Earnings Quality Final Project Leap Wireless International Inc Jay Hedstrom Company Description Leap Wireless (Leap)

) is one of the leading providers of wireless digital communications to moderate to low income, value-seeking wireless customers nationally. They offer prepaid monthly and pay-as-you go unlimited voice and data plans and these services are marketed under the Cricket brand. While they own their own spectrum and network in certain regions of the country, they also rent capacity in their out-of-network footprint from Sprint which allows them to reach customers on a national scale. Their proprietary network covers ~95 million people and they served 5.9 million customers as of 6/30/12. Earnings Quality & Fundamental Analysis Issues Business Combinations Because wireless spectrum is such a valuable and expensive intangible asset for the wireless industry, occasionally companies will form joint ventures to acquire spectrum in certain regions by pooling their resources. Two companies may also acquire a pre-existing companys assets in a joint venture structure. It seems this is what Leap has done with their Savary Island and STX Wireless ventures. Leap owns a noncontrolling 85% stake in Savary Island, which owns spectrum located in the upper Midwest of the United States. I suspect that Leaps ownership in the entity was structured specifically to be non-controlling because there exists a very small business designation provided by the FCC which aids such businesses in acquiring spectrum through the FCCs auctions. It seems possible that, since Savary is not technically controlled by Leap, it can be considered a very small business. Importantly, however, Leaps Savary Island joint venture partner has the right to sell its 15% interest to Leap at a specified purchase price. On the other hand, Leaps stake in STX Wireless, a holder of wireless spectrum and operating assets in South Texas, is a 75.75% controlling interest. Given the previous specifics, it should come as no surprise that Leap consolidates the assets and liabilities of both joint ventures on its balance sheet. Savary Island is consolidated because it is considered a variable interest entity (VIE) since Leap is the primary beneficiary of the venture due to its majority stake. There are a couple of issues related to accounting for these ventures that are worth highlighting. First, the unowned portion of Savary Island is accounted for as a redeemable non-controlling interest which is located between total liabilities and equity on the balance sheet. Due to the puttable nature of the ownership interest, I believe that a liability account would be a more appropriate place for this interest except that the non-controlling interest holder has not acted on its right to sell to Leap, so I do not believe a liability has technically been generated. Additionally, 15% of the profits and losses associated with Savary Island are allocated to the redeemable-non-controlling interest account, which helps make it more equity-like. I also want to stress that while the goodwill generated from these transactions seems relatively low, a large portion of the purchase price paid by the joint ventures was allocated to identifiable intangible assets such as customer relationships and wireless spectrum licenses (see the following table for the STX Wireless acquisition). These licenses are considered indefinite-lived intangibles and yet the estimation of their fair value involves some discretion (more on these assets later). Overall, however, my level of concern regarding the accounting for these joint ventures is low. This is because: Leap has not reported meaningful goodwill impairments since the joint ventures acquisitions; the company discloses the carrying amounts of the separate assets and liabilities of both of the ventures in the footnotes to their audited financial statements; customer relationship assets, while likely a non-trivial asset to value, are amortized over their useful lives of four years so

it is not like the company is hiding an expense through their fair value allocations during acquisitions; similarly, I believe it is a positive indication that only 22% of the purchase price of STXs net assets were allocated to goodwill, indicating a low risk of attempting to boost future earnings; and there are relatively frequent wireless spectrum asset sales within the industry which provide current comparable transactions for determining the fair value of Savarys and STXs wireless licenses during the fair value assessment at acquisition.

STX Wireless
USD millions

Assets Contributed Cash FV of Leap's contribution to STX Wireless at 24.25% FV of prior Leap JV's contribution to STX Wireless at 24.25% Total Consideration

40.7 65.8 34.1 140.6 % of consideration 2% 1% 30% 24% 36% 22%

Net Assets Acquired Inventories Other current assets Property and equipment Wireless licenses Customer relationships Goodwill Total Assets Accounts payable and accrued liabilities Deferred revenue Deferred tax liablity Other long-term liabilities Total liabilities Total net assets acquired

FV 2.3 0.8 42.0 33.7 50.4 31.3 160.6 3.8 4.4 10.7 1.2 20.0 140.6

-3% -3% -8% -1% 100%

Revenue Recognition Since Leap sells both wireless plans of various duration as well as wireless handsets, it must apply the multiple element revenue recognition approach (or, as Leap calls them, multiple element arrangements). As such, the estimated selling price of the wireless service contract is deducted from the total consideration received from new customers, with the remainder allocated to equipment revenue.1 Equipment revenues and the related costs, such as the cost of the handset, are recognized when service is activated by these new customers. Clearly there is discretion in the estimation of the price of the service contracts and therefore, the amount that can be recognized upfront for each new customer has the potential to be manipulated. Unfortunately, it is difficult to assess this risk through ratio analysis because there are a number of other variables which impact the related line items in the income statement. For example, previously existing
1

