Amit Chokshi
submits:
Sprint (
S
) recently reported
Q409 earnings
that fell short of Street expectations. This sent share prices
tumbling with investors trying to gauge when S's long awaited
turnaround will materialize. Given the competitive landscape S
faces, a number of Street analysts have written S off and have
continued to beat the drums of the Company's demise. The stock is
also reflecting significant investor apathy and skepticism
regarding S. However, if one takes a closer look, a compelling bull
case could be made for the Company. Rather than first cover the
merits of S, it may make sense to review why the Street and
investors are negative on the stock. While some of the bear case on
S is clearly valid, there are also some misconceptions regarding
the Company and once those are highlighted, S may become a more
attractive investment.
Bear Case Highlights:
1) Sprint's key operating metrics are worst in class: Bears are
quick to point out that S significantly lags its peer group in
terms of key operating metrics. As Tables I and II illustrate,
this is true. The Company has lagged its peers for years,
particularly the two dominant players Verizon Wireless (
VZ
) and AT&T Mobility (
T
). However, one should note that from a free cash flow
perspective, S is free cash flow positive and while its free cash
flow margin ("FCFM") lags VW and ATM, it exceeds, and has
exceeded, pre-paid peers Leap Wireless (
LEAP
) and MetroPCS (
PCS
) for years.
Click all images to enlarge
TABLE I: S vs. PEERS
TABLE II: S POSTPAID CHURN vs. PEERS
S lagging its peers has been widely known for years and may not
be as important a factor as the fact that S has been cash flow
positive in recent years with its free cash flow reaching record
levels in fiscal 2009. This is particularly interesting because S
has achieved this without having a signature phone as ATM has had
with the Apple (
AAPL
) iPhone or nationwide coverage to boast about like VW. Better
phone options tied to the Company's first-mover advantage in 4G
coverage could be positive catalysts for S (discussed in the Bull
case).
2) VW and ATM pricing wars will crush Sprint: In January 2010, VW
and ATM both announced plans to reduce the monthly rates they
charge. Pricing wars can be brutal and many Street analysts and
investors expect that the pricing changes will crush S. I don't
see this as very likely for a number of reasons. The first is
that VW and ATM price cuts mainly target the voice component of
plans with both carriers reducing unlimited voice plans from
$99.99 to $69.99. "Voice" is the key word as adding text and data
increases these plans considerably. For example, after announcing
the reduced voice plans, VW
expanded the number of 3G Multimedia phones under its
plans that require additional monthly fees for data
. More so, the fact is that S plans are still cheaper than what
is offered by VW and ATM. For example, both carriers offer
unlimited family plans for roughly $120 per month which includes
1400 minutes over 2 lines. In comparison, S offers its Sprint
Simply Everything plan for $100 which includes 2 lines and 1500
minutes. The same results hold when comparing similar plans
across voice, text, and data between the three carriers with S
offering more for less.
If one cannot be assuaged to remain on a carrier even if that
carrier has one of the best smartphones around or the broadest
national coverage, then price may be the biggest factor.
Additionally, at that point, price elasticity may be irrelevant.
A consumer may not be willing to stay with VW for a $30 discount
when a competitor like S still offers a better bargain. While VW
and ATM are viewed as "premium" carriers that can therefore
charge more, customer views may be changing in this regard and
the moves by VW and ATM seem to support this view.
So as it stands, VW and ATM plans, despite significant discounts,
are still above S's comparable plans. Another reason why these
price cuts may not harm S is because of the increased adoption of
smartphones and commensurate data usage. To be clear, while VW
and ATM may have curried some consumer favor by these
initiatives, this is really a bait and switch designed to
ultimately isolate data charges which will be going up across the
industry as smartphone adoption increases.
The game plan is to upsell customers into smartphones which carry
data fees and ultimately make the move to implement data
"metering" plans. This is another reason why this pricing move by
VW and ATM may be more flash than substance. As mentioned, the
pricing of their plans are not superior to S despite the cuts. In
fact, the new pricing plans may have consumers refocus on
comparing all of the major carriers and they may be surprised
with the findings. For example, while ATM may have the most
sought after phone, it has arguably the worst network for the
iPhone based on the 3G coverage.
EXHIBIT I: 3G COVERAGE (source VW)
Note: Blue (
ATM
), Green (
S
), Purple (T-Mobile), Red (
VW
)
Another reason current pricing plan discounts may matter less
is as industry and consumer adoption of smartphones increases,
higher data consumption will yield better economics for all
carriers, especially on 4G networks where delivering data is
actually cheaper compared to existing 3G networks. Since 4G
rollouts are happening now with S, and broader 4G adoption could
occur in the next 18-24 months, carriers may be in a position to
charge much more once new phones are unveiled with stronger data
usage.
