Sprint Is Trading Above Our Fair Value Range

| About: Sprint Corporation (S)

One of the most important things investors have to remember is that value is not a point estimate, but a range of probable valuation outcomes. All of the value (cash flow, earnings) is in the future, while the future is inherently unpredictable. So how a fair value be a point estimate? That's exactly our position. Let's calculate the range of probable outcomes for Sprint's (NYSE:S) valuation -- and yes, we don't think Sprint is worth $4; we think it is worth between $2 and $6, our fair value range.

But before we dig into the details, a little background to help with the understanding of this article. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation we gave at the Las Vegas Money Show last month), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Generally speaking, more interest in a stock leads to more buying, which leads to a higher stock price.

If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Sprint posts a VBI score of 4 on our scale, reflecting our 'overvalued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Sprint to peers AT&T (NYSE:T), Centurylink (NYSE:CTL), and Verizon Comm (NYSE:VZ). In the spirit of transparency, we show how the performance of our strategy versus that of peers:

Our Report on Sprint

Investment Considerations

Investment Highlights

• Sprint's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality
firms out there.

• Sprint offers a comprehensive range of wireless and wireline communications services to over 50 million customers. The firm is widely recognized for developing innovative technologies, including the first wireless 4G service from a national carrier in the US.

• Sprint's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

• The Spring/Clearwire tie-up will optimize the value creation of spectrum assets. For one, the deal will give the combined entity full control of valuable spectrum resouce and LTE deployment.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Sprint's 3-year historical return on invested capital (without goodwill) is 4.2%, which is below the estimate of its cost of capital of 12%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Sprint's free cash flow margin has averaged about 3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Sprint, cash flow from operations decreased about 50% from levels registered two years ago, while capital expenditures
expanded about 86% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Sprint's shares are worth between $2.00 - $6.00 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. But why is it so large? Click here. The estimated fair value of $4 per share represents an implied EV/EBITDA multiple of about 5.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.1%. Our model reflects a 5-year projected average operating margin of 4.4%, which is above Sprint's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. For Sprint, we use a 12% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $4 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Sprint. We think the firm is attractive below $2 per share (the green line), but quite expensive above $6 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Sprint's fair value at this point in time to be about $4 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Sprint's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $6 per share in Year 3 represents our existing fair value per share of $4 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.