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Equity Security Analysis

companies lead and take the risks. Finally, Arch strove to consistently deliver reliable
and immediate service by its choice of technologies and protocols,2 and by expanding
its networks and their capacities to accommodate and expedite message ¬‚ow. Arch
believed that fast, reliable, and ef¬cient message delivery was the core objective of pag-
ing and critical to generating and retaining customers.
Arch was one of the industry™s fastest growing paging providers, seeking growth

Arch Communications Group
through a blend of strategic acquisitions and internal additions. The ¬rm had grown from
a local provider to a national one, traditionally concentrating on serving small and me-
dium sized markets with low pager penetration rates. Now Arch was also entering major
metropolitan markets, in an effort to establish a nationwide footprint.
In Arch™s industry, ¬nancial performance was commonly assessed by analyzing
operating cash ¬‚ows or EBITDA.3 Most paging companies were not able to show positive
earnings, and net losses were considered an ordinary near-term industry phenomenon.
These losses in part resulted from the large capital expenditures, heavy debt ¬nancing,
and high depreciation rates common to the sector. Analysts expected earnings to turn
positive when networks matured and infrastructure spending slowed. Performance
evaluation for the present was, therefore, based on EBITDA. Arch™s EBITDA grew 162.6
percent from $18 million in 1994 to $47.2 million in 1995. Net revenues also grew:
124.7 percent from $63.1 million in 1994 to $141.8 million in 1995. Subscriber numbers
grew from 538,000 in 1994 to 2,006,000 in 1995. (Exhibit 4 shows Arch™s ¬nancial
On November 13, 1995, Arch stock was trading at $29.62. Five months later, in
March 1996, the stock had fallen to $23. By July 1996, Arch™s stock price had dropped
to $12.50 per share. The plunge in the stock™s value had paralleled the falls in prices of
most paging sector stocks. Analysts, however, felt Arch was still a sound investment,
suffering from “guilt by association” due to the poor performance of fellow companies
in its sector, and investor misunderstanding of industry dynamics. Despite the falls in
price, analysts continued to recommend investing in Arch stock, rating it a “buy.”

Introduced in the 1950s, pagers were compact, portable, one-way wireless messaging
devices used for mobile communication. Pagers were ¬rst used almost exclusively by
the business sector and time sensitive professionals such as doctors and law enforcement
personnel. But by 1995, the paging industry had revenues over $4.1 billion, 34.5 million
paging subscribers (eight million units added in 1995), and a 13 percent pager penetra-
tion rate of the population.

2. Pager protocol is the set of rules de¬ning a network™s capacity and the rate at which data travels through it.
3. EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) is the paging industry™s measure of ¬nancial
performance. This metric is the basis for a ¬rms™s valuation by industry equity analysts and is important in a com-
pany™s ability to secure ¬nancing.
Equity Security Analysis

13-21 Part 2 Business Analysis and Valuation Tools

Most pagers worked on the same basic technology. Each pager had an identi¬cation
number and was basically a receiver always tuned to a speci¬c radio frequency listening
for messages directed to its number among a constant broadcast of messages. To page a
user, a caller dialed the pager™s identi¬cation number by phone and left a voice4 or text
message with either an operator or an automated system. The pager user was then alerted
Arch Communications Group