3) Sprint is over levered and on the brink of bankruptcy: Many
bears point to the large debt load carried by S and suggest this
is far too much for the Company and it will lead to bankruptcy.
This does not seem very likely due to the Company's cash flow
production and its maturity schedule. While S carries $21.8B in
debt, the Company also has roughly $3.9B in cash, yielding $17.1B
in net debt. S generated $6.0B in EBITDA in 2009, resulting in a
Net Debt/EBITDA ratio of just 2.8x. This is not a highly
leveraged company. Capital expenditures were $2.2B in 2009 and
are expected to be just $2.0B in 2010 while interest expenses
will run about $1.5B in 2010. After these funding needs, S could
have over $2.0B in excess cash flow.
S also faces little refinancing risk as shown in Table III. In
2010, S will need to refinance just $750MM in debt. S has $3.9B
in cash on hand as well as an additional $2.7B in capacity under
its revolver, making this refinancing a non-event. Other
refinancing amounts are also very manageable in the coming years
given the Company's cash flow production capabilities. Most
importantly, a significant portion of S's debt is due well after
2016. In fact,
over $5.0B in debt or nearly 30% of the Company's net
debt, is due after 2020
. While S is facing challenges, high leverage does not appear to
be one of them.
TABLE III: S MATURITY SCHEDULE
Without a doubt, S faces some challenges but some of the key
aspects of the bear case are not as pronounced once one takes a
closer look at them. Now let's cover the reasons why S may be an
attractive long.
Bull Case Highlights:
1) Churn and customer losses appear to be moderating: S is a
turnaround play and it's been a business that has for years
struggled to "turn", but recent data suggests that the Company
may finally be turning a corner. In Q4 09, the Company's postpaid
churn improved from 2.16% to 2.11% year over year. In addition,
postpaid gross and net adds seem to have bottomed in H1 09 and
have been improving since then as illustrated in Table IV. Rather
than focus on the absolute numbers, the strength in terms of the
trend reversal may be the most important factor (denoted in
growth comparisons).
TABLE IV: POSTPAID GROSS AND NET ADDS
2) Improved customer service: The Company's customer service is
improving and this will have a direct positive benefit on future
earnings. S customer satisfaction has improved for seven
sequential quarters and fewer customer issues have allowed S to
shutter 27 call centers in the past two years. This has yielded
annualized cost savings of $350MM per year and further
improvements should also allow S to improve the middle part of
its income statement. To put that in context, in 2009 S
recognized $17.2B in operating expenses or roughly 53% of total
revenues. The $350MM in annualized savings would yield an 80
basis point margin improvement on the same level of sales. As the
Company continues to improve customer service, further cost
improvements should be realized.
3) Next generation/4G and Smartphone operating systems ("OS")
innovations will benefit S: S has had no signature phone in
recent years while its peers benefited from either having broad
geographic coverage ((
VW
)) or an exclusive deal with the iPhone ((
ATM
)). As a result, S and other carriers have had difficulty in
competing with the two largest players whose broad geographic
coverage appealed to users - in the case of VW - or exclusivity
of the best phone drove consumers to ATM. However, increased
interest in smartphones and the development of powerful competing
OS should benefit S.
This doesn't mean that S will suddenly have the popular iPhone
under its network. For S investors that are hopeful that someday
S will have the iPhone, it is highly unlikely to happen. Aside
from its exclusive deal with ATM, AAPL seems interested in
sticking only with GSM as opposed to CDMA for its current
generation of iPhones. This rules out S, and given that VW never
struck a deal early on with AAPL during the developmental phase
(VW uses CDMA), until 4G is fully rolled out, AAPL will most
likely be sticking with ATM.
Nonetheless, increased proliferation of smartphones should
benefit S as a number of very interesting devices are being
released in 2010 that are not the iPhone. In recent years,
Research in Motion (
RIMM
) and Apple dominated the smartphone market in good part due to
their application software market. Windows Mobile has been a weak
competitor and not widely used by the top US smartphones, so
RIMM's Blackberry Market and AAPL's App Store were really the
only place developers could focus on in terms of programs, "app
candy," and other software that made the user experience that
much better. By doing this, the overall moat for these devices
only strengthened with hundreds of thousands of applications for
these phones relative to a fraction of those for competing
phones.
In 2009, Palm (
PALM
) reminded everyone about WebOS with the release of the Palm Pre.
