After hiring a new CEO and dropping the pursuit of a merger with T-Mobile US (NASDAQ:TMUS), it wasn't surprising to hear claims that Sprint (NYSE:S) plans a pricing war. The third largest domestic wireless provider is left with limited options now that it can't merge with the fourth largest wireless provider to create a strong competitor to AT&T (NYSE:T) and Verizon Communications (NYSE:VZ).
Previous research titled "Is Sprint Dead Without T-Mobile?" predicted a dire situation for the stock if it couldn't merge with T-Mobile. The stock was trading around $7.40 at the time of writing that article and now trades at $5.69 based on ending pursuit of the merger. On top of that, the other issue is that Chairman Masayoshi Son has made it clear that he isn't interested in a buy out, leaving the company and more importantly shareholders out in the cold. The one thing Sprint offers is valuable assets in wireless spectrum and a new 4G LTE network that would be attractive to suitors, but with a weak balance sheet and no history of profits can it afford a costly price war alone?
With the domestic wireless market very mature, it seems odd to compete on pricing, but new CEO Marcelo Claure apparently laid down the gauntlet with the following statement to employees:
We're going to change our plans to make sure they are simple and attractive and make sure every customer in America thinks twice about signing up to a competitor... "very disruptive" rate plans are coming next week, and Sprint will react quickly to bring competitive offers to potential customers.
Price competition will intensify.... Sprint will soon be ready to join the fray.
The financials don't suggest Sprint is ready for competing on price.
Peaking Financials At Breakeven
After years of losses, Sprint reported a surprise profit for the quarter ending in June. The operating income of $519 million was the highest number in over seven years. In addition, the adjusted EBITDA margin of 24% was the best in six years. The net income only squeaked into the positive column at $23 million.
Unfortunately, these improved financials are coming on the backs of subscriber losses and declining ARPUs. The company has reduced costs in the last year to achieve these numbers. The cost of wireless services declined $243 million over the prior year to offset lower service revenue. However, the intent was for the network consolidation plan to reduce costs while increasing revenue. Even wireless SG&A expenses have shrunk by roughly $250 million since peaking at $2.4 billion in Q313.
The numbers are significant improvements over any of the numbers in the last six to seven years, but the pricing war will quickly reverse this progress.
Weak Balance Sheet
While some of the income and EBITDA metrics are hitting levels not seen in years, one needs to note that net income only slightly creeped into the positive column. The wireless provider is competing against giants in the industry that produce billions in free cash flow (FCF). Sprint on the other hand has negative free cash flow and quarterly interest expense of $512 million. So despite the positive numbers, FCF was negative $496 million in the last quarter, a number actually larger than the negative $396 million in the year-ago quarter.
Of course, part of the problem with FCF in the last year were the capital expenses to get the network upgraded to 4G. Sprint expects these capital expenditures to decline going forward, though the new CEO stated that the new 4G network took too long to build out possibly suggesting an increase in capital expenditures in the short term.
The biggest concern for investors is that Sprint doesn't have the balance sheet to compete in a price war. According to the latest financials, Sprint has $32.5 billion in debt and roughly $27 billion in net debt after subtracting the roughly $5.5 billion of cash on hand.
It seems absurd that Sprint spent the last several years improving operations and upgrading the network to only initiate a price war at the very moment it reached positive income. Ultimately, the price war started by T-Mobile and evidently destined to be finished by Sprint is negative for the whole industry.
Both AT&T and Verizon are at risk to lower pricing plans taking down ARPU and even potentially stealing customers. Investors should not own stocks in the sector based on this news.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a short position in S over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.