of message receipt by the broadcast of a paging signal (tone) to the pager. Users then
called the operator or checked the pager to retrieve the message.
There were four pager types:
Tone. The simplest type alerted by tone. Users called an answering service for messages.
Digital/Numeric. Digitals displayed numeric messages, usually a phone number where
the caller could be reached. Digitals alerted by tone or vibration (for loud or quiet alerts),
and screened and stored numbers. In 1995, digitals accounted for 85 percent of all pagers
in use.
Alphanumeric. These pagers had both numeric and text messaging, eliminating message
retrieval. The pagers™ text capability allowed for immediate user action. These account-
ed for only 10 percent of the market but were the fastest growing segment.
Tone/ Voice. These pagers delivered voice messages after tone alerts, and made up 3 per-
cent of the market. Average retail price per pager was $57 for tone, $77 for digital, $138
for alphanumeric, and $189 for tone/voice.5 Pagers had an estimated 4“5-year life.
The two main industry participants were pager manufacturers and paging service pro-
viders (paging companies). Most pagers were made by one of a few major manufactur-
ers. In 1994 Motorola had produced 83 percent of all pagers in service, while NEC
(another manufacturer) had produced 12 percent.6 Motorola™s dominance was based on
its ability to consistently meet service providers™ delivery schedules, its reliable equip-
ment, and strong brand. Most equipment was distributed and activated by service pro-
viders, and most service providers sourced equipment mainly from a major maker.
Paging companies provided paging service and also leased and sold pagers. In 1995“
1996 the three largest service providers, PageNet, MobileComm, and Arch, together
served 45 percent of the total paging market. Over half the market was served by the 8“
10 largest companies, while the rest of the market was served by small local providers.
While most paging was regional, nationwide service was also available. Rarely, compa-
nies had “roaming” agreements, fee-based contracts between providers to serve users
that entered areas not covered by their provider, as was common practice in the cellular
industry. On average, it cost $11.00 per month to use a service. Users were charged ¬xed
periodic fees, regardless of usage, that included pager rental but not special fees such as

4. Voice messages, while easy to use, occupy large airtime on a provider™s limited frequency.

5. MTA-EMCI, State of the U.S. Paging Industry: 1996
6. 1995 NATA, Telecommunications Market Review and Forecast.
524 Equity Security Analysis

Equity Security Analysis

excess use charges. The most costly service was alphanumeric, followed by tone/voice,
digital, and tone only.
In 1995 only three companies offered nationwide service as it consumed a lot of
bandwidth,7 was not widely demanded, and might require market frequency compatibil-
ity if the provider did not have a nationwide license. Nationwide licenses, because they
operated on one frequency, were useful to large providers that had many resellers be-

Arch Communications Group
cause they eliminated the need to coordinate equipment, infrastructure, and frequencies
from market to market. Nationwide service was used mostly by business travelers. Pro-
viders also offered nationwide service to differentiate themselves.

There were three distribution channels: direct, retail, and reseller. Retail and resellers
were indirect channels and were becoming very important as consumers became a grow-
ing market segment. In 1994 30 percent of all new pagers added were through resellers.

DIRECT DISTRIBUTION. Equipment and service were acquired by subscribers di-
rectly from service providers. Providers bought pagers from the manufacturer and leased
or sold pagers to subscribers, more commonly leasing, in addition to providing service.
Leasing contributed to the large costs borne by providers: equipment, maintenance, and
replacement tied up large sums of cash as 25 percent of a company™s pagers were
replaced each year. Increasingly, however, subscribers opted to own their pagers (28 per-
cent owned pagers in 1989; 52 percent by 1994). “Churn”8 in this channel was the lowest
across channels, roughly 3 percent per month. The providers bore all expenses, but
produced the highest average revenue per unit (ARPU) because it sold direct. This chan-
nel had the highest cash ¬‚ow per subscriber and was the most pro¬table channel for

RETAIL. Equipment and service acquired through retailers were usually subject to
mark-ups to compensate the retailer who did not work for the equipment maker or ser-
vice provider. After the sale, the subscriber became the service provider™s client and had
no further contact with the retailer. Provider ARPU was equal to that from the direct
channel, but churn was the highest among channels.

RESELLERS. Resellers purchased equipment and service directly from the provider
and resold to their own clients. Resellers bore the full costs of service and equipment and

7. Bandwidth is the volume of information per unit time that a transmission medium can handle. Larger bandwidth
means more information can be transmitted in a given time period and at a faster speed.

8. Churn is the rate at which subscribers leave service providers by switching providers, subscribing at introductory
costs and then dumping the provider at the end of the promotion, skipping payments, and other voluntary or invol-
untary service deactivation. Churn is higher among consumers than business users.
Equity Security Analysis

13-23 Part 2 Business Analysis and Valuation Tools

supplied providers with the lowest ARPU. Low revenue, however, was accompanied by
low costs, and thus higher cash ¬‚ow margins for the providers. Churn was zero, because
the provider only focused on net additions.