While there are many fans of WebOS, the operating system lacks
the marketing and financial muscle to compete with the Blackberry
market and App Store. Consequently, with a smaller user base,
there's little incentive to offer programs on WebOS relative to
the App Store which makes further improvements and software
enhancements to PALM phones more difficult. This once again makes
it difficult to drive device interest when competing phones have
a much larger base of OS programmers and applications.
However, Google (
GOOG
) made a big splash into mobile operating systems with its
Android system and GOOG has the financial firepower and vested
interest to make Android a big success. More importantly, while
the App Store has tighter programmer controls, Android is open
source which should attract a number of developers. Android
developers get the backing of an innovative company like GOOG and
open source which should be a win-win for them. So how does this
help S? In recent years, it was the combination of form factor
and OS that made the iPhone and Blackberry so attractive. The
form factor of the iPhone could be copied but the lack of a
powerful competing OS made the user interface generally less
attractive.
However, with Android there's a viable open source OS that will
give the App Store and Blackberry Market a big-time run for their
money. Programmers and consumers have both received Android very
well with positive reviews by both key groups. In fact,
technology research firm Gartner predicts that Android will be
the second most popular smartphone platform in 2012, supplanting
Blackberry and iPhone OS (Nokia's (
NOK
) Symbian OS would still be #1 due to its reach outside of the
US). Again, so why will this benefit S?
Prior to Android, phone manufacturers could offer phones that
were similar in design to the iPhone but fell very short in terms
in offering smooth, computer-like media, graphics, and user
interface. The advent of Android and its open source nature make
it very attractive to phone manufacturers to easily adopt and for
software providers to utilize and develop a deep library that can
be used across Android phones. With the introduction of more
advanced smartphones with a robust OS, there are legitimate
iPhone competitors whereby those that want a solid phone will
have other devices and ultimately other networks like S to choose
from. As it currently stands, if one wants an iPhone, they are
locked into ATM even though ATM's network can't always keep up
with the iPhone (especially in the New York City area).
What this means in the long-term is that the dominance of the
iPhone and Blackberry may start to show some vulnerability. This
was partly seen in the latter half of 2009 when Motorola (
MOT
) partnered with VZ to release its exclusive and popular DROID
device. In H2 2009, S partnered with HTC to release the
Android-powered Hero. These are very attractive phones and HTC is
getting more aggressive with the US market. Anyone that takes a
look at their device lineup will see that HTC is the real deal.
The Company's partnership with HTC on future phones could lead to
an eventual big hit.
Another reason that increased user demand for smartphones could
benefit S is due to its head start in 4G deployment via Clearwire
(
CLWR
). S owns 57% of CLWR and other strategic investors include Intel
(
INTC
), Comcast (
CMCSA
), Google, and Time Warner Cable (
TWC
). One problem users of smartphones experience is that they
stretch the data capabilities of current networks so they may
essentially have a phone/data experience that is similar to a
Ferrari that is always stuck in second gear. CLWR offers WiMax,
with this format capable of higher data transfer capabilities
than current 3G networks (10 Mbps at WiMax vs 1-3 Mbps at 3G).
This addresses the "clogging of the pipes" 3G smartphone users
face.
CLWR has rolled its network out to 30 large cities in the US
while VZ and T will start deploying their 4G network under the
Long Term Evolution ("LTE") format over the course of the next
two years. Some observers believe that WiMax and LTE is a format
war where there can only be one survivor and since VZ, T, and
other companies are backing LTE, WiMax will eventually fizzle.
This would contradict statements by CLWR CEO Bill Morrow, who has
indicated that CLWR's hardware can adjust from WiMax to LTE
relatively easily, requiring mostly just a software update.
Additionally, CLWR will be available in New York, Boston,
Washington DC, Houston, San Francisco, Denver, Minneapolis, and
Kansas City by 2010. Due to the head start S has through CLWR in
deploying 4G, phone manufacturers may have an incentive to get
ahead of RIMM and AAPL in deploying 4G phones faster and thus
have a strong incentive to partner with S. This window of
opportunity may also allow S to finally have a signature phone.
In Q3 09, VW rebounded with the introduction of the DROID while
ATM has always had the iPhone.
Recent news reports suggest S will have a 4G (3G compatible)
phone ready by H1 2010 with speculation that the 4G phone will be
the rumored HTC Supersonic. If management does in fact partner
with a company like HTC, which has made some amazing phones of
late, then S could take advantage of an open field in terms of
having the only 4G phone utilizing a network that will cover
120MM people in the US capable of much more impressive feats in
terms of data and user experience when other carriers will still
be rolling out their 4G networks.
