Sprint Gets New Life

 | Oct 18, 2012 | 12:30 PM EDT  | Comments
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On Monday, Sprint Nextel (S) confirmed that it would be selling 70% of itself to Softbank, which holds the third-largest cellular provider in Japan. The company cited the "long-term evolution" of 4G LTE as the prime motivation. Most countries continue to make the switch to 3G radios, so the adoption of 4G worldwide is not yet a regularity. Additionally, Sprint will be off-loading much of its worrisome debt, eliminating fears about the sustainability of its business. Billionaire hedge fund manager David Einhorn has the largest stake in Sprint of any hedge fund, with about a 72.5 million shares (view his portfolio here).

This move comes after Deutsche Telekom confirmed the anticipated merger of its T-Mobile brand in America with MetroPCS (PCS), creating a stronger value cellphone option for American consumers. The newly formed company will have 42.5 million subscribers and about $25 billion in annual revenue, according to company estimates. The motivations for the merger in this case were much the same as with Sprint's sale to Softbank. T-Mobile wants to catch the full wave of the upgrade to LTE radios, which boast faster download times, while expanding its presence in the value cellular market.

The valuation in all of these companies pre-merger is difficult to gauge. MetroPCS shareholders have filed a lawsuit in which they claim that MetroPCS is "drastically undervalued" in the deal. Shares have fallen since the announcement, and shares now trade for approximately 15x forward consensus earnings. On a price/sales basis -- perhaps a better gauge of value for cellular retail -- Metro PCS does look to be undervalued at 0.8x sales. However, Sprint is trading at 0.5x sales, indicating that its price (for a number of reasons, including its status as a value cellular network and its lack of positive earnings reports) does not fully reflect its revenue base. This multiple compares to 1.6x and 1.1x sales for AT&T (T) and Verizon (VZ), respectively.

Present valuations rather clearly reflect two different tiers of providers: "troubled" value providers (new Sprint, new T-Mobile) and premium providers (AT&T and Verizon). However, IHS iSuppli analyst Dexter Thillien said he thinks that this pair of mergers will be disruptive for this broad categorization: "AT&T and Verizon have followed a premium-pricing strategy when it comes to data services, leveraging their superior networks. However, a resurgent Sprint with a strong network and low-cost unlimited data plans could put pressure on AT&T and Verizon's wireless margins." Merger of two cellular providers will naturally result in better signal coverage, which is one of the only justifications for charging a premium on phone service.

More competitive forces in a given market naturally result in more risk for investors in that market. We recently reported on the challenges facing Sprint, including its Clearwire (CLWR) investment, and noted that AT&T and Verizon are still in the best position to ride the positive secular trends in cellular communications. Mergers help to cut costs, but other significant issues lurk in the premium-end market. Phone subsidies are a consistent hindrance for premium providers looking to benefit from the smartphone boom; providers pay about $400 for every iPhone that they sell in the hope that comprehensive data packages will justify the costs. Slight increases in monthly rates and increasingly stingy discounts on new phones are helping phone providers sustainably pass on more costs to customers. After taking into consideration both the dividend yields for AT&T and Verizon of more than 4.5% and their record in the past year of cutting costs, we are still optimistic about the frontrunners.

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