It has been 3 months since our last article on Clearwire (CLWR), which has been the longest stretch of time in between 2 Clearwire articles. While we have naturally kept up to date with the latest developments regarding the Clearwire saga since January, there has been little in the way of concrete developments. Clearwire has continued to reiterate that it is in discussions with DISH (DISH), all while recommending that shareholders vote for the Sprint (S) offer. And minority shareholders, led by Crest Financial, continue to oppose the current terms of the deal. However, this past weekend, the merger saga, which has become one of the most public merger battles of the past several years, took on a new dimension. A third bidder has entered the fray. But perhaps more importantly, Clearwire has revealed what we believe is its ace in the hole: its ability to default on its debt.
Sprint & Clearwire: Who Needs the Merger More?
The relationship between Sprint and Clearwire has been a tumultuous one from the start, driven by their symbiotic need for each other, as well as their fiduciary duties to their own investors. For Clearwire, Sprint has long been its source of financing, allowing Clearwire to build out its LTE network at a pace that would be likely impossible without Sprint. And for Sprint, Clearwire's spectrum is an essential component of its strategy to compete with AT&T (T) and Verizon (VZ), a strategy that has been deemed so important that CEO Dan Hesse has agreed to cede control to SoftBank. Shares of Clearwire soared in October when news broke of the talks between Sprint and SoftBank, as investors viewed this as a sign that Clearwire would finally be bought out. However, in the days after news of these talks was released, sources close to Sprint's management team and board of directors denied that this would occur immediately. These sources noted that Sprint and SoftBank wish to see their own deal through to the end before beginning to deal with Clearwire. However, between October and December, something occurred to change Sprint's thinking. The firm moved quickly during that time frame, and on December 17, 2012, Sprint and Clearwire announced that they had reached a deal for Clearwire to be taken over at $2.97 per share. The Sprint-SoftBank deal, however, is nowhere near complete, and is currently slated to close in mid-2013, according to the 2 companies. By moving to acquire Clearwire as quickly as it has done, we believe that Sprint has revealed its intentions. Clearwire's spectrum, as we have noted multiple times before, is an integral part of Sprint's long-term strategy. Many critics of Clearwire have argued that because the company has been dependent upon Sprint for financing, it is therefore at the mercy of Sprint when it comes to takeover negotiations. We, however, see things differently.
By working on both the SoftBank and Clearwire deals simultaneously, it is likely that Sprint and CEO Dan Hesse wish to step up competition with AT&T and Verizon as quickly as possible, hence their motivation to take control of Clearwire months ahead of prior estimates. However, we do not believe that it will be so easy for Sprint to take control. DISH injected itself into the process on January 8, when Clearwire announced that DISH had offered $3.30 per share to acquire all of Clearwire. DISH CEO Charlie Ergen is among the shrewdest dealmakers in the United States, and he is likely fully aware that Sprint will never agree to such a deal. However, for Clearwire investors, this may not be a negative. As we have noted before, the terms of Clearwire's merger with Sprint include a provision that requires that a majority of non-Sprint investors (equivalent to 75% of all of Clearwire's outstanding shares) must approve the deal, and many minority investors, led by Crest Financial, have opposed Sprint's $2.97 offer. Clearwire has repeatedly stated in its proxy filings that the merger with Sprint is the best course of action, even as it has stated that its talks with DISH are continuing. And on Friday, April 12, Clearwire's latest proxy statement disclosed the existence of Party J, an entity that has bid $1-$1.5 billion for 5 billion MHz-POP's of spectrum (some quick back of the envelope math shows that this bid, for 10.63% of Clearwire's spectrum, values all of the company's 47 billion MHz-POP's of spectrum at $9.4 billion, even at the low end of the offer; the value rises to $11.75 billion at the midpoint of Party J's offer). On its own, Party J's offer is not very compelling, at least at the low end. Its $1-1.5 billion bid for 5 billion MHz-POP's equates to a price of $0.20-$0.30 per MHz-POP. But, this bid was unsolicited (as Clearwire is barred by the terms of its merger agreement with Sprint from soliciting offers), and it shows that multiple parties are now interested in Clearwire's spectrum. Clearwire's proxy also once again warned shareholders that failure to complete the merger with Sprint could lead to a financial restructuring, possibly via bankruptcy. However, a Clearwire bankruptcy would be highly damaging for Sprint, as it would throw control of Clearwire's spectrum into doubt, spectrum that Sprint's actions have proven it views as essential to its strategy going forward. Clearwire's executives and board know this, and in the company's latest proxy, Clearwire stated that its board of directors is "actively considering" whether or not to make a June 1, interest payment on its debt. The specter of defaulting on Clearwire's debt should lead to a selloff in the company's share price. That would be the conclusion that an outsider would be likely to draw. However, Clearwire's history has shown that it has used such a tactic before, fully aware of the implications that a default and/or bankruptcy will have.
