There’s a legitimate question as to whether the wireless industry has enough money to pay historical prices for spectrum the FCC intends to auction over the next 18 months. The FCC intends to auction approximately 150 MHz of spectrum between the AWS-3 and the Broadcast Incentive auction (assuming 65 MHz at AWS-3 and 85 MHz in the Broadcast Incentive auction) by the end of 2015. This approximately 47 billion MHz/PoPs based a US population of 310 million. At historical prices of approximately $1.00 per MHz/PoP for AWS-3 spectrum and $1.50 per MHz/PoP for 700 MHz spectrum ($1.28 from 2008 auction adjusted for inflation), the AWS-3 auction would raise $20.15 billion and the broadcast incentive auction would raise $39.525 billion, for a total of $59.657 billion, which we round to $60 billion. Unfortunately, its unclear the wireless industry has, in aggregate, this much money to spend.
Total wireless industry cash flow is approximately $35-$40 billion. Moreover, it is highly concentrated. AT&T and Verizon have 64% of the industry subscribers and over 80% of the profits. Sprint and T-Mobile have approximately 18% and 12% marketshare. After AT&T and Verizon, industry cash flows fall rapidly. Both Sprint and T-Mobile are cash-flow negative after accounting for debt service. There are approximately 100 smaller carriers. And since most are privately owned, their financials are unavailable. But, it is unlikely the total cash flows of the smaller carriers total more than $1 billion annually.
Currently, AT&T and Verizon control 77% of the wireless broadband spectrum below 1 GHz and approximately 50% of the spectrum between 1 GHz and 2.5 GHz. For AT&T and Verizon to get 60% of the spectrum auctioned and T-Mobile and Sprint to get 20%, the Big-4 will need to spend $48 billion assuming historical pricing discussed above. AT&T and Verizon would need to spend roughly $18 billion each (assuming both win 30%) while Sprint and T-Mobile would need to spend $6 billion (assuming both win 10%). This would leave the smaller carriers to spend $12 billion for the 20% remaining spectrum, which would be virtually impossible given their size. This leads to the potential that smaller carriers get even less, and that industry concentration increases.
Rural Focus Doesn’t Help Smaller Carriers Enough
However the reality is a bit more complex. The Big-4 will largely be bidding for spectrum in the largest markets where they need it the most (and where in the Incentive Auction, supply is likely to be less). Conversely, the smaller carriers are likely to bid in smaller markets, where pricing is likely to be lower. We’ve noticed a trend towards greater disparity in spectrum pricing between large and small markets. We believe it is reasonable to assume they will only need to pay 50% of average national prices, or $6 billion to win 20% of the auction at historical prices. This leaves the Big-4 needing to pay $54 billion for 80% of the spectrum to maintain historical prices. We believe both of these are very tall orders.
Investors are Likely to Lower Participation
Historically, investors (aka, spectrum speculators) participated in spectrum auctions by bidding for underpriced spectrum with the hopes of selling to a carrier at a higher price when they were ready to use it. But given the increased concentration of the wireless industry since the last major auction in 2008, investor participation is likely to be lower. Simply put, there are fewer carrier for them to sell to, making their holding spectrum a more risky proposition. Of course, some investors are likely to participate in both the AWS-3 and the Broadcast Incentive auctions, but probably at lower levels than in the 2008 700 MHz auction (Auction 73).
AT&T Threat to Limit Participation in FCC Auctions Must be Taken Seriously
AT&T recently suggested it might reevaluate its participation in FCC spectrum auctions if certain conditions were not met. While many industry observers dismissed this as merely a negotiation tactic – and it may very well be – it must be seriously considered. AT&T is not only talking about not participating aggressively in the spectrum auction, but it is also acting that way. In spite of the run-up to a very expensive auction, AT&T has continued to freely spend cash on its generous dividend (over 50% payout ratio) and its stock buy-back program (despite a cash balance of only $3.44 billion), which seems incongruous with the notion that it is getting ready to spend $15-20 billion on an FCC auction. Without aggressive participation by both AT&T and Verizon, the auction prices will almost certainly fall well short of expectations.
