The purpose of this article is to highlight the complex and intertwined regulatory issues which are presumed to be the main areas of contention for a successful merger between Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS), and to provide an analysis so that investors are able to make a better informed decision regarding these two stocks. In my first article, Sprint and T-Mobile US - A Winning Proposition, I proposed a four prong strategy that would allow Sprint to acquire T-Mobile which would assuage the fears of the regulatory agencies and win public support; however, I did not specifically address the regulatory issues believed to be the most critical. In Part 1 I will layout two of the four critical issues that Sprint will have to overcome in order to obtain regulatory approval for the merger which are as follows: 1) Market Share & Concentration, and 2) The Doctrines of Unilateral & Coordinated Effects. I will continue the analysis in Part 2 by reviewing The Disruptive Role of a Merging Party and The Entry of New Participants.
The first issue, market share and concentration, is important when it comes to how the regulatory agencies will initially view the potential dissension of the merger. The Herfindahl-Hirschman Index (HHI) is the empirical measurement for which the Department of Justice (DOJ) and the Federal Trade Commission use to measure market concentration in a particular industry, with a scale of 0 (perfect competition) to 10,000 (monopolistic). The agency's guidelines for horizontal mergers in highly concentrated markets (HHI > 2,500) and where the proposed merger increases the HHI over 100 points the merger will raise the red flags of antitrust. Moreover, a merger that increases HHI over 200 points presumes to the agencies that competition is at risk due to an enhancement of market power. The HHI for the mobile wireless industry is individually calculated in each of the 172 Economic Areas (EAs) by using the number of mobile wireless connections held by facilities-based mobile wireless operators; the agency then derives the operator's percentage share of connections from the number of these respective connections. The chart below shows the maximum HHI measurement, the minimum HHI measurement and the average measurement which is calculated by the weighted average of all HHIs (weighted by EA) from 2009 to 2011 with an estimate I calculated for 2012 only using the total number of connections for each of the four major operators (I did not use the weighted averages per EA).
The chart below shows my calculation versus the traditional calculation for the years 2009 through 2011 with the same estimate for 2012 as shown above.
The purpose of exercise above is to understand the hypothetical increase of the HHI with a combined Sprint/T-Mobile merger. Assuming that the market share for each operator in 2013 is comparable to 2012, then the average HHI in the mobile wireless industry in a post-merger Sprint/T-Mobile world would increase to 3,349 which is nearly a 450 point increase over the estimate for 2012 or a 486 point increase over the average HHI scores between 2009 and 2011. This increase will almost certainly legitimize the regulatory concerns of increase market power in the industry. However, if Sprint decides to keep the networks separate it might be possible to argue that since approximately 99% of the connections will be on separate networks (due to the separate network technologies) and that only 1% of the connections will be on some type of shared LTE network, then the HHI measurement would barely change and antitrust concerns would be a moot argument based purely on the HHI measurement (currently LTE connections only make up roughly 1% of all connections). I am not completely convinced that the market concentration issue will carry the same weight and scrutiny as it did during the attempted acquisition of T-Mobile by AT&T mainly because I believe there are two other important aspects to this argument which Sprint is in a better position to defensively argue its point where AT&T failed.
The two other important points that are necessary to introduce in order to more thoroughly analyze this issue are 1) market concentration is higher with lower density EAs (rural areas) while lower market concentrations are correlated to higher density EAs (urban and dense-urban areas), and 2) highly concentrated markets do not necessarily lead to market power or that firms will engage in anticompetitive pricing models over the long run. The first point is important because some might believe that the FCC will require Sprint to give up spectrum in some EAs as a precursor for the deal to be approved. Since the vast majority of the spectrum controlled by Sprint is in the higher range of the ultra-high frequency (UHF) bands (2.5/2.6 GHz) which will be deployed in the higher density urban areas the concession of this spectrum does not promote the desired changes to reduce market concentration nor will it allow a possible new entrant to build an efficient network outside of these metropolitan areas. A new entrant would have to enter into a roaming and/or a MVNO agreement with AT&T and/or Verizon, the largest holders of spectrum in the lower end of UHF (below 1,000 MHz) which have better propagation properties and are more efficient (larger coverage footprint) for use in rural areas and have better in-building coverage. The fact is that all spectrum is not created equal and for a more competitive market place all operators need to have an equal mix of spectrum, which is not the case at the moment. A scenario that would require Sprint to concede spectrum belies logic because it will not necessarily decrease market concentration in the short or medium terms and it would not change the industry fundamentals where the two industry leaders control the prime, lower frequency spectrum. Regarding the highly concentrated markets, there is a rather lengthy economic argument that we can use to prove that highly concentrated markets do not necessarily lead to market power or that firms will engage in anticompetitive behavior. This can be proved by using elasticity of demand functions to understand a firm's incentive to exercise market power, in particular how a firm takes advantage of market power in relation to increases in prices to consumers. It should be clear that any incentive to increase market power will also be tightly tied to the doctrine of unilateral and coordinated effects and will be highly scrutinized in terms of the effects of the merger on prices and competition in the market.