3) Valuation: S is a turnaround story and faces a challenging
uphill battle. The prior points cover some interesting angles and
potential catalysts for S but would have little value if not for
the fact that S appears to be grossly undervalued across a number
of metrics. Against its main peers, S is significantly
undervalued. As Table V demonstrates, S trades at a substantial
discount to its peers with low EV/Revenue, EV/EBITDA, P/TBV, Free
Cash Flow Yield metrics.
TABLE V: S PUBLIC COMPS
The quick response to the Company's valuation discount is that S
is an operational laggard relative to VZ and T. But in comparison
to its prepaid rivals, S generates free cash flow while LEAP and
PCS do not. Yet these businesses both trade at healthy valuation
multiples. Further, price competition in the prepaid space is
likely to crimp the performance of PCS and LEAP in future years,
leading to reduced earnings in future years. LEAP and PCS both
appear to realize this which is why they are considering merging.
In addition, LEAP and PCS have both been experiencing increasing
churn rates (prepaid) over the past two years. In contrast, S's
prepaid churn has been improving over this time, which would
suggest there's value in its strong brands such as Boost and
Virgin Mobile. At the very least, LEAP, PCS, and S should have
some level of valuation convergence given that S maintains two
very strong prepaid brands like LEAP and PCS but also generates
positive cash flow, unlike PCS and LEAP.
TABLE VI: PREPAID CHURN
S is also attractive from the perspective of P/BV and P/TBV.
As is the case when a business is viewed as healthy, it tends to
be valued well over book value and tangible book value. This is
the case with both T and VZ, which carry significant levels of
goodwill and intangible assets (excluding FCC licenses) and trade
for industry leading P/TBV multiples. PCS and LEAP also trade at
significant premiums to S in terms of P/BV and P/TBV.
While S has its challenges, this valuation discount seems
pretty steep. For example, one can review the Company's latest
balance sheet and conduct a quick liquidation analysis which
seems to indicate that S is trading at just 25% above a
reasonable liquidation value. Currently, S has about $18.1B in
book equity, which equates to $6.24 per share in book value. In a
liquidation, a number of these assets would be written down and
Table VII presents a reasonable reduction in book values. S
appears to have some assets that will have "sticky" value such as
the $19.9B in FCC licenses it controls.
TABLE VII: S LIQUIDATION ANALYSIS
Even in a liquidation, S would likely command strong demand
for this asset as the International Telecommunications Unions
recently found that the US needs to have 800 MHz in spectrum
available by 2010 for mobile voice and data. It took a decade to
get 700 MHz in spectrum auctioned off and more importantly, the
past decade has seen a greater number of participants in the
market in terms of spectrum buyers. There are the typical
incumbents such as the traditional telecoms but technology
companies such as GOOG will also be hungry for spectrum. As a
result, the value of the Company's FCC licenses could hold up
very well in a liquidation given the frequencies of these
licenses are in the sweet spot for mobile transmission. The
Company's PPE consists of network infrastructure which is also
likely to retain value.
Carrying out the liquidation analysis in Table VII yields a
liquidation share price of $2.62 with current share prices just
25% above this level. If S was bleeding cash and financially
crippled, this valuation could makes sense but S has been free
cash flow positive for years. More importantly, free cash flow
grew from 2008 to 2009, yielding a very attractive free cash flow
yield of 29%.
While S has its share of challenges, these valuation levels seem
to be too tempting to ignore. At current prices, S is attractive
as a standalone investment or a potential buyout by a strategic
investor such as Deutsche Telekom (
DT
) (controls T-Mobile). As indicated earlier, S is making progress
in turning around its postpaid trends as customer attrition has
been improving rapidly in each quarter. Customer service has been
improving as well which will reduce future operating expenses. S
has made the bulk of its major network upgrades whereby 2010
capital expenditures will be roughly $2.0B. This suggests that
the Company's operations are bouncing along a possible bottom
while the broader telecom industry gears up for 4G. This should
yield improved pricing power and lower costs, as consumers will
want to use high powered smartphones on this network that can
accommodate higher data needs, benefiting carriers that will be
charging more for this usage (higher subscriptions) but have
lower delivery costs as 4G is more efficient for data delivery
than 3G.
Improvements in churn are a huge margin opportunity for S and if
the Company can make additional progress on churn, there should
be an immediate benefit to the Company. Taking advantage of
relatively open skies in 2010 is another "must do" for S in terms
of securing a signature phone paired with its expanding and first
mover 4G network. Last, broader adoption of smartphones and the
4G networks to accommodate the data needs of increasingly
advanced mobile devices in the coming years could also usher in a
new environment where revenues and margins can expand for the
industry including S.
DISCLOSURE:
Author manages a hedge fund and managed accounts Long S.
See also
BP's Credibility Reestablished
on seekingalpha.com