Forget T-Mobile U.S.: Telecom Is Still For Spenders

Apr. 3.14 | About: T-Mobile US, (TMUS)


TMUS's efforts to win subscribers have worsened margin contraction.

Questions about stickiness of new subscribers, given importance of network quality.

Combination of S and TMUS makes sense, but regulatory hurdles.

Telecom industry rewards those who spend on building out their networks.

Un-carrier? Try unsustainable and unprofitable.

The massive loss T-Mobile US (NASDAQ:TMUS) reported this week hasn't slowed the hyperactive tweeting of its CEO John Legere. Nor, apparently, has the news scared off his groupies on Wall Street, though that may have more to do with continuing takeover speculation.

The numbers reported, however, clearly call into question the sustainability of the company's aggressive marketing strategy. Spin the results any way you want - and several Wall Street supporters are certainly taking their liberties. But it's hard for any objective observer to be sanguine.

True, T-Mobile US grew its customer base by an outwardly impressive 1.645 million users in the last three months of 2013. And unlike in previous quarters, most weren't low-margin prepaid customers. It's also unclear, however, just what sort of users these new additions will be, as the company has done away with contracts.

Will these "branded postpaid net additions" prove as sticky as contract customers historically have been? Or will the company start to see its customer loss or churn rate accelerate from the current 1.7 percent annualized rate, which is still 70 basis points above churn rates for AT&T (NYSE:T) and Verizon Communications (NYSE:VZ).

The answer likely boils down to network reliability and quality. But without the cushion of contracts, there's not a lot to stop T-Mobile US users from moving on if they're dissatisfied.

Customer additions also came at a very high cost. Total revenue in fourth quarter 2013 was robust, rising 10.2 percent after taking into account the acquisition of MetroPCS. Smartphone sales hit a record 6.2 million units, or 91 percent of total phones sold. That suggests rising use of high-speed data, which is the key to improved margins.

T-Mobile US, however, experienced the polar opposite in its fourth quarter. Mainly, the combined services revenue of the company and MetroPCS was actually 1.1 percent lower than in the year-ago quarter.

The combined company's branded postpaid average revenue per user fell by 2.9 percent, the consequence of offering so many discount plans for service. Cost per new customer rose by $10 during the quarter to $317.

As a result, T-Mobile US's fourth-quarter cash flow - again after leaving out non-recurring items - dropped 7.8 percent from the third quarter.

In contrast to its sector rivals, the company did not include financial statements with its earnings release. The Form 10-K filed with the Securities and Exchange Commission, however, has plenty more disturbing news.

Front and center is a collapse in operating margins. Excluding $8.134 billion in impairment charges in 2012, the company had $17.832 billion in total operating expenses that year. This figure was $23.424 billion in the fourth quarter of 2013.

In 2012, T-Mobile US posted operating margins of 9.6 percent; this figure shrank to 4.1 percent in 2013.

Moving further down the income statement, combining interest expense to affiliates -- Deutsche Telekom (OTCQX:DTEGY) -- and interest, presumably paid to outside investors, yields a total of $1.223 billion, nearly twice the prior year's $661 billion.

That figure is certain to rise further in 2014. Management has announced capital spending plans of $4.3 billion to $4.6 billion in cash, versus projections of cash flow before cash interest and taxes of $5.7 billion to $6 billion. Even leaving out taxes, cash interest alone will consume the difference.

That, in turn, means more debt. In 2013, for example, T-Mobile US issued $2.494 billion in bonds, versus a total of $324 million in repayments. That was despite a $1.787-billion stock offering.

Of course, even elevated capital spending won't come anywhere close to keeping up with AT&T and Verizon Communications. Both have announced capital spending plans in the neighborhood of the numbers they ran up last year, which I show in the table, "Spend to Dominate." That's better than a 4-to-1 spending advantage for Verizon Communications and a nearly 5-to-1 margin for AT&T.

As for the bottom line, net income dropped by nearly 90 percent in 2013 (leaving aside the one-time impairment charge). That's a shortfall for which the bulls have already forgiven the company. But it's red ink that's likely to keep spilling in 2014, given that the fourth quarter was the third consecutive reporting period in which T-Mobile US has suffered a loss.

Exit Strategy

Perhaps the company will find a way to restore margins while competing on price with industry leaders. Its leading shareholder, however, hardly seems convinced.

Two years ago, Deutsche Telekom was thwarted in its attempt to sell T-Mobile US to AT&T for US$39 billion. After a 55 percent-plus gain in the stock over the past 12 months, T-Mobile US's market capitalization is back to $24.5 billion, which puts the market value of Deutsche Telekom's 66.71 percent equity interest at $16.34 billion.

The German giant unloaded 535,000-plus shares on Dec. 31, 2013. In fact, insider sales have been fast and furious over the past 12 months, starting from a share price in the low $20s.

Deutsche Telekom's apparent quest for a sale is almost certainly the biggest reason so many on Wall Street are still sticking around: 15 analysts rate the stock a buy, versus 11 holds and one sell. And a much-rumored bid from No. 3 US wireless company, Sprint Corp. (NYSE:S) would make a lot of sense.

The combination of these two companies would face some challenges, particularly when it comes to integrating networks and brands. But even assuming some attrition, the combined subscriber base of nearly 100 million would be comparable to AT&T and Verizon.

The company would also have more than 50 million postpaid subscribers, much closer to Verizon Communications' 95 million and AT&T's 70 million-plus -- though T-Mobile US's tearing up of contracts adds uncertainty to its numbers.

More important, the two companies' combined capital spending in 2013 was $10.858 billion. Pooling efforts would no doubt create considerable synergies, quite possibly closing the spending gap even more with the industry's big dogs.

Deutsche Telekom would demand an all-cash exit. But at a much more solid No. 3 in a growing market, Sprint/T-Mobile would quite possibly enjoy far more favorable access to the capital markets. And SoftBank (OTCPK:SFTBY), which owns 80 percent of Sprint, has reportedly lined up banks to finance a deal. That's a pretty good indication the parties are ready and willing to make a move.

But would regulators sign off on the merger? Predictably, the US Dept of Justice and Federal Communications Commission have emerged as major hurdles to doing any deal.

Both agencies have frequently decried the increasing concentration of wireless industry power and profit under AT&T and Verizon Communications. But like their counterparts in Europe, they've bought into conventional wisdom that it must preserve four national competitors as some kind of magic number. And T-Mobile USA's fourth-quarter customer growth has only dug them in further.

Both AT&T and Verizon Communications picked up customers in the fourth quarter. And they did it while cutting debt, boosting profit margins and reducing their defection rates.

Learn more about my favorite telecom names in Top Essential-Services Stocks for 2014.

Disclosure: I am long VZ, T. 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.