The doctrine of unilateral effects focuses on four areas, but only two of these areas are pertinent to our topic 1) Capacity and Output of Homogeneous Products, and 2) Innovation and Product Variety. The first part of this principle deals with a unilateral output strategy where the suppression of output leads to a rise in profit. One of the criteria for an effective unilateral output strategy is low elasticity of demand and the elasticity of demand for mobile wireless broadband is relatively low because there are no close substitutes, it is a broadly defined good and a higher necessity good. I do not believe a merged Sprint/T-Mobile will be able to benefit from an output suppression strategy, in fact, this argument is relatively dubious because Sprint is not the market leader, T-Mobile is not necessarily offering a homogeneous product at higher operating cost and both companies are already offering unlimited data plans (supply is perfectly elastic). The second area of potential regulatory review will focus on the question of whether or not the merger will diminish competition innovation for new and original product and service offerings. This is the more serious of the two issues and is tangential to the maverick issue which will be discussed in Part 2. T-Mobile is introducing innovative wireless services which are taking market share from Sprint so the regulators will most certainly want to understand how this merger will effect innovation and product offerings post-merger. If the post-merger firm were to eliminate these offerings then the question would be how much harm would come to consumers. If Sprint were to eliminate the innovative services and plans currently offered by T-Mobile where consumers prefer the T-Mobile offerings causing harm to the consumers the DOJ would examine the incentives towards anticompetitive behavior ascribable to the merger.
The regulators will review how the merger will affect the coordinated interaction in terms of the incentives to reduce competition through the enhancement of market power and to the extent and probability of coordinated conduct in the industry. The regulators will challenge the merger when there is a strong belief that it may lead to coordinated conduct and if all three of the following conditions are met: 1) there is an increase in market concentration, 2) the market shows signs of vulnerability to coordinated conduct, and 3) there is credible evidence that a merger will enhance this vulnerability.
We have already discussed the market concentration issue and now we will examine the four characteristics of an industry that is vulnerable to coordinated conduct, 1) Transparency, 2) Diminished response to churn, 3) Price/value reciprocity, and 4) Low elasticity of demand. The mobile wireless industry shows some vulnerability to coordinated conduct in the areas of transparency where pricing is transparent for homogeneous products and in regards to a low elasticity of demand as discussed above. The industry does not necessarily show vulnerabilities to coordinated conduct in the other two areas because the limited amount of firms in the industry do not show apathy towards churn and fight to reclaim lost customers. The firms that offer the best "value" for their services are able to retain customers up until a better "value" offer is introduced into the market. Whether or not the industry is vulnerable to collusion and coordinate conduct is nebulous, but I would argue that this is not an industry that is vulnerable to coordinated effects. The next criteria is a bit more complex because the proposed merger involves a maverick firm. I will save the maverick firm analysis for Part 2, but to finish the analysis regarding coordinated conduct I am not convinced that a merger between Sprint and T-Mobile will enhance the vulnerability of coordinated conduct because the merger does not change the paradigm in regards to the response to churn and the price/value reciprocity.
In conclusion, a possible Sprint/T-Mobile merger faces resistance to approval as analyzed in the two main areas presented 1) Market Share & Concentration and, 2) The Doctrines of Unilateral & Coordinated Effects. First, Sprint will need to argue that an increase in market concentration is not a deal breaker in terms that it will create excessive market power in the industry. Second, the regulators will have to conclude that the industry is not vulnerable to coordinated conduct and that a merger will not enhance coordinate conduct in the industry. Even if Sprint successfully convinces the regulators that increased market share will not create excessive market power and that the regulators conclude the industry is not vulnerable to coordinated conduct there are still two remaining areas of regulatory inquisition, The Disruptive Role of a Merging Party and The Entry of New Participants, both of which will be examined in Part 2.
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. I have no business relationship with any company whose stock is mentioned in this article.