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Summary

  • There is a strong possibility that the FCC will allow the merger of T-Mobile and Sprint corporation.
  • The new-entity that will be formed, as a result, will be able to compete on equal-footing with Verizon and AT&T.
  • T-Mobile and its investors, irrelevant of the outcome of the merger-deal, are in a win/win position.

T-Mobile (NYSE: TMUS), a telecom service provider, has been showing an impressive subscriber-growth for several quarters now. This all started when the Federal communications commission turned down AT&T's (NYSE: T) bid to acquire T-Mobile several years ago. The break-up fees and the spectrum acquired from this development helped T-Mobile in improving its network. The fees also helped the company in its "un-carrier" price-reduction strategy, responsible for the recent growth of T-mobile's subscriber-base. Recently Softbank, the parent of Sprint corporation (NYSE: S), agreed to acquire T-Mobile for a sum of $32 billion, and hence the future prospects of T-Mobile are starting to look a lot better. The company will benefit from this development whether the deal goes through or not. However, chances of the deal going through are not as slim as perceived by the market.

The deal


Picture credit: cnet.com and besttechie.com

  1. Softbank is offering $40 per share for the controlling interest in T-Mobile. Deutsche Telekom will retain a non-controlling interest of 15% in the company.
  2. It is expected that T-Mobile's CEO will retain his title after the merger.
  3. If the regulators block the merger, Softbank will have to pay a breakup fee of $2 billion.

FCC and the department of justice expressed a desire to have at least four network operators. There are already four players in the market, and a merger between T-Mobile and Sprint will reduce this number to three odd players. FCC is skeptical about reducing the number of players and believes that it will lead to unfavorable pricing for the consumer. This weakens the chances of approval for the deal. Despite all the negativity surrounding the deal, Softbank's case seems to be a strong one. Softbank is pitching that three strong operators are a better proposition for the consumer. As Verizon and AT&T are quite ahead, T-Mobile or Sprint alone can't create meaningful competition and the result, effectively, is a two-player industry. Softbank is convinced that a duopoly is not healthy for the market. It resulted in higher prices in the U.S. market. In Japan, the subscriber market-share is distributed more evenly. DoCoMo, Softbank, and KDDI hold around 40%, 30% and 28% of the market share. In contrast, the major portion of the total subscriber-base is held by Verizon and AT&T in the U.S. Furthermore, the larger players are in a position to charge higher rates because capital-constrained smaller players like T-mobile can't compete with them on coverage.


Source: Softbank's presentation

The average speeds in the U.S. are also lower due to the lack of motivation to compete. The average download speed of Softbank is around 21.3Mbps, compared to the U.S. average of 6.5Mbps. Hence, Softbank's case is not that weak, and there is a possibility that the FCC will consider the merger-option.

Case 1- Deal approved
The new-entity, T-Mobile and Sprint combined, will emerge as the third largest telecom service provider with almost 100 million subscribers. T-Mobile and Sprint, combined, have the low-band and the high-band spectrum. The low-band spectrum will be useful in stretching the coverage into rural and suburban areas. The high-end spectrum band will be useful to address the capacity issues in the densely populated urban areas. A study from Huawei concludes that the capacity is easier to find in the higher frequency bands, and hence it is suitable for dense areas. The low-band spectrum provides better coverage, and it is suitable for low-cost, wider-coverage implementation. The new-entity will end up with more options in the spectrum-band department, helping it to compete on equal footing with Verizon (NYSE: VZ) and AT&T.

Cost benefits will also arise because of the elimination of the duplicate functions. The synergy benefits of this deal can exceed $20 billion, noted Hannes Wittig, an analyst at JP Morgan. The management of Softbank believes that increased access to the airways, better bidding prospects for spectrum, and the improved infrastructure will result from this merger.

T-Mobile's investors will receive $40 for each share held, which is a premium to the current stock price. All in all, the approval of the deal will be a win-win for both T-Mobile's investors and the new-entity.

Case 2- Deal blocked
If the deal gets blocked; T-Mobile will, nevertheless, end up in the money. T-Mobile will receive a breakup fee of $2 billion. The company can use it to continue its "un-carrier" aggressive price-reduction strategy that helped the company steal subscribers from the competition. The funds can also be used to finance the purchase of low-band spectrum in 2015. The acquisition of the low-band spectrum will result in more reliable and wide coverage for T-Mobile, thanks to the superior propagation qualities of the low-band spectrum.

T-Mobile is already hedging against any unfavorable outcome of the deal. It is planning to acquire low-band spectrum from several small players. Verizon is the No.1 network of the U.S. because of its low-band spectrum. T-Mobile will improve its network coverage and reliability by acquiring the low-band spectrum. Hence, T-Mobile is not on the losing-side even if the deal is blocked by FCC.

T-Mobile Valuation- Case 2
T-Mobile will receive a breakup fee of around $2 billion in case the merger gets blocked. The company can use this instant cash to improve its network and continue its aggressive price-reduction strategy. Anyhow, incorporating the breakup fee into the cash-flow based valuation model drives a price target of $46.90 for TMUS.

Amounts in billion

2014

2018

Perpetuity

Adjusted Cash flow

1.14

5.07

6.07

Present value

1.01

3.15

26.70

NPV

37.66

PV

46.90

Source: Focus Equity estimates

I believe that this price target is in line with the growth prospects of T-Mobile, and the stock has the ability to post gains of around 35%-40%. Follow this link to see the detailed valuation along with the assumptions made to drive the price target.

Bottom line
The telecom industry is undergoing a round of consolidation. The merger will increase the competition, resulting in price wars. T-Mobile will benefit regardless of the outcome of the merger. In the case of the approval of the merger, the new-entity will emerge as a strong competitor to Verizon and AT&T. Cost savings and synergy benefits will add to the bottom line of the new entity. However, if FCC blocks the deal, T-Mobile will take the breakup fee to strengthen its spectrum-position. It will also continue to support its "un-carrier" strategy. From an investment perspective, T-Mobile is a good investment option because it is positioned in a unique way in this merger scenario.

Source: Merger Or No Merger, T-Mobile Is Poised To Win