Sprint's Strong Q4 Mitigate Concerns About Rising Competition, Stock Fairly Valued
Sprint ( S ) announced a strong set of Q4 2013 results on February 11, as a surprising positive postpaid net-add figure and strong EBITDA margin expansion alleviated some of the concerns surrounding rising competition in the industry, especially from T-Mobile. Excluding the recent Clearwire and US Cellular transactions, Sprint reported postpaid net adds of 58,000, which was significantly higher than what we were expecting given T-Mobile's strong performance during the holiday quarter. However, a bulk of the outperformance was driven by tablets, which generate lower ARPU (average revenue per user) than smartphones. Smartphones accounted for a huge 95% of postpaid handset sales, so the company has been doing a good job of adding valuable smartphone users, who generally have higher-ARPU data plans. Though smartphone demand benefited from seasonality, Sprint, like Verizon ( VZ ) and AT&T ( T ), sold fewer of them compared to 2012, thereby benefiting from lower subsidy expenses. This effect, coupled with the cost savings that Sprint realized from shutting down its iDEN network, more than offset the dilutive impact of Clearwire's results and the loss of iDEN revenues, as its EBITDA margins expanded by over 400 basis points as compared to the prior-year quarter.
Going forward, the company expects to realize further margin gains as Network Vision (NV) nears completion and customers increasingly adopt its Framily and Easy pay device installment plans. At the mid-point, Sprint's EBITDA guidance for 2014 indicates a 22% increase year-over-year. However, increasing adoption of Sprint's Framily plans, which were introduced earlier last month, and connected data-only devices such as tablets, could cause ARPU levels to take a hit. Service disruptions due to the ongoing Network Vision initiatives are likely to continue to impact Sprint's postpaid net adds in the coming months.But NV's com pletion by the mid-year and the deployment of Spark, which will gain momentum in the later half of the year, should help Sprint post much better net add figures towards the end of the year.
The high level of capital expenditures that Sprint expects to maintain throughout 2014 should continue to keep its cash flows depressed in the coming months. However, the company's capital structure has improved over the past few quarters with Softbank's capital infusion and the refinancing of Clearwire's debt at lower interest rates. It is also undertaking a workforce reduction plan, in addition to the previously announced job cuts, which should help control SG&A expenses in the coming years. We have increased our price estimate for Sprint to $8 , in light of its improved capital structure, ongoing cost-cutting activities and the better-than-expected postpaid figures for Q4.
T-Mobile Competition Seen Primarily At The Low End
T-Mobile's aggressive posturing last year, when it launched the iPhone on its network for the first time and introduced no-contract plans, saw the carrier perform impressively against its rivals. Last quarter, T-Mobile added 869,000 net postpaid subscribers, as compared to a loss of 515,000 in the prior year quarter. While T-Mobile's subscriber gains have come at the expense of most rivals, Sprint seems to have been affected the most due to its lagging LTE coverage and Network Vision upgrades causing service disruptions in many markets. T-Mobile's porting ratios announced last month revealed that it gained 3 subscribers for every 1 that it lost to Sprint last quarter - the most among the top three carriers. Th a t Sprint still managed to hold on to its market share in the past year is mostly due to the subscribers it added from deals with US Cellular and Clearwire. Although Sprint's fourth-quarter postpaid net adds were better than expected, most of those were driven by tablets, of which the carrier added as many as 466,000, including prepaid. Tablets, being data-only devices, generate much lower ARPUs than smartphones. Last quarter, Sprint's postpaid ARPU declined sequentially due to the higher tablet mix.
Still, it is a good sign that most of Sprint's postpaid weakness isn't coming from the higher-value smartphones, which accounted for almost 95% of its postpaid handset sales last quarter. With Sprint adding as many as 157,000 smartphone subscribers during the quarter, it is likely that the impact is being felt primarily at the low end, where feature phones dominate. Sprint said that it saw strength in smartphones and tablets, but feature phone sales declined significantly. While subscriber defections are still likely to be a concern over the next two quarters due to Network Vision-related issues, Sprint expects these upgrades to be substantially complete by the mid-year. Its LTE coverage - also a concern over the last couple of years - is expected to reach 250 million PoPs by then and become less of a disadvantage as compared to rivals. With Sprint's Spark plans expected to pick up speed after the Network Vision rollout, we expect the carrier to become a lot more competitive to wards the end of 2014 and beyond.
Spark Strategy And Framily Plans
Sprint's Spark strategy will help it make use of Clearwire's 2.5GHz spectrum to add data capacity and potentially push 4G speeds to more than five times what is currently prevalent in the industry. By catching up in LTE coverage and potentially leading the industry in data capacity and speeds, Sprint will finally have a compelling advantage over rivals to differentiate on service rather than pricing. This is important for the long-term ARPU growth of the company, which is currently limited by its over reliance on unlimited plans. With data demand surging, offering subscribers access to unlimited data could prevent Sprint from capitalizing on the future growth in data usage as LTE speeds become ubiquitous. By differentiating on data speed and capacity, Sprint could come up with innovative speed-based tiers at premium pricing to mitigate the long-term impact of its unlimited data plans. However, Sprint's Spark rollout will be slow, with only 100 million PoPs (or about a third of the U.S. population) expected to be under coverage by the end of the year ( see Sprint's Spark Program Will Have Long-Term Benefits, Doesn't Mitigate Near-Term Risks ).
In order to mitigate the market share loss in the near term, Sprint launched Framily plans last month, which reward subscribers for adding more people to their service plans. For every subscriber that is added to an existing Framily plan, subscribers realize savings of $5 on each of their monthly bills. This continues until 7 lines have been added to the account, after which the plan pricing remains constant at $25. Although this new plan will help Sprint reduce churn in the coming months, its ARPU levels are likely to take a hit due to the reduced pricing. However, in order to subscribe to these plans, customers either need to pay the full price of the phone upfront or in 24 monthly installments. We expect the reduced margin impact of subsidies, as well as the potential subscriber gains, to more than offset the ARPU hit in the coming periods.
High CapEx Justified In The Long Run
In the long run, we expect the surging demand for data as a consequence of rising LTE adoption to help Sprint support ARPU levels as voice declines. As LTE speeds become ubiquitous, Sprint's unlimited plans will become even more valuable as subscribers easily exceed their monthly quota on rivals' tiered plans. The TD-LTE deployment is therefore key, as it will help increase Sprint's data capacity in order to support the huge future demand of its unlimited-data subscribers. However, the implementation of Spark will require significant capital expenses. Despite the fact that Network Vision is expected to be substantially completed by mid-2014, Sprint maintained its CapEx estimate at last year's elevated level of $8 billion.
While the network modernization plan is proving to be expensive, it is also helping reduce operating expenses substantially by eliminating the duplicate fixed costs of maintaining different networks. It is allowing for better 3G/4G coverage and reducing roaming costs, as the spectrum previously used for iDEN is increasingly utilized for the CDMA/LTE network. Rolling out an LTE network is helping the Sprint improve its service gross margins as well, since it is a much more efficient network to manage than the existing 3G networks. Sprint's wireless EBITDA margins in 2013 increased by 2 percentage points over the previous year. Also, going forward, we expect Sprint's long-term capital expenses to decline substantially to their historical averages as TD-LTE deployment is completed and Sprint realizes the benefits of the higher data capacity of Clearwire's spectrum.