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Qwest needs to cut the cord

The third-largest U.S. phone company is making a strong comeback, but its future could be stunted without a major wireless play.

Qwest Communications International needs wireless--badly.

This, of course, isn't exactly a revelation to anyone who's been following the descent--and now rebound--of the nation's third-largest telecommunications company. But as Qwest continues to get back on track, that lack of a wireless business could prove vexing.

On Monday, the company will host its first major investor conference in New York since its new chief executive officer, Edward Mueller, came on board last summer. The meeting will provide Mueller and his team an opportunity to assure analysts and investors that the company has a game plan to grow Qwest's business in what promises to be a very challenging time.

Mueller is likely to expand on comments he made earlier this month during the company's quarterly conference call about Qwest's wireless plans and what it might mean for the company's current partnership to resell Sprint Nextel's wireless phone service.

"I think we have much to do in wireless," he said during the call. "We need a partner for voice, but we need a partner for data and broadband data, so as we look forward, we'll need someone to help us with both of those."

The problem for Qwest is that unlike the two other large phone companies in the country, AT&T and Verizon Communications, it doesn't own any of its own wireless infrastructure. The company sold the last of its wireless spectrum and cell phone infrastructure to Verizon Wireless in 2004 for $418 million in cash. So any new move in wireless would require it to either acquire new spectrum or work closely with another provider, which will likely not provide the same upside as its telecom brethren will enjoy.

"Qwest's lack of wireless infrastructure is a huge weakness," said Patrick Comack, an analyst with Zachary Research. "There is opportunity in wireless. But the problem is that they are at the mercy of Sprint or whoever else they partner with."

Denver-based Qwest, which provides local phone service in 14 western U.S. states, has been through the ringer in recent years. The company has battled its way past a scandal, which led to a fraud conviction of former CEO Joseph Nacchio, and near bankruptcy to get back on its feet.

With the turnaround complete, the company is entering the next phase of its comeback with strong momentum in its broadband business. Thanks to some major cost-cutting efforts in the past year, Qwest has managed to generate a significant amount of cash and profit. Earlier this month, the company reported that it generated $2.9 billion in profit from $13.8 billion in sales in 2007, compared with $593 million in profit on $13.9 billion revenue in 2006.

The company also reported it had $1.8 billion of free cash flow in 2007. This is money that is available for things such as capital spending. With a steady flow of cash, the company declared a dividend of 8 cents to shareholders, the first time it has made such a payout to investors since 2001.

But while Qwest was able to cut costs and generate profits in 2007, its revenue declined slightly in 2007, and Mueller said he expects sales to either dip again or remain steady in 2008.

Losing landlines
The big problem for Qwest and other local phone companies is that they are losing traditional landline phone customers. Last year alone Qwest lost 738,000 home-phone lines, a 9.1 percent drop from the previous year. And it's expected to lose more landlines this coming year as more customers cut the cord at home and use cell phones or alternative services, such as Vonage, which uses voice over IP technology.

Qwest has made up for some of this loss by ramping up sales in broadband. The company added 95,000 high-speed Internet subscribers in the fourth quarter. It also has been increasing network speeds. And Mueller has said he plans to use some of the company's cash to put more fiber in the ground for broadband services to increase speeds.

But wireless, or the company's lack of wireless, appears to be a stumbling block, especially as AT&T and Verizon Communications, the No. 1 and No. 2 phone companies in the country, are getting more aggressive with their wireless offerings. Even though these companies have traditionally not competed for local phone customers, nationwide wireless networks change the game. And now AT&T and Verizon are directly competing against each other as well as against Qwest and other major wireless operators.

Recent changes in wireless pricing could entice even more people to cut their phone lines at home and go exclusively with wireless. Last week, AT&T, Verizon Wireless, and T-Mobile USA introduced new unlimited local and long-distance domestic calling plans for a flat fee of $100 a month. These plans, which free customers from worrying about how many minutes they're using, could potentially eat further into Qwest's landline business. And because Qwest has no wireless service of its own, it can't offer a similar alternative.

The best that Qwest can do is resell wireless service from Sprint Nextel. Currently, Qwest provides wireless service to 824,000 customers. The way it works is that Qwest purchases cellular minutes from Sprint and then creates its own cell phone minute packages with its own handsets.

But analysts say that Qwest is at a disadvantage in this arrangement because Sprint requires a lag time between when it launches new services, such as faster wireless broadband services, and when Qwest can offer those same services. What's more, the arrangement with Sprint doesn't provide much profit margin for Qwest.

Instead, Mueller has said he wants a more lucrative partnership. The company could look for an arrangement that is similar to the one it has with satellite TV provider DirecTV. In this arrangement, Qwest bundles DirecTV service with its phone and Internet packages. DirecTV handles equipment, installations, and customer service. But Qwest also receives monthly fees from DirecTV based on the number of subscribers.

Donna Jaegers, director of research for equity research firm Janco Partners, believes that Mueller may be expressing frustration with the Sprint deal as a way to renegotiate a more favorable arrangement with Sprint when their current deal expires next year.

"When executives start voicing displeasure like this it's usually to put themselves in a better negotiating position," she said. "The contract isn't up until early 2009, but Mueller knows that Sprint can't afford to lose any more customers."

Indeed, Sprint is struggling too. The third-biggest U.S. wireless carrier lost some 683,000 post-paid contract customers last quarter.

But the problem for Qwest is that the only other likely cell phone partner is T-Mobile, which doesn't have a strong network footprint in rural areas, where many of Qwest's customers reside. Alltel is another potential partner. Even if Qwest could find another partner, the company will still be at the mercy of someone else who owns the network.

Some analysts and industry watchers wonder if Qwest might have bigger wireless ambitions. There have been some rumors floating around that the company is talking to Sprint, Clearwire, and Intel about WiMax. Jaegers said that WiMax could be a very useful technology for Qwest as it pushes forward with its broadband strategy.

"About 20 percent of Qwest's footprint is not dense enough for DSL," she said. "So WiMax would make a lot of sense."

But the problem, Jaegers said, is that the spectrum that Sprint is using to build its network is in the 2.5GHz band, which requires more densely deployed transmission towers. This would be an expensive solution to solve Qwest's rural broadband problem. And even though Qwest is carrying around a lot of cash, it's difficult to say how much investors would tolerate the company investing in building a WiMax network.

But without its own spectrum, Qwest can't build its own wireless rural network. The company is also not participating in the most recent 700MHz spectrum auction, which could have been used to build a rural broadband network. But Jaegers said the company could partner with a license winner in that auction.

Still, Qwest's options in wireless are limited. And this could potentially come back to haunt the company.

"I think if you look way back when Qwest first sold off its early spectrum licenses, you'd probably say that was a strategic mistake," Jaegers said. "But now with the wireless market already 85 percent penetrated, I'm not sure what else they can do."