When Sprint (S) and T-Mobile US (TMUS) explored a merger in 2013 and 2014 before regulatory hostility led them to call off their plans, the argument the carriers made to both investors and regulators for doing a deal was pretty simple: Neither carrier had the scale to effectively compete against Verizon (VZ) and AT&T (T) on their own, and it was only by joining forces that they'd have the network coverage and marketing resources to take on the leaders.
Since then, T-Mobile has punched a giant hole in that argument by steadily delivering profitable growth and share gains, and forcing its rivals to respond with major discounts. In addition to giving deal opponents a big talking point, the self-proclaimed "Un-Carrier's" financial success gives it a lot of bargaining power should it choose to pursue a tie-up with a rival that still faces its share of issues.
Reuters reports Japanese tech/telecom conglomerate SoftBank, whose 2013 acquisition of a controlling stake in Sprint hasn't quite gone as planned, is willing to forego control of a merged Sprint/T-Mobile entity to T-Mobile parent Deutsche Telekom as part of a deal. It adds SoftBank and DT are expected to start merger talks in April, after a major FCC low-band spectrum auction that prevents current discussions ends.
The report arrived a few days after outspoken T-Mobile chief John Legere suggested on his company's fourth-quarter earnings call he's open to M&A. "If we choose to, we can continue to drive growth on our own...or participate in various forms of consolidation," he said. The remarks come amid speculation that a Trump Administration FCC and DOJ will be more willing to sign off on a T-Mobile/Sprint merger than their Obama Administration predecessors.
T-Mobile shares closed up 5.5% to $63.92 following Reuters' report, making new all-time highs along the way. Sprint closed up 3.3% to $9.30, leaving shares close to a 52-week high of $9.65. T-Mobile currently has a $50.1 billion market cap and $24.9 billion in net debt, and Sprint a $36.6 billion market cap and $31.3 billion in net debt. In that context, SoftBank's reported "offer" to cede control isn't especially charitable.
Regardless, the financial synergies a deal could provide remain significant. By merging, Sprint and T-Mobile would have greater network economies of scale, whether for infrastructure spending, spectrum usage or the managing of their networks. And some of the money saved by eliminating duplicate coverage could be applied towards expanding T-Mobile's coverage so that it's more competitive with Verizon/AT&T's. T-Mobile/Sprint would also be able to cut overhead, gain more leverage with phone suppliers and lower their combined ad spend and retail store footprint.
And -- though chances are both companies will try to downplay this, since it's exactly what many deal opponents in Congress and elsewhere fear -- a merger could yield a stronger pricing environment. Particularly since T-Mobile and Sprint generally offer the lowest pricing of the four major U.S. mobile carriers, and Verizon/AT&T have responded to it by cutting their own prices and re-introducing unlimited data plans.
But a deal also presents some challenges. In telecom as in so many other industries, replacing two distinct brands and product/service lineups with just one -- in this case, one has to assume T-Mobile's brand and service plans will be kept, and Sprint's jettisoned in time -- tends to cause share loss over the short-term. And the fact that T-Mobile and Sprint run incompatible 3G (though not 4G) networks reduces network-related synergies a little.
The bigger issue, however, is that Sprint today is still arguably just a borderline viable business. The company only expects break-even adjusted free cash flow (FCF) this fiscal year (ends in March) in spite of cutting its capex budget to a range of just $2 billion to $2.3 billion, well below the $4.7 billion spent in the prior year. And though Sprint's rock-bottom pricing has allowed it to halt postpaid subscriber losses, this pricing has also led service revenue to continue declining. Sprint also tends to rank last among the big 4 carriers in customer satisfaction, thanks in part to its network quality.
Because of all this, the Sprint/T-Mobile's combined capex might actually rise over the short-term -- Sprint has already forecast its capex will rise in the next fiscal year -- as T-Mobile works to address Sprint's underinvestment and improve the quality of service Sprint subs receive. That, along with the potential share loss mentioned previously, could offset a chunk of the cash-flow benefits that will come from various synergies.
Throw in the fact that Sprint, at its current valuation, would cost T-Mobile $77 billion in equity and assumed net debt, and a merger isn't quite as much of a no-brainer for the Un-Carrier as some would argue. Especially since T-Mobile, which had 2016 FCF of $1.4 billion in spite of spending $4.5 billion on capex, saw 11% service revenue growth in Q4 and expects strong cash flow growth over the next 3 years, is doing just fine as a standalone business.
Thus while Deutsche Telekom, as well as many T-Mobile investors, might still feel as if a merger is in its long-term interests, it might also feel the need to drive a hard bargain to financially justify a deal. And whether or not it feels this way, DT certainly has more leverage than SoftBank/Sprint to engage in hardball negotiating tactics. Particularly given M&A hopes have had much to do with Sprint's 50%-plus rally from where it traded in early November, before Trump was elected.
That, along with still-meaningful possibility that regulators will once more object to a merger, makes investing in Sprint on expectations of a shareholder value-enhancing deal a risky proposition. Sprint needs a merger to guarantee its financial future. T-Mobile's future looks secure whether it signs on the dotted line or walks away.