Sprint/T-Mobile Merger: 6 Things You May Want To Know

Dec.30.13 | About: Sprint Corporation (S)

I'm going to dedicate this article to answering 6 key questions a fellow contributor of Seeking Alpha had asked me. Hopefully by answering these questions you will be able to come away with a fuller understanding of Sprint's (NYSE:S) take-over of T-Mobile (NASDAQ:TMUS).

What if Softbank/Sprint buys out only DT's stake at whatever valuation and leaves the float trading as a stub? In the absence of a tender, why should the publicly trading stub appreciate?

I don't think it's very likely that SoftBank (OTCPK:SFTBY) will buyout Deutsche Telekom's stake without giving a tender offer to T-Mobile's remaining shareholders. While Deutsche Telekom has a 72% stake in the stock, SoftBank would most likely buy in equal proportion of shares from both a public and private float.

In the absence of a tender offer, for the public float, it's likely that T-Mobile stock will continue to appreciate. T-Mobile and Sprint when combined could generate significant cost efficiencies by closing overlapping operations that are no longer necessary (call centers, retail locations, and administrative tasks). Also, because T-Mobile, Sprint, and SoftBank are joined together, the combined entity may have enough mobile subscribers to negotiate lower prices on mobile handset devices. Leveraging economies of scale should be sufficient enough of a growth catalyst to move the value of T-Mobile stock higher.

Considering the larger carriers all own more spectrum than they actually use and seem to be "spectrum squatting" (i.e. buying up all the spectrum so small competitors can't compete), is the additional spectrum beyond the bundle already owned by S/CLWR really going to add value?

It's hard to say that the additional spectrum won't add value, but it's hard to say that it will. Data consumption is expected to explode, and the number of mobile devices per user is expected to increase significantly.

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Source: Statista

The added spectrum could come in handy as the amount of data consumption per device is expected to grow from 600MB per month to 2.2GB per month. This is a 25% compound annual growth rate over the next six years. Having 228 MHZ of spectrum (Clearwire, Sprint, and T-Mobile) should give Sprint a distinct advantage against AT&T (NYSE:T) and Verizon (NYSE:VZ) in the future.

Considering both S and TMUS have historically struggled to hang on to postpaid subs, and Sprint continues to lose postpaid subs, why would this marriage of two losers produce a winner?

Well it's likely that over the short-term subscriber figures could drop even further. However, as cost efficiencies and further investment into network technologies continue a higher percentage of revenue can be converted into profit. Currently Sprint's operating margin is 1.23%, and T-Mobile's is 5.18%. Currently, Verizon's operating margin is 14%. So you 'd have to think that by Sprint and T-Mobile being combined they can drive operating margins that are closer to Verizon's, and in turn grow profit exponentially in a very short period of time. By having positive cash flow, Sprint and T-Mobile can invest more aggressively into network infrastructure to keep pace with Verizon and AT&T.

So it all comes back to ensuring that T-Mobile and Sprint are able to drive better margins, which would in turn lead to better capital expenditure spending. A better network will retain customers, and the slightly lower prices offered by T-Mobile and Sprint for post-paid plans will result in market share losses for AT&T and Verizon eventually.

With interest rates rising (10 year treasury > 3%, maybe even 3.5%) any financing for this deal will require junk levels of interest payments. Why would that not add a huge headwind?

Well it depends on how the deal is financed. This is where currency arbitrage and leveraging lower interest rates from different markets comes into play. Currently the Japanese 10-Year treasuries are less than 1%. Implying that the amount of interest that SoftBank would have to pay despite being junk levels bonds would not reach the level of interest that would have to be paid for a U.S. issuance of debt. In an environment where interest rates are artificially depressed like Japan the spread between higher and lower risk debt is narrow enough so that the cost of interest is also lower even on the riskier end of the spectrum. This is why SoftBank is pursuing a capital raise with Japanese banks, however there are also rumors that SoftBank is also in discussions with Goldman Sachs, and other U.S. based investment banks as well.

In the end, SoftBank will borrow cash at the lowest interest possible. I estimate that SoftBank will pay no more than 8% on a ten-year note. The cost of interest can be fully covered with the net income that SoftBank currently earns from its operations. So I don't think it's a very significant head-wind. Perhaps when the note reaches maturity, SoftBank would have to reduce CAPEX spending, but that's so far in the future I really wouldn't worry about it.

Postpaid cellphone plans are already very expensive. At what point does the law of supply and demand constrain future price hikes? All these articles on telecoms talk as though demand is inelastic. Already for a family of 4, a family plan with limited data runs $250-$300 after taxes. I don't think there is room for a whole lot of growth there.

Growth will probably have to come from new household formations or even further consolidation of the overall communication industry. If there's no further consolidation by mobile telecoms buying more traditional communications companies like Century Link (NYSE:CTL) and DISH Network (NASDAQ:DISH) then revenue growth would have to depend heavily on price increases with marginal growth in aggregate population to drive sales.

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Source: International Telecommunication Union

Currently the income elasticity of demand is 0.34 for phones. This low level of elasticity implies that pricing can increase without having too significantly of a negative impact on demand going forward. However, the increase in pricing would have to be gradual as the price of mobile plans in the United States is already the highest in the world at $80 per month per user.

Given saturation of the US market, any gain by S/TMUS must come from T or VZ. Why would anyone switch to S/TMUS unless for lower prices or features like "unlimited data" which invite adverse selection? How will that increase revenues or decrease costs?

As I have mentioned earlier both T-Mobile and Sprint already operate at lower operating margins than AT&T and Verizon. However, the added spectrum allocated to Sprint and T-Mobile will allow the duo to continue to offer unlimited data despite high rates of data consumption growth. Cash from SoftBank will have to be directly invested into Sprint's and T-Mobile's CAPEX in order to keep the defect rate lower. However, with lower pricing, and better service features, Sprint and T-Mobile should be able to increase revenues with user growth.

Because network technologies are a fixed expense, offering unlimited data shouldn't have too negative of an impact to expenses, assuming the cost of network build out isn't proportional on a percentile basis to data usage. In fact, I'm sure that as economies scale, margins will improve despite rising data usage.

Conclusion

I hope by answering these specific questions I have been able to address any concerns I have not been able to with previous articles I have written on the topic. Granted the merger is not set in stone yet, but with investment banks lining up to offer financing to SoftBank/Sprint, I'm thinking the cat is pretty much out of the bag.

Additional details will be released when SoftBank and Sprint propose a tender offer to T-Mobile shareholders.

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.