Leap Wireless 2011 10-K, p. 43.

customers also pay for handset upgrades, the revenues for which are included in equipment revenue. However, despite this limitation, the chart below demonstrates that it is unlikely that Leap has pulled additional revenues forward by manipulating the fair value of service plans year-to-year because while the cost of equipment has increased 337% since 2004, total equipment revenues have increased only 63%. Ultimately, the risk for revenue manipulation should be limited as a majority of Leaps customers purchase pay-as-you go or month-to-month plans, making any potential over-allocations of revenues to equipment to recognize additional revenues up-front a very short-term phenomenon. Leap Annual Equipment Revenues & Expenses
900.0 800.0 700.0
USD Millions

600.0 500.0 400.0 300.0 200.0 100.0 -

2004

2007

2008

2010

Equipment Revenue

Cost of Equipment

Based on the following table, it looks like Leap may have taken advantage of channel stuffing to its licensee retail stores or other parties in 2011. The net accounts receivable to revenue ratio increased by almost 100bps between 2010 and 2011 after having not increased more than 30bps since 2006 (please note that Leap does not disclose its allowance for doubtful accounts). Indeed, Leap has continued to produce poor results and lose subscribers, so perhaps there was an added impetus to overstate revenue in 2011.
2005 19 958 2.0% 2006 38 1,167 3.3% 2007 21 1,631 1.3% 2008 31 1,959 1.6% 2009 37 2,383 1.6% 2010 51 2,697 1.9% 2011 87 3,071 2.8%

Accounts Receivable, Net Total Revenue ('000s) AR / Revenue

Accounting for Property & Equipment and Capitalization The most notable aspect of Leaps property and equipment balances is that the company capitalizes its network construction and other telecommunications expenditures in construction-in-progress until the network is placed in service and the assets are transferred to depreciable PP&E accounts. Salaries of engineers and technical specialists as well as interest expenses associated with the network build-outs are also capitalized. This has the effect of greatly increasing PP&E during a period of expansion. For example, the period between 2006 and 2008 saw Leap invest heavily in building out its network infrastructure in new markets following the acquisition of new spectrum. Thus, the net PP&E to sales ratio grew from

2011

2005

2006

2009

68% in 2004 to 94% in 2008. This was not a red flag, however, because once Leap officially launched in its new markets, it began depreciating the expenditures that had previously been capitalized in construction-inprogress (see the following supplemental tables and charts). Another sign that Leaps capital expenditure accounting has not been aggressive is the fact that only $46mn of construction-in-process assets or 20% of 2009s balance have been impaired, and this impairment occurred in 2010 after Leap changed its growth strategy by slowing its network build-out efforts and focused on renting spectrum from Sprint. Equally important, based on Leaps accumulated depreciation and gross depreciable asset balances, the companys assets have about 50% of their useful lives remaining. This implies that significant maintenance capital expenditures should not be expected over the next few years.
2004 68% 33%
2010 3,096 343 147 108 3,694 (1,657) 2,037 447 3.71 53%

Net PP&E / Sales Capex / Depreciation

Property & Equipment Property and equipment, gross Network equipment Computer hardware and software Construction-in-progress Other Total property and equipment, gross Accumulated depreciation Property and equipment, net Approximate Depreciation incurred Avg age of P&E (years) Avg remaining "useful" life of P&E

2005 65% 107%

2006 92% 261%

2011 3,246 456 100 112 3,913 (1,956) 1,957 525 3.73 49%

2007 81% 167%

2008 94% 240%

2009 89% 170%

2010 76% 87%

2011 64% 81%

Construction-in-progress Historical Balance

700 600
500

USD Millions

400 300 200 100 -

2004

2005

2006

2007

2008

2009

2010

2011

As an aside, Leap also disclosed an asset retirement balance of $32.9mn as of 12/31/11. This is associated with the expected cost of removing its equipment from leased towers. Based on the balance at the beginning of 2010 and the associated accretion expense recorded during the year, Leap discounts its asset retirement obligation at 9.7%. This rate seems high given that the coupon on Leaps 2020 bonds is 7.75% and the rate for government bonds are far lower than that. This is a red flag for Leap, but a minor one, given that I expect the absolute balance is small and that Leap will renew its cell tower site leases as long as they are in operation. There will be no need to remove their equipment unless they choose to upgrade. Deferred Tax Assets Leap has accumulated a large gross deferred tax asset balance of $1.15bn as of 12/31/07. The balance is associated with items such as deferred charges, wireless license expenses recognized for book purposes but not for tax purposes, and share-based compensation. But the largest deferred tax asset contributor by far is the $974mn in net operating loss carryforwards (85% of the gross DTA balance) which have been accumulated over a number of years of operating loss generation. Importantly, however, the company has established a full valuation allowance against its net deferred tax asset due to the uncertainty regarding the prospects of generating future earnings against which the operating losses can be used as a tax deduction. I view this as a prudent and appropriate judgment at this time. Due to the increase in the valuation allowance each period,

