Paine Webber:
John Hodulik
Soo Kim,
<<WCII_up.doc>>
WINSTAR: Upgrading to Buy, sell-off unwarranted
August 18 , 1999
KEY POINTS
* We are upgrading WinStar to Buy from Attractive based on the recent
pullback in the company's shares, our belief in the company's ability to hit
second half targets, and the growing acceptance among larger carriers of the
value of fixed wireless as a inexpensive broadband access platform.
WinStar's recent share price of $45 5/8 provides over 35% upside to our
12-month target price of $62 per share.
* In the second quarter, the company posted strong top line growth and
EBITDA results in line with our expectations. Gross margins were 100 bps
below our estimate, however, and likely played a major role in the company's
failure to participate in the rebound the sector has experienced in the past
two weeks.
* We are unconcerned by the shortfall as the higher than expected
expenses were largely the result of an accelerated roll-out of network
infrastructure. Despite this ramp, the company posted gross margins of 29%
of sales for the month of June, substantially above the 24% figure reported
in total for the quarter.
* This suggests strong margin expansion heading into the third
quarter. Additional leverage at the gross margin line should come from the
company's improving line mix and continued progress in converting operating
leases to capitalized leases through the company's contracts with Williams
and Metromedia Fiber Networks.
* Yesterday the company enhanced its ability to serve customers by
acquiring additional spectrum in and adjacent to current markets. The
spectrum gives WinStar a larger addressable market while assuring it has the
capability to serve businesses as bandwidth requirements continue to
increase.
* At this point, we believe WinStar remains the way to play the fixed
wireless space and its growing acceptance as an alternative broadband access
methodology. We are maintaining our 12-month target price of $62 per share
based on our DCF analysis.
Gross margin expansion remains on track
We are upgrading WinStar shares to Buy from Attractive based on the downturn
in the company's stock price and our renewed confidence in the company's
ability to hit its 1999 targets. The shares have slid almost 30% since the
third week in July when interest rate fears hit the sector. Ambiguous
regulatory pronouncements in the first week of August added fuel to the
fire, exacerbating an already jittery market for CLEC stocks.
As these issues have begun to dissipate, many of the stocks in the sector
have bounced on their recent lows, buoyed by strong second quarter results.
WinStar shares, however, have not participated in the run-up due largely to
perceived weakness in the company's August 10th earnings release. While
revenues and EBITDA losses came in as expected, weakness in gross margins
shook investor confidence in management's visibility into the second half.
We do not share this view, believing that the company is on track to hit our
gross margin estimates of 38% in the fourth quarter. While additional
expenses related to network expansion kept margins below the 25% we had
expected for the quarter, gross margins in June were 29% of sales. We
believe this suggests the company's "network-centric" strategy continues to
play out as expected and that the WinStar is well on its way to hitting our
profitability targets for year-end.
Accelerating the network roll out
The 100 bp shortfall in gross margin was caused by the company's accelerated
roll-out of its fixed wireless hub sites. At year-end 1998, WinStar had
only 16 hub sites in place. By August, the company had 97 in operation and
43 under construction, many of which were already incurring operating costs
associated with connectivity.
These hub sites are key to the company's ability to increase its reach in
local markets with high margin, facilities-based service. More hubs lead to
more on-net buildings, increasing the addressable market and facilitating
the growth of on-net access lines.
Figure 1
WinStar improving line mix, gross margin expansion
3Q98 4Q99 1Q00 2Q00
Fixed Wireless 18.0% 20.0% 23.4% 27.1%
Type II 19.0% 20.0% 21.0% 18.6%
Resold/Data 63.0% 60.0% 55.6% 54.3%
Gross margins 25.2% 10.5% 22.9% 24.0%
Source: PaineWebber and company data.
The company has recently proven its ability to ramp-up service delivery on
its own network, adding 33,120 new FW lines in the second quarter versus
26,000 in the first quarter and 17,500 in the fourth quarter of 1998. This
has brought the company's installed on-net line mix to 27.1%, up from 23.4%
in the fourth quarter.
Figure 2
WinStar "on-net" line growth
3Q98 4Q98 1Q99 2Q99
FW lines (total) 46,260 63,800 89,800 122,920
FW lines added 17,010 17,540 26,000 33,120
FW line mix 18% 20% 23% 27%
Source: PaineWebber and company data.
Aside from the leverage provided by the increasing mix of on-net traffic,
WinStar should also see gross margin improvement as a result of its
contracts with Williams and Metromedia Fiber Networks. Approximately $8
million in monthly recurring costs will be removed as the company moves
traffic from leased long haul connections onto the Williams network. As of
the second quarter, about half of the affected traffic had been transferred
leaving about $12 million in quarterly operating costs, equal to roughly 10%
of estimated third quarter revenues, to fall off in the second half.
Capacity from MFN will have a similar effect on the company's gross margins,
decreasing WinStar's reliance on leased lines currently used to link hub
sites.
Tweaking our numbers
Based on last quarter results and factors unrelated to the core telecom
business, we are making minor adjustments to our 1999 numbers. First, we
are taking down New Media revenue estimates by $3.5 million and $5 million
for the third and fourth quarters, respectively, based on slower growth in
the second quarter. Telecom related revenue estimates remain unchanged and
we now expect total revenues of $112.2 million and $131.1 million in the
third and fourth quarters.
From a cost standpoint, we are maintaining our operating expense estimates
despite the lower revenue generated by the New Media business. This lowers
gross margins to 30% from previous estimates of 32% in the third quarter, in
line with previous company guidance. We believe this estimate to be
conservative based on the company's performance in June while allowing for
further acceleration of the company's network expansion. We continue to
expect the company to post gross margins of 38% in the fourth quarter.
Estimated EBITDA losses edge up from $71.9 million to $73.7 million in the
third and remain unchanged at $59.9 million for the fourth quarter.
growing need for fixed wireless
The rapid growth of data services has highlighted the shortcomings of
current access networks that have been largely unable to cope with increased
bandwidth requirements. Meanwhile, improvements in fixed wireless technology
are enabling spectrum holders to deliver value-added services to end-users
in the business and residential markets at a fraction of the cost of
traditional transport. The compelling economics will only improve as
companies such as Lucent and Nortel continue to invest their R&D dollars in
the development of new fixed wireless platforms.
Sprint and WorldCom have been quietly assembling spectrum to allow them to
provide broadband services to the residential market. On the business side,
only WinStar, Teligent and NEXTLINK have the bandwidth required to offer
high-speed services on a commercial scale to small, medium and large
customers. These three companies are well positioned to leverage
advancements in wireless technology that make spectrum so attractive to the
giants in the industry in the most attractive segment of the
telecommunications marketplace.
WinStar is currently the best positioned to benefit from improving FW
technology and the increasing bandwidth needs of the business market. As
the last remaining, unaffiliated FW pure-play, the company also appears to
be the most likely target of a larger carrier looking to extend the reach of
its local fiber networks. WinStar's ability to deploy network and provide
facilities-based service will only enhance its value to a potential
acquirer.
RISKS
Risks to the company include ability to execute, increasing competition,
changes in technology, potential adverse regulatory rulings, high financial
leverage and continued dependence on the capital markets. |
