether by the shareholders' representative or AT&T, will be net of expenses incurred in the administration and maintenance of the asset, as well as any contingent claims. Additionally, any proceeds in excess of Leap's $169.1 million cost basis will be taxed at 38.5 percent before distribution

"We think the Leap stub is the best way for certain investors to capitalize on the trend. We believe Leap's share price is valuing the spectrum at $64 million; in two years, we estimate after sale proceeds to investors of $306 million, or ~ $255 million after discounting for time, cost of capital, and illiquidity," Manning said.

Once all impediments are removed, and the spectrum can be used to augment adjacent spectrum blocks, the value of this stub will be closer to $306 million, enabling investors to capture the upside when it is sold.

The key roadblock could come from the operators of Channel 51 in larger markets who are reluctant to relocate to another channel owing to the potential to miss out on proceeds from the upcoming incentive auction. Leap and other carriers continue to press the FCC to implement incentives to encourage current Channel 51 broadcasters to! relocate! to another channel prior to the incentive auction.

"We believe this is a possibility. Leap has stated that it does not believe there is substantial interference between its 700 MHz license and Channel 51. However, it would still need the broadcasters' concurrence before it could commence operation," Manning noted.

If Leap manages to mitigate the interference issues with Channel 51 before the incentive auction, we believe potential buyers could range from investors to speculators. Recently, the market has seen investors buy Lower A Block Spectrum with the pending sale of 10 licenses by Cox to an entity backed by venture capital investors (Columbia Capital).

Verizon is the most logical acquirer. Although it did sell the spectrum to Leap in the first place, that was part of a larger spectrum purchase Verizon made from Leap and was also when Verizon was trying to sell 700 A & B spectrum as part of getting approval for its AWS purchase from Spectrumco. Verizon does own the A block in 80 percent of the top 25 markets already. In addition, Verizon has said it will deploy any spectrum it couldn't sell.

"If they are going to deploy the spectrum in other top markets we believe this would benefit from using the spectrum in Chicago as well," Manning added.

Leap would realize maximum returns by waiting until after the 600 MHz incentive auction. The existing Channel 51 will likely become uplink spectrum contiguous to the A block in 692 to 698 MHz, and the holders of this spectrum license would also likely find the A Block attractive for the ability to have a larger block of contiguous spectrum.

Finally, the spectrum could have value as a stand-alone license. Chicago has one of the highest population densities in the country, and A block spectrum is well suited to provide widespread coverage with excellent propagation. 

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