the effective tax rate calculation has limited utility given that the company still reports an income tax provision in their income statement despite generating pre-tax losses for book purposes. Contractual Obligations In addition to Leaps $3.2bn of on-balance sheet debt relative to only $613mn in shareholders equity, it is also subject to substantial off-balance sheet liabilities. For instance, discounting Leaps future lease payments at 7% (roughly the yield on Leaps long-dated debt), I estimate that Leaps operating leases are equivalent to an additional liability of $1.37bn. Leaps exposure to a leased asset is to be expected as many in the wireless industry lease space for their equipment with cell tower owners and operators. Although this significant offbalance sheet liability conceivably increases Leaps debt load by 45% which is concerning from a leverage perspective I do not believe that there should be concerns about how Leap accounts for their operating leases. First, Leap reported rent expense of $261mn in 2010 and expects lease payments to total $256mn in 2013. The fact that there is minimal difference between the two values is a positive sign. Companies are only required to disclose minimum operating lease payments in the footnotes and therefore a firms actual rent expense has the potential to be much higher Minimum Contractual Lease Paymanets 300 than prior forward-looking disclosures. Moreover, due to Leaps high ongoing 250 depreciation expense, as demonstrated in an 200 earlier exhibit, many investors focus on Leaps EBITDA metric to assess its operating 150 performance. While rent expense is included 100 in EBITDA, capital lease principal and interest payments are not. Therefore one could say 50 that accounting for the use of the associated assets as operating leases is more appropriate 2013 2014 2015 2016 2017 2018 2019 2020 and conservative for reporting purposes.
Minimum Lease Payments (est. '17-20) PV of Lease Payments (@ 7%) Sum of PV'd Lease Payments 2013 262 256 1,366 2014 261 251
USD Millions

2015 253 239

2016 206 192

2017 175 160

2018 135 121

2019 101 89

2020 66 57

The off-balance sheet liability story does not end there for Leap, however. The company has also entered into legally binding minimum purchase agreements with business partners such as Sprint and Apple associated with Leaps usage of Sprints wireless network in certain areas of the country and its opportunity to sell the iPhone 5. These obligations amount to a cumulative payment of $1.1bn between 2012 and 2016. Because Sprint and Apple have not fully performed on their associated multi-year obligations namely making the network available and functional for Leap and delivering iPhone 5 smartphones to sell to Leap subscribers, respectively I believe that this amount technically fails to satisfy one of the criteria for being designated a liability. While Leaps accounting for these obligations appears correct under GAAP, it would seem like capitalizing a liability would be the more conservative accounting approach for these future payments. Accounting for Intangible Assets

