Expensive Valuations And Intense Competition In Industry Earn Sprint A Neutral Thesis

| About: Sprint Corporation (S)

Summary

Company needs to consistently work at improving network quality and reduce costs.

S will continue to face pressure on cash flow base in short term.

Stock is currently trading at expensive valuations as compared to industry average.

I reiterate my "neutral" rating on Sprint Nextel Corporation (NYSE:S). The company recently reported mixed results for the first quarter of 2014. S' healthy smartphone sales and the success of "Framily" installment plan resulted in wireless revenue growth of 2% and total revenue growth of 1% year-on-year in 1Q'14. In addition, ongoing cost reduction plans (Network Vision Plan) coupled with EIP penetration helped the company improve margins; the company reported a 450bps year-on-year increase in EBITDA margin for the quarter. However, despite the company's on track 4G-LTE deployment plan, the company's subscriber base remains pressurized in a highly competitive telecom sector, as postpaid churn rate increased to 2.18% in the quarter. In addition, the company has been investing to upgrade its network and improve leverage; it experienced a 7th consecutive quarter of FCF burn. Moreover, the stock is currently overvalued as compared to its peers, as it is trading at EV/EBITDA of 10.75x as compared to its industry average of 8x, as shown in the table below.

Financial Highlights from 1QFY14

In a highly saturated U.S. telecom sector, S's competitive position remains highly challenged, as it delivered mixed 1Q'14 financial results. The company managed to grow its top-line results in the recent quarter, with increased smartphone sales and a consumer shift to the Framily plan; by the end of 1Q14, almost 3 million customers were on the Framily plan. Moreover, the Framily plan has more to offer in the coming quarters, with recent international-adds on offer for Framily plan subscribers, which will have a positive impact on the company's performance.

The total YoY revenue growth of 1% in the quarter was mainly driven by wireless revenue growth of 2% in 1Q'14. Also, the company experienced a 1% year-on-year growth in postpaid ARPU and a robust 22% growth in the adjusted EBITDA. The following table shows postpaid wireless revenue growth and ARPU for the company.

1Q-13

1Q-14

Postpaid Revenue Growth (Y-O-Y)

1.7%

2%

Postpaid ARPU

$62.4

$63

Click to enlarge

Source: Company's Quarterly Earnings Report

Efforts to Improve Costs

As the industry remains competitive and the company directs its investments to improve its network, S is also undertaking cost control efforts to support its earnings. The company's Network Vision savings, the closure of the Nextel platform and a reduction in subsidy through EIP remain the important measures taken by the company to achieve cost savings. The results of the cost savings measures remain satisfactory, as in the recent first quarter S reported a 22% increase in adjusted EBITDA. I believe the company will continue to enjoy cost saving benefits in upcoming quarters to support margins and offset the impact of network improvement spending.

The company was successful in lowering its cost of services by $65 million in the quarter as a result of cost control efforts. However, SG&A for the quarter was flat year-on-year mainly due to higher bad debt and selling expenses. The following table shows gross margin, SG&A and operating margin for the company.

1Q-13

1Q-14

Gross Margins

41.6%

46.2%

SG&A as percentage of Revenue

26.5%

26.8%

Operating Margins

0%

6%

Click to enlarge

Source: Company's Quarterly Earnings Report & Calculations

The following chart shows the EBITDA margin trend for the company.
Source: Company's Quarterly Earnings Report

Competitive Environment
The Telecom Industry remains highly competitive. Price wars and improvement in service quality are the main tools used by companies to counter competition and strengthen their subscriber bases. The rapid adoption of LTE has been observed in the North American Telecom Industry, which is completely saturated, with leading 4G-LTE service providers like AT&T (NYSE:T) and Verizon (NYSE:VZ) dominating the market. S, in recent times, has been aggressively working to expand its 4G-LTE network; by the end of 1Q'14, S covered 225 million pops with its 4G-LTE across 443 markets. The company needs continuous efforts to expand the network, which will ensure improved service quality and strengthen its subscriber base in the medium-to-long term. However, in the short term, the company will continue to face pressure on its subscriber base due to intense competition and the dominance of VZ and AT&T. The chart below shows that the company has been struggling to maintain a satisfactory net subscriber addition trend. However, S is likely to experience improved subscriber metrics by the end of 2014, as it plans LTE expansion to 20 new markets through the Sprint spark service.

Source: Company's Quarterly Earnings Report

Balance Sheet Position and FCF burn

S' highly leveraged balance sheet remains a concern for investors. The company is committed to lowering its debt and improving its risk profile. The company currently has a debt of equity of 1.25x, down from 3.4x in 2012. The company has upcoming debt maturities of $879 million, $754 million and $3,554 million in 2014, 2015 and 2016, respectively, which will further lower its leverage.

However, the upcoming debt maturities will put pressure on the company's cash flow base, which is already weak. In the recent first quarter, the company faced the 7th consecutive quarter of FCF burn, as it has been spending on improving its network service. The following chart shows the FCF burn over the quarters for S.

Source: Company's Quarterly Earnings Report

Conclusion

The company has been facing intense competition in the industry. I believe the company needs consistent efforts to enhance its network quality and reduce costs, which will portend well for the company's performance in the medium-to-long term. In the short term, I believe the company will continue to face pressures on its cash flow base, as it has been undertaking CAPEX to strengthen its network. Moreover, the stock is currently trading at expensive valuations, as S is trading at an EV/EBITDA of 10.75x, in comparison to its industry average of 8x, as shown below. Due to the aforementioned factors, I have a neutral rating on the stock.

Company

EV/EBITDA

S

10.75x

T-Mobile (NASDAQ:TMUS)

9x

VZ

6x

Industry Average

8x

Click to enlarge

Source: Yahoofinance.com

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.