Substitute Products
Arch Communications Group

CELLULAR PHONES. Two-way cell phone communication had analysts continually
predicting the demise of paging, yet in 1995 pagers had 34.5 million subscribers to the
32 million cellular subscribers. Several factors explained pager dominance. First, $56
per month for cell service made $11 per month paging service the lowest cost form of
wireless messaging. Cell users were also charged per incoming or outgoing call, and if
they went out of their service area. Second, cell phones had a shorter battery life (a few
hours) than the multiple-month pager battery life. Third, pagers were also cell comple-
ments, used as screening devices for the phones. Fourth, pagers helped manage cell
costs. Cell users generally made rather than received calls (over 85 percent of all cell
calls were outbound), and left phones off to conserve batteries and control costs, using
pagers to get messages. Cell phones were, however, becoming smaller, less costly, and
more feature laden (including longer battery lives and silent alerts). Cell phones also had
a unique value as emergency situation devices.

PERSONAL COMMUNICATION SERVICES (PCS). PCS was a generic term used for
a range of advanced mobile communication technologies. PCS used a larger spectrum
(range of sound wave frequencies) that could be either narrowband (NPCS) for advanced
paging technologies like two-way paging, or broadband (BPCS), which supported the
more costly and spectrum consumptive technologies cell service was based on. Narrow-
band providers could offer advanced services and have more reliable networks. NPCS
and BPCS offerings were feared to cannibalize or destroy current paging networks.

MOBILE SATELLITE COMMUNICATIONS. Satellites served subscribers not served
by land or cellular systems, and nonconsumer markets. Satellites offered wireless ser-
vices over vast geographic areas with minimal ongoing capital costs for the provider.
Pro¬table satellite-based global wireless services could be developed, and already satel-
lite providers had started to eye the consumer market.
Paging subscribers had grown 27 percent per year from 1990“1995. Large paging
companies had even higher subscriber growth rates. This growth was fueled by the mar-
ket shift from business to consumer, changing user perceptions of pagers, falling product
and service prices, and an expanding variety of product and service options. The histor-
ical images of pagers as costly professional items or illegal drug trade tools were fading:
nearly 65 percent of new owners used pagers as personal “lifestyle management” tools.
Increasingly time constrained and busy consumers demanding both accessibility and
mobility relied on pagers as integrative tools. But, despite such high growth, service pro-
viders had slim margins. Paging was capital intensive and companies needed large re-
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Equity Security Analysis

current capital injections. Infrastructure and equipment accounted for the two largest
capital outlays.


Arch Communications Group
From 1994 to 1996 the Federal Communications Commission (FCC), the regulatory au-
thority over the airwaves, allocated limited radio spectrum to be auctioned off by license
for various wireless services. The auctions debuted licenses for bandwidth supporting
advanced services, such as PCS. Bidders for and winners of the new licenses were sub-
ject to FCC determined regulations meant to limit bidding to only serious investors, pro-
mote rigorous competition, and ensure effective use of spectrum. These rules included
limiting the number of different PCS channels a provider could own to three, restricting
license transfers, and requiring providers to show pro forma construction plans.
For auctioning purposes, spectrum suitable for paging was divided into four geo-
graphic service areas: nationwide, regional (comprised of ¬ve regions each with 20 per-
cent of the U.S. population), MTAs (51 major trading areas), and BTAs (493 basic trading
areas). Each service area was allotted channels of frequency requiring operating licenses.
A total of 7 MHz of spectrum9 was available or already being used by paging companies,
approximately 4 MHz of which was for advanced paging. Commonly, 25 kHz of one-way
frequency supported numerous local and regional providers using a variety of protocols.
The same channel in different markets could be occupied by many providers.
By 1995 the nationwide and regional auctions had taken place. (MTA and BTA
licenses were to be auctioned in 1996.) The auctions sold licenses for eleven nationwide
channels and 30 regional channels (six channels in each region). In each region two and
four of the six channels respectively were identical so that a provider could acquire the


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