As of 12/31/2011, 40% of Leaps assets consisted of wireless licenses, goodwill and other intangible assets. Thus, an analysis of Leaps intangibles is an important component of assessing the firms accounting quality or potential areas of concern. As discussed above, one group of prominent indefinite-lived intangible assets is Leaps ownership of wireless spectrum licenses. Although such licenses are issued with 10-year terms, they are renewed for a small fee and Leap expects to renew its licenses for the foreseeable future. Leap evaluates the remaining useful lives for the licenses on a quarterly basis to determine if events such as regulatory, legal or technological developments warrant updating the categorization of any of the licenses to finite-lived assets to be amortized. One point to note is that Leap combines all of its operating market wireless licenses into a single unit to assess whether impairment has occurred. The company believes that utilizing the licenses as a group represents the highest and best use of the assets.2 This is important because Leaps licenses are not contiguous by location, so lumping those assets together when analyzing a potential impairment could be misleading. For example, the fair value of a license in one region of the country may be below its carrying amount by $50mn while another license in another part of the country may have a fair value that is $75mn in excess of its carrying value. By combining these licenses, Leap would not report an impairment. I expect that the risk of a hidden license impairment is low, however, as Leap has recorded its operating wireless licenses at $1,779mn on its balance sheet compared to a fair value estimate of $2,453mn at 12/31/11. This fair value measurement is based on sales prices of wireless spectrum of similar size and type that have been sold recently through government auctions or by private parties. Because the fair value of the spectrum licenses are 37% higher than their estimated carrying value, and because they cannot be written-up in value, it is possible that management will seek to sell some of the licenses to boost earnings amidst a period of underperformance. Indeed, Leap effectively sold licenses in 3Q12 and recorded a pre-tax gain of $128mn. However, the risk of earnings manipulation through this means is also reasonably unlikely as the gain was broken-out from operating income and the market widely recognized that the $128mn gain was one-time in nature. On 4/13/03, Leap and its subsidiaries filed for Chapter 11 bankruptcy. Upon its reorganization in 2004, the company was required to apply the estimated fair value of its entire business based on what a buyer would pay at that time for the businesss future cash flows to its identifiable net assets, which were reduced by the present value of the liabilities expected to be paid post-reorganization. This analysis resulted in over $400mn in goodwill as of the end of 2004. In 2010, Leap performed the first step of its goodwill impairment test, which relied on a 30% control premium applied to the market capitalization of the firm. Due to protracted pressure on the firms stock price, Leap ultimately wrote down the full carrying amount of goodwill during the year after conducting a second fair value allocation test. Typically such an impairment is a red flag or warning sign that management overpaid for an acquisition or did not meet its synergy expectations. In this case, however, since the goodwill was driven by fresh-start accounting following its bankruptcy and restructuring, I take somewhat of a less dim view of the charge to earnings. Based on the following table, one can see that Leaps intangibles as a percentage of revenue has come down significantly, even in years prior to the goodwill write-down, indicating that the firm is not overstating earnings in recent years by accruing economic costs on its balance sheet. Alternatively, it appears that it is possible management boosted earnings in 2011 by reducing its marketing expenditure by 300bps compared to 2010.
2

Leap Wireless 2011 10-K, p. 93.

The ratio of selling and marketing expenses to revenues was also the lowest it has been since 2005 after holding steady in the mid-teens throughout that time. This is certainly an issue to monitor going forward to determine if Leap management is under-investing in its efforts to acquire new subscribers.
2004 153% 11% 2005 144% 10% 2006 201% 14% 2007 143% 13% 2008 120% 15% 2009 100% 17% 2010 77% 15% 2011 67% 12%

Intangibles / Revenue Selling & Marketing Expense / Revenue

Conclusion While Leap is a stock issue with significant risks for investors including excessive leverage and business model headwinds the foregoing analysis of key accounting areas that can be subject to discretion and manipulation demonstrates that Leaps accounting should likely not be an area of concern for investors. Other than Leaps reduction in marketing expense as a percentage of revenues in 2011, I did not find what appeared to be an aggressive approach among its accounting for business combinations, property and equipment, deferred tax assets, intangibles and contractual obligations (though I would prefer that GAAP required the reporting of the Sprint and Apple commitments as a liability on the balance sheet). The one other area to be monitor going forward is the relationship between its receivables and revenues since 2011 saw a notable jump in accounts receivable to revenue, indicating channel-stuffing and something which also would have impacted the marketing to revenue ratio negatively.

Appendix
2004 INCOME STATEMENT Service revenues Equipment revenues Total revenues Cost of service Cost of equipment Selling and marketing General and administrative Total operating expenses EBITDA x-impairments
EBITDA margin

2005 769 189 958 204 231 100 160 694 264
28%

2006 956 211 1,167 264 311 159 197 931 236
20%

2007 1,396 235 1,631 384 406 206 272 1,268 363
22%

2008 1,709 250 1,959 488 465 295 332 1,580 379
19%

2009 2,144 239 2,383 609 561 412 358 1,940 443
19%

2010 2,483 215 2,697 841 592 414 362 2,209 489
18%

2011 2,829 242 3,071 981 818 369 356 2,524 547
18%

695 148 844 195 187 92 139 612 231

27%

Depreciation and amortization Impairments and other charges Operating Income / (Loss) Gain (loss) on sale of assets, net Equity in net income of investees, net Interest income Interest expense Other income (expense), net Loss on extinguishment of debt Pre-tax Income / (Loss) Income tax expense Net Income / (Loss) Accretion of redeemable non-controlling interests Net loss attributable to common stockholders EPS - Basic EPS - Diluted Basic shares o/s Diluted shares

