At first glance, AT&T's (NYSE:T) recent announcement of its acquisition of Leap Wireless (LEAP) seems to be an expensive way to acquire spectrum holdings, but on closer review, there appear to be some additional drivers behind this deal that make it close to fairly valued.
Leap holds wireless operating and non operating licenses for spectrum that as of December 31, 2012 was valued at around 2.3 billion and is situated in the 700MHz band, which is complimentary to AT&T's current systems. This value was included in an accounting for fair value of assets, and as such is likely to be a bit high. Given today's environment of rapidly expanding 4G networks and increasing demand for bandwidth for data, a premium can be expected for any spectrum purchased. In a previous interview at the tail end of 2012, Leap's CEO Doug Hutcheson stated that the market value of Leap's spectrum holdings were around 3 billion.
The net debt on Leap's balance sheet is currently $2.8 billion and will be assumed by AT&T if the deal is approved. At $15 per share, this puts the cash required to complete the deal at $1.2 billion. The total cost to AT&T for this deal sits at around $4 billion when both the cash and assumption debt are taken into account. Given that a major hurdle for Leap was the refinancing of its debt during 2014-2016, this deal creates substantial value for Leap shareholders. With a $4.9 billion dollar TTM cash position, AT&T should have little trouble paying for the deal and financing the additional debt on its balance sheet after the fact.
The acquisition of Leap will mean an addition of ~5 million customers for AT&T that are currently predominately on prepaid plans. This will expand AT&T's prepaid customer base significantly from the 7.1 million that it is currently at, but the margins provided by prepaid customers are significantly less than those for postpaid subscribers. It is likely that the $2.8 billion in revenues that Leap currently brings in for a net income of ($182 million) will likely turn positive for AT&T when the reduced advertising and equipment costs are factored in as these are the largest negatives currently affecting down Leap's net income.
This deal comes on the back end of the failed acquisition of T Mobile (NYSE:TMUS), which was shot down by the Department of Justice's antitrust division. Due to the consolidation of the telecom market in the US, the number 2 telecom buying the number 3 or 4 telecom company in the country seemed a bit anti-competitive and possibly not good for consumers. This deal should not run afoul of the same issues, as Leap is a much smaller company that is primarily focused on prepaid customers in major cities across the US. The acquisition of Leap's network shouldn't eliminate options for current customers and may actually have the effect of making AT&T's prepaid plans cheaper as Cricket's current plans are honored and AT&T tries to not lose customers during the transition.
Sum of the Deal
The saturation of smart phones and consumers on postpaid plans appears to have made the prepaid market an increasingly important source for increased growth for the telecom companies, forcing all of them to introduce plans that are increasingly attractive for prepaid consumers. There is some irony in the fact that the telecom sector is now fighting over customers that no one wanted to support even a few years ago. Considering this tough growth environment, it seems that AT&T is willing to pay a premium for marginal customer growth in a segment with relatively thin margins in order to obtain the spectrum that comes along with it.
So after considering these factors, the question becomes: Is the spectrum ($2.3 -3 billion) and the added revenues from Leap's prepaid customers worth the price ($1.2 billion) and the debt that will be assumed ($2.8 billion)? This means that additional revenues from Leap's customers would have to come to $1-1.7 billion for AT&T to break even after the deal.
This expectation makes the valuation for the deal seem a bit rich to me, but it does address AT&T's spectrum issues and help grow an increasingly important customer segment for growth in the US market.