I received a variety of emails and phone calls from investors in December 2010 when Greenlight Capital (GLRE) founder David Einhorn announced a stake in Sprint-Nextel (S). As any reader of my blog posts would know, S was one of my highest conviction holdings in 2010. However, by the time that Einhorn announced his fund's stake in S, I had actually sold off my entire stake in the company. The following is a modified excerpt from the Kinnaras Capital Management LLC Q4 2010 letter which discusses why I sold S.
Investors may be curious regarding the divestiture of Sprint-Nextel, our highest conviction holding in 2010. When Greenlight Capital founder David Einhorn revealed a stake in S in early December (a few weeks after we had sold), I received a few "what do you think about that" emails; not surprising when one considers Greenlight Capital's ~22% annualized return since inception in 1996. One of the reasons I sold S was simply due to a flurry of much more attractive prospects that arose in Q3. The limited capital we control allows us to invest in any segment of the market, and I wanted to take advantage of that opportunity in Q3.
Nonetheless, I would have considered holding on to a small stake in S if I had greater confidence in its management team, marketing efforts, and competitive dynamics. When establishing our stake in S in early 2010, one component of my investment thesis was the head start S had on its rivals in deploying next generation ("nextgen") cellular capabilities. S's 4G service is provided through its majority stake in Clearwire (CLWR). S would also be releasing two spectacular phones using Google's (GOOG) Android Operating System in the summer -- the HTC EVO (EVO) and Samsung Epic. Sales data was demonstrating that Android phones were gaining considerable momentum, and the EVO and Epic were two of the most widely anticipated smart phones of 2010.
Heading into 2010, S would be the first to 4G with a significant lead time over its rivals, had two highly-rated phones that could compete against any of the top smart phones, had a very compelling price point relative to other carriers, experienced massive improvements in customer service, and had already demonstrated success in rationalizing parts of its business to drive operational improvements. S also faced few financing constraints, with most of its debt maturities far into the future. The stock was cheap across a number of valuation metrics and had a number of catalysts in place that could drive improvements in valuation.
Here's where the train started to go off the tracks. The telecom business is highly competitive, and I believe companies have to go for the jugular when it comes to advertising to demonstrate their key strengths over their competitors. For example, Verizon (VZ) directly mocks AT&T's (T) network coverage in its television ads, leading the viewer to believe that VZ has the best coverage while T has overpriced and weak network coverage.
S intended to release the EVO in June, and a number of third party sources considered it to be the best smart phone available. S had for the first time a legitimate top-shelf product and had also developed a very competitive pricing plan, offering far more value to a subscriber relative to VZ and T. I had expected some aggressive and smart advertising to promote the EVO functionality and S phone plans directly against its competition.
Instead there appeared to be little to no advertising until the final two weeks of the release, and the marketing was very mundane. Effective marketing "shows" rather than "tells," and the EVO commercials were far too convoluted, doing nothing to effectively demonstrate the powerful capabilities of the phone. The video below is one of the initial EVO commercials and should illustrate my point.
I felt S had squandered a huge opportunity when there were no other competitors to market leading up to the introduction of the EVO, and from that point on I began to question S's advertising efforts. For example, S runs advertisements before the coming attractions start in movie theaters. As theaters are usually pretty empty before the coming attractions start, I would wonder how effective the use of these ad dollars was in attracting new subscribers. I also was skeptical of the company's sponsorship of CBS's NFL halftime show and sponsorship of the Sprint Cup for NASCAR. My personal view was that S could be far more effective with advertising that demonstrates what its network and exclusive phones could do rather than spend ad dollars on blanket sponsorship.
The next problem arose with S's handling of CLWR. CLWR is majority-owned by S, but was also competing directly against its parent company by offering CLWR-branded service as well as specific connection devices such as the iSpot, which competed against the S Overdrive. Considering that CLWR burns considerable cash, much of it from S, it was bizarre that S sat idly by for so long allowing CLWR to use S cash to develop products to compete against its parent. In Q4 it became apparent that CLWR would need more capital, setting up additional tension between S and CLWR.
At this point S needs CLWR, as it provides S with its 4G service, but CLWR will still require billions to further expand coverage in the U.S. It will be challenging for S to fund CLWR's needs while also executing its own capital spending plans. S has taken far too long to decide to rationalize its iDEN and CDMA networks, but it intends to start in 2011. This project will require billions and excludes the roughly $2B+ needed on maintenance capex and FCC license expenditures. These are not immaterial expenditures, considering S generates under $6B in EBITDA.
What exacerbates this problem is that competitors are now coming to market with 4G services. While S had a large lead in terms of time, it squandered that lead with ineffectual marketing and poor management of CLWR. The company has a compromised operational and financial strategy, and is now facing competition with far better marketing and deeper resources.
For example, S marketing executives could learn a lot from T-Mobile. T-Mobile has released some excellent ads which are exactly what I envisioned S would have done but did not. The T-Mobile ads copy the "I'm a Mac/I'm a PC" commercials Apple (AAPL) developed, whereby T-Mobile goes directly after AT&T and the iPhone, highlighting AT&T's poor network performance and limitations of the iPhone 4.
S could easily have done similar ads, but for whatever reason, S CEO Dan Hesse has been reluctant to highlight any design and operational advantages the EVO and Epic have over the iPhone or that the S network has over competitors. T-Mobile has had no such qualms, and it would be little surprise if sales of T-Mobile 4G devices (even though T-Mobile really does not have 4G) accelerate due to the smart advertising.
Aside from T-Mobile, VZ is also beginning to market its 4G service. VZ has the deepest pockets of U.S. telecoms and will be rolling out its coverage network at an aggressive clip, while S and CLWR struggle to address financing and operational aspects. In addition, 4G smart phones appear to be slated for wide availability across carriers in 2011. While the EVO and Epic were two of the best phones released in 2010, there are a host of very impressive phones set to be released in 2011 such as the Motorola (MMI) Droid BIONIC, Samsung 4G LTE Smartphone (nextgen Galaxy S), and HTC Thunderbolt. What will make this challenging for S is the cost subsidies associated with increasingly advanced phones will not be as easily absorbed by S relative to its peers, as the company's current plans yield lower ARPU relative to its peers. This could result in further margin pressures.
When entering 2010, S has a number of tangible opportunities, and I felt if the company successfully executed on these, operations would improve significantly and thus yield a better valuation for the stock. S had its chances, but I believe itmissed what was essentially the one "open year" it had to increase subscribers with a relatively light competitive field. As Q3 and Q4 passed, the window between S and its competition was virtually eliminated.
I expect that 2011 will be a year where its deeper pocket rivals like VZ flex their muscles and offer 4G services with other attractive smart phones. S may still pay off handsomely for investors, but I felt we had better places to invest and that the outlook for S was getting increasingly more challenging.
Disclosure: Author manages a hedge fund and managed accounts with no position in any of the companies mentioned above.