253 (22) 1 2 (21) (0) (41) (41) (41) (0.68) (0.68) 60.0 60.0

195 12 56 15 10 (30) 1 52 52 (0) 52 0.87 0.87 60.1 60.1

227 8 2 22 23 (61) (3) (17) (9) (26) 1 (25) (0.41) (0.41) 61.6 61.6

302 1 59 1 (2) 29 (121) (6) (41) (36) (76) (4) (80) (1.20) (1.20) 67.1 67.1

331 0 47 (0) (0) 15 (158) (7) (104) (39) (143) (7) (150) (2.21) (2.21) 68.0 68.0

411 1 32 (0) 4 4 (210) 0 (26) (197) (41) (238) (2) (239) (3.30) (3.30) 72.5 72.5

457 477 (446) (5) 2 1 (243) 3 (55) (743) (43) (785) (87) (872) (11.39) (11.39) 76.5 76.5

548 27 (28) 3 3 0 (256) (0) (278) (39) (318) 3 (315) (4.14) (4.14) 75.9 75.9

2004 CASH FLOW STATEMENT Net Income / Loss Stock compensation Depreciation and amortization Impairments Other items Cash From Operations Acquisition of a business Purchases of property and equipment Change in prepayments for purchases of property and equipment Purch of and deposits for wireless licenses and spectrum clearing costs Proceeds from sale of wireless licenses and operating assets Purchases of investments Sales and maturities of investments Purchases of membership units of equity method investments Dividend received from equity investee Change in restricted cash Net cash provided by (used in) investing activities Proceeds from issuance of long-term debt Repayment of long-term debt Payment of debt issuance costs Purchase of non-controlling interests Non-controlling interest contribution Proceeds from sales lease-back financing Proceeds from issuance of common stock Distributions made to joint venture partners Other Net cash provided by (used in) financing activities BOP Net Change in Cash EOP Cash (41) 253 (22) 190 (83) 6 2 (135) 91 22 (97) (37) (37) 84 57 141

2005 52 26 195 12 22 308 (209) (10) (244) 109 (307) 329 (0) (332) 600 (418) (7) 1 176 141 152 293

2006 (26) 26 227 8 56 290 (591) (4) (1,019) 40 (150) 178 (4) (1,551) 2,260 (1,169) (23) 12 260 1,340 293 80 373

2007 (76) 29 302 1 60 316 (505) 13 (5) 10 (643) 531 (19) (4) (623) 370 (9) (8) 9 10 10 (5) 377 373 70 443

2008 (143) 35 331 0 127 351 (31) (796) (6) (8) (598) 532 (1) (2) (910) 536 (11) (8) 8 (42) 484 443 (76) 367

2009 (238) 43 411 1 68 284 (700) 6 (35) 3 (883) 733 0 (876) 1,057 (898) (16) 267 (2) 409 367 (183) 185

2010 (785) 37 457 477 126 312 (41) (399) 1 (13) (488) 816 (1) 1 (124) 1,180 (1,118) (1) (78) 5 2 (2) (13) 185 176 360

2011 (318) 15 548 27 115 388 (1) (442) (10) (5) 5 (826) 488 12 (1) (780) 397 (24) (7) 26 1 (3) (3) 387 360 (6) 355

2004 BALANCE SHEET Cash and cash equivalents Short-term investments Inventories Deferred charges Other current assets Total current assets Property and equipment, net Wireless licenses Assets held for sale Goodwill Intangible assets, net Other assets Total assets Accounts payable and accrued liabilities Current maturities of long-term debt Other current liabilities Total current liabilities Long-term debt, net Deferred tax liabilities Other long-term liabilities Total liabilities Redeemable non-controlling interests Total stockholders' equity 141 113 26 69 349 576 679 458 152 10 2,222 141 40 22 203 371 146 31 751 1,470

2005 293 91 37 42 464 622 821 15 426 114 38 2,500 168 6 44 218 588 137 36 981 2 1,518

2006 373 66 90 67 596 1,079 1,838 8 426 80 59 4,085 317 9 85 411 1,677 148 48 2,283 30 1,772

2007 433 179 65 54 731 1,317 1,866 426 46 47 4,433 226 11 115 351 2,034 183 90 2,658 51 1,724

2008 358 238 99 27 57 779 1,843 1,842 46 430 30 84 5,053 229 16 231 476 2,726 271 105 3,579 52 1,629

2009 175 389 108 39 77 788 2,121 1,922 2 430 25 84 5,372 229 16 231 476 2,726 271 105 3,579 52 1,629

2010 351 68 104 47 91 662 2,037 1,968 31 65 72 4,835 347 9 221 576 2,832 296 115 3,819 105 911

2011 345 406 117 58 134 1,060 1,957 1,789 204 32 41 68 5,153 460 22 256 739 3,199 334 172 4,443 96 613

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