The Ace in the Hole
Clearwire's byzantine ownership structure has left Sprint with a majority stake in a company it has little operational control of. And that dilemma applies to the company's spectrum as well. For readers unfamiliar with Clearwire's ownership structure, we will provide a brief review. (For a more detailed overview of Clearwire's ownership structure, as well as the implications of this structure on Clearwire shareholders, readers may refer to a prior article on the company.) The company's spectrum is housed in a subsidiary known as Clearwire Communications. Through control of Clearwire Communications Voting Units, Clearwire maintains 100% voting control of its subsidiary. But, Clearwire's Class B investors (Sprint, Intel, etc…) each receive one unit of Clearwire Communications Class B Common Units for every Class B share of Clearwire that they own. This has the effect of giving Clearwire's Class B investors 67% economic interest in Clearwire Communications, and therefore the company's spectrum. But, this spectrum backs Clearwire's debt, and the company's bylaws give liquidation rights only to Class A shareholders (the publicly traded shares). This has the effect of securing the 33% economic interest that Clearwire's Class A investors have, for each share of Class B common stock, combined with a Class B Common Unit of Clearwire Communications, may be converted into one share of Class A common stock (our previous articles on Clearwire provide more detail regarding this issue). This is but one element of Clearwire's byzantine ownership structure that has left Sprint with little operational control over Clearwire. But, this element also has the effect of holding Sprint hostage to Clearwire's debt. If Clearwire defaults, its bondholders will seize control of the company's spectrum, thereby throwing Sprint's strategy into chaos. Their interests may not align with those of Sprint, and uncertainty is not something that Sprint can afford if it wishes to become more competitive relative to AT&T and Verizon. Under normal conditions, the shares of a company that states it is considering not making payments on its debt are likely to sell off. However, when news broke that Clearwire is considering just such a course of action (or rather inaction), alongside the news of Party J's bid, shares rallied well over 3%. Threatening to default on its debt is a strategic move that Clearwire has successfully used before.
In late 2011, as Sprint and Clearwire were negotiating their latest wholesale agreement, Clearwire CEO Erik Prusch publicly told The Wall Street Journal that the company was debating whether or not to make over $200 million in interest payments. Shares of Clearwire plunged after Prusch's comments, but in hindsight, it became clear that this was most likely a strategic ploy to force Sprint's hand. More than one analyst noted that Sprint would be the biggest loser in a Clearwire bankruptcy (despite comments from Sprint that such a bankruptcy would be "constructive"), because it would jeopardize Sprint's access to Clearwire's spectrum. The same potential exists here, and the move by Clearwire's board sets June 1 as a potential date for when there can be a resolution to Clearwire's merger drama. We do not see a default by Clearwire as a positive for Sprint. Sprint has been diligently working to turn itself around, and a Clearwire default would throw the company's carefully crafted strategy into jeopardy by creating a cloud of uncertainty over Clearwire's spectrum. In our view, this latest threat of default has the same purpose as the company's late 2011 threat: to force Sprint's hand into making a deal. It worked in 2011, and we believe that it will work again in 2013.
The battle over Clearwire is far from finished. Many of the company's minority investors, led by Crest Financial, are opposed to the deal. DISH, despite its threats of withdrawing its offer if Clearwire draws on Sprint's financing, has yet to do so. And Party J (which is described as a strategic buyer) has now also entered the fray, highlighting interest in Clearwire's spectrum. In our view, Clearwire will be taken over at a price higher than $2.97. As we have noted before, precedent transactions support a higher price, and Clearwire has traded above Sprint's offer price ever since DISH's bid was disclosed in early January. And Crest Financial has launched a proxy fight to block the merger, and we fully support the firm's move. We have not sold a single share of Clearwire since our last article regarding the company, for we believe that the company's shares are worth more than $2.97, and that over the course of the next several months, Clearwire's takeover drama will be resolved at a price that more accurately reflects the company's true worth.