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Risk Reward Balance for U.S. Cellular

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On Dec 5, we retained our Neutral recommendation on United States Cellular Corporation (USM - Free Report) , subsidiary of Telephone & Data Systems Inc. (TDS - Free Report) . Despite gaining momentum in wireless services, the company’s third-quarter top and bottom-line results declined year over year and missed our projections. Currently, the Zacks Consensus Estimate for the company is pegged at a loss per share of 35 cents and it carries  a Zacks Rank #3 (Hold).

Why Neutral?

U.S. Cellular has taken a number of strategic actions to accelerate long-term growth. These measures include introduction of a new billing system, expansion of distribution channels, continuous rollout of 4G LTE, enhancement of LTE handsets and various spectrum transaction deals. The company is also focused on improving cost and profitability by managing equipment subsidies and data delivery cost.

Moreover, U.S. Cellular has instituted several marketing initiatives. One such example is the introduction of four new bundled services that offer unlimited Internet and messaging plans with top popular features, at affordable prices. In addition, the company is gaining significantly from its “Hello Better" campaign that focuses on customer services. Given these positives, U.S. Cellular has witnessed substantial branding power resulting in a flat sequential churn rate.

We believe these initiatives will bring down the retention cost on existing customers, thereby improving churn rates and the rate of customer accretion. This will consequently result in Service revenues of $3,590–$3,640 million estimated for 2013

U.S. Cellular remains optimistic about the growing demand for smartphone, which has market penetration of 46%, supporting growth in data revenues.  The company expects equipment pricing to remain competitive given the growing market for smartphones, which will also lower the equipment sales.

Smartphone sales represent approximately 64% of equipment sales, and 89% of the smartphones are 4G devices. Over the near term, rapid transition of the wireless market from the 3G to 4G LTE space and the demand for 4G devices are likely to remain high. To tap into this opportunity, the company has introduced a wide range of 4G LTE devices in 2013 as part of a robust competitive portfolio that includes top Android devices.

To increase smartphone penetration in the prepaid market, the company offers its “U Prepaid” service across 400 selected outlets of Wal-Mart. U.S. Cellular also provides its postpaid products and services through Wal-Mart’s Sam's Club and is negotiating with other large retailers for product distribution. Moreover, it started offering Shared Data Plans for consumers and business to allow customers to flexibly use data services by choosing any single bucket of data for their smartphones, basic phones, tablets, hotspots and wireless modems.

We believe that the long-term higher average revenue per user (ARPU) from smartphone users and full utilization of LTE network capacity by migration of customers from 3G to 4G networks will mitigate the operating cost headwinds from higher subsidies on smartphones.

However,customer churn remains a primary concern for U.S. Cellular and the absence of iPhone prior to November this year was a key contributor to this issue. Further, a higher mix of smartphones and increased subsidies on 4G LTE devices will continue to affect the company’s expenses. We believe that the aggressive LTE network rollout plan may strain finances, if capital expenditures exceed management’s expectations in order to keep networking technologically competitive.

Moreover, high costs associated with network integration and construction of new cell sites, increasing capacity in existing cell sites and upgrading of wireless technology or spectrum licensing; are also expected to considerably pressurize the company’s margins.

U.S. Cellular operates in an intensely competitive wireless market and remains significantly challenged by its competitors’ lower-cost mobile service plans. On a regional level, the company’s immediate competition is from Leap Wireless International Inc. . Additionally, U.S. Cellular remains  susceptible to aggressive pricing by larger rivals like AT&T, Inc. (T - Free Report) .

If management attempts to raise prices, it may markedly slow down subscriber growth. As the U.S. wireless market reaches maturity, pricing strategies will be the most salient customer retention element. Further, the ongoing consolidation in the wireless industry through mergers, acquisitions and joint ventures are stiff challenges.

Weighing these positive and negative factors, we remain cautious over the near-term performance of the company and thus, retain our Neutral recommendation. 

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