Spectrum Price Increases have Tapered
Additionally, the rapid rise of Wi-Fi offloading, now accounting for nearly 50% of wireless traffic and the proliferation of small cell sites has put a damper on spectrum prices. Recent sales have shown only mid-single digit increases. Verizon’s sale of 700 MHz A-block spectrum to T-Mobile for $1.85 per MHz/PoP is particularly striking. This represents a 16.3% increase (2.5% annual rate) from the $1.59 per MHz/PoP paid for the same spectrum in Auction 73 in 2008. However, when it was auctioned, the spectrum was facing significant impairments. There was no prospect of alleviating the channel 51 interference issues and handset interoperability appeared to be a long-term challenge. Since then, the handset interoperability issue has been resolved via industry agreement and the broadcast incentive auction is likely to resolve the channel 51 interference issues. Even with these “upgrades” to the spectrum, it still sold for single digit returns.
Credit Markets are Open – for Now
The credit markets are open for risks loans and interest rates are near historical lows. This may improve the ability of carriers to borrow to finance their FCC auction participation. However, credit markets can close quickly and there is no guarantee they will remain open to support bidders for the FCC spectrum auctions.
Declining Profitability of Wireless Industry Pressures Prices
There are two main reasons a wireless company bids for spectrum. The first is that they need the spectrum to serve their customers. In this case, they will pay as much as needed to avoid the cost of cell-splitting, up to the amount their customers will pay for the marginal capacity. The second reason carrier bid for spectrum is to keep it out of the hands of their competitors so they can maintain higher pricing. The largest carriers seem to have focused on the latter. Verizon is currently running its entire LTE network, a network carrying approximately 20% of the nations wireless traffic, on a single 22 MHz block on the 700 MHz band. Additionally, Verizon’s customers are disproportionately focused in high-density urban areas. This would imply the entire country could operate on about 100 MHz of the 618 MHz currently allocated for mobile broadband. Yet Verizon appears eager to bid for more spectrum. Of course future services will require additional spectrum. But the US “spectrum crunch” appears to be more an issue of allocation than absolute spectrum availability.
But hoarding spectrum from competitors makes less sense when reliable Wi-Fi is available and small cells are increasingly affordable. We’re already seeing carrier pricing fall in recent months. Should this trend continue, there will be less motivation to pay higher prices for incremental spectrum.
New Entrant Could Change Dynamics
The biggest factor that could help maintain pricing would be the arrival of a new entrant. Given the maturity of the U.S. wireless market, it is unlikely a new entrant will arrive unless they bring significant synergies. The most obvious of these is DISH Network/EchoStar. They already have 40 MHz of AWS-4 spectrum and 5 MHz of 700 MHz spectrum. Additionally, they have 14 million customers they are already billing and serving, relationships with consumer electronic distribution channels and a strategic need for a data service to stem their subscriber losses. But they have appeared hesitant to enter and are likely waiting for the right partner. This could be a company such as Google, but it could also be an existing wireless carrier such as T-mobile. If the latter, that carrier’s participation in the FCC auctions might be tempered as DISH/EchoStar would significantly augment their spectrum holdings. But if it is a company such as Google, teamed with DISH/EchoStar they could bid aggressively to shore-up spectrum holdings and support historical spectrum prices.
FCC and Industry Options
If the AWS-3 auctions don’t go well, the FCC will likely delay the Broadcast Incentive auction and wait until the industry has additional demand for the incremental spectrum. The FCC has until 2022 to complete the Broadcast Incentive auction. The alternative is to complete the auction at lower prices. While it is good to put spectrum in the market, if pricing is too low, carriers may be forced to write down the value of their current spectrum holdings on their financial statements. This could have the effect of causing them to blow bank covenants and/or making additional financing harder. The prospect of sharply reduced auction pricing is likely to cause the carriers to pressure the FCC to delay auctions or reduce their size. The other option would be for the FCC to allow the largest carriers to control an even larger amount of spectrum. If this occurs in the Broadcast Incentive auction, it would cement AT&T and Verizon’s positions dominating critical Sub-1GHz spectrum. The FCC clearly has some tough decisions ahead.