U.S. Cellular Upped to Neutral

We are upgrading our recommendation on U.S. Cellular ( USM - Analyst Report ) to Neutral from Underperform based on stellar second quarter performance. Despite the economic slowdown, the company’s earnings gave a stellar performance, thanks to smartphone sales.

The company remains optimistic on the growing demand for its smartphones. In second quarter 2011, smartphone sales represented approximately 41% of equipment sales and are expected to remain crucial in driving revenue ahead.

U.S. Cellular continues to expand its smartphone and tablet arena and plans to launch its first 4G enabled smartphone packed with Android 2.3 operating system in 2011 and will continue to roll outthrough 2012.

Over the years,U.S. Cellular has been successful in acquiring selectedwireless licenses in areas adjacent to already established coverage regions. This enables the company to build contiguous operating marketswhich, in turn, provides extended in-network capabilities for customers.

U.S. Cellular’s advancement in 3G Evolution-Data Optimized (EV-DO) technology has materially increased the throughput of data transmissions on its network which is comparable to the offerings by other nationwide cellular carriers. Currently, the company covers approximately 98% of its customers within its 3G network.

U.S. Cellular is evaluating the adoption of LTEtechnology to cater to 4G wireless technology demands.U.S. Cellular plans to deliver LTE services by November 2011 through nearly 1,250 cell sites to more than 25% of its subscriber base across 24 markets. The initial deployment of the 4G LTE will be in Iowa, Wisconsin, Maine, North Carolina, Texas and Oklahoma.

U.S. Cellular also looks forward to a spectrum swap with Verizon Communications that will provide 13 lower 700 MHz B-Block licenses and 5 lower 700 MHz C-Block licenses in Idaho, Illinois, Indiana, Kansas, Nebraska, Oklahoma, Oregon and Washington.

U.S. Cellular has instituted several marketing initiatives, including four new bundled services that offer unlimited Internet and messaging plans with popular features at affordable prices. In October 2010, U.S. Cellular launched “The Belief Project,” which focuses on price plans and handsets as well as provides a compelling high-value portfolio of products and services.

In the first quarter, U.S. Cellular had approximately 2.3 million customers under its Belief plan. Further, the project is expected to have a positive impact on long-term profitability by increasing post-paid subscribers at least 10% over in the next several years and contributing to growth in average revenue per customer.

However, we believe U.S. Cellular has significant challenges ahead. Most of the regional marketsare extremely competitive as evident by consolidations among several large carriers. Companies like AT&T ( T - Analyst Report ) , Sprint Nextel ( S - Analyst Report ) , Verizon Communications ( VZ - Analyst Report ) have participated in several merger and acquisition deals that resulted in Tier-1 carrier expansion into sparser geographical markets.

As a result, pricing strategies have become highly competitive and any rise in prices may result in a considearble slowdown in subscriber growth. As the U.S. wireless market reaches maturity, pricing strategies will be the most salient customer retention element.

U.S. Cellular remains challenged by lower-cost mobile service plans from competitors. Sprint Nextel’s Boost mobile unit, Leap Wireless, and MetroPCS have revised their service plans, which start at $40 per month and include all taxes and regulatory fees.This plan may appear more appealing to cellphone users than U.S. Cellular’s $70 Primary Plus plan launched in November 2010.

While U.S. Cellular has effectively evolved its wireless network from earlier CDMA technology to faster versions, such as EV-DO, the aggressive network roll-out plan may strain finances moving forward. Moreover, high costs associated with customer acquisition and retention is expected to weigh on its margins.

The company’s high-margin roaming revenues remain under pressure. While this represents an industry-wide trend, it is likely to impact U.S. Cellular more than other rivals, given the company’s strong reliance on roaming fees and pricing factors.

Consequently, we have a Neutral recommendation on U.S. Cellular supported by Zacks #3 Rank (Hold).