Sprint (NYSE:S) is an underperforming company which will likely improve over the next several years as a result of both efficiency gains and improving competitive dynamics. Currently, Sprint is undervalued by up to 50% because the market is focusing primarily on the company’s current cost structure and competitive position. The potential AT&T (NYSE:T) / T-Mobile (OTCQX:DTEGY) merger has raised additional concerns about Sprint’s ability to attract top devices to its platform. Because the value of a stock is based primarily on the outlying years (exit value assumption), Sprint’s stock will likely revalue at a much higher level when investors fully price in what the company will likely become.
Sum of the parts: Normalized Sprint + Network Vision NPV
Sprint deserves a discounted valuation because of the many headwinds (iPhone) and risks (WiMax, Clearwire (CLWR)) they face. I account for this risk by building in a large margin of safety through the use of a higher discount rate and adjusting cash flow assumptions lower.
For the valuation, I am assuming a ~5% decline in EBITDA for 2011 ($5.34 billion) and the company- guided CAPEX (ex Network Vision) of $2.5 billion (FCF of $2.85 billion which is the 3 year average). To build in a margin of safety, I assume a normalized FCF of $2.5 billion and a 2% perpetual decline (to account for the risk that Sprint starts losing subscribers again). I believe the 12% reduction in FCF for the valuation leaves room for additional CAPEX spending association with a potential shift to LTE from WiMax (see section on Network Vision for information on a transition to LTE). And, assuming a 2% perpetual decline in FCF leaves room for subscriber losses from the Verizo (NYSE:VZ) iPhone launch longer-term (1-3 years).
One secular factor which will hopefully offset the iPhone risk is the move towards smartphones. Not only do smartphone users generate higher long-term margins, they have lower churn rates (churn rates are a key driver of margins). And, in the last 6-12 months, there have been a growing number of lower priced smartphones (under $100 with potentially lower device subsidies). As a result, the trend towards smartphone adoption will likely accelerate in the future.
I use a 13% discount rate (higher then the CAPM implied rate to account for the execution risk). Given the fact that Sprint’s earnings are not heavily correlated with GDP, I would expect the market to eventually apply a discount rate at closer to 10%. However, I am keeping the rate at 13% to add a greater margin of safety. Based on the valuation, the core business is worth ~$5.50 ($2.5 billion / (13% + 2%)).
I believe it is better to use a single period normalized FCF valuation rather then a full valuation model because the simple model reduces the number of assumptions needed to arrive at a reasonable valuation. It is impossible with any degree of accuracy to forecast future profits within a 15-20% range, so using additional forecast years only adds potential sources of errors.
The Network Vision NPV is around $2.50 (up to $3.50 and as low as $1.50, depending on the actual timing versus company guidance). The project will increase Sprint’s network efficiency and dramatically lower long-term costs. Also, it is important to note that this project will make it easier for Sprint to eventually switch from WiMax to LTE. Furthermore, the guidance used to arrive at the $2.50 NPV does not include potential benefits from network sharing, so there is a margin of safety in the estimate. Adding the normalized cash flow and Network Vision NPV gives a fair value of ~$8.00 per share.
Sprint’s main problems are a) device lineup b) inefficient network c) Clearwire / WiMax.
First, Sprint currently does not carry the iPhone and there is a legitimate concern that Sprint will lose subscribers over time as a result. While this is a near-term headwind, the actual losses will be manageable given that AT&T carried the iPhone for years. Already, analysts are concluding that demand for Verizon’s iPhone is “solid, but not spectacular.” And based on many conversations with several retailer sales representatives, most of the demand is coming from existing Verizon customers. Lastly, although Sprint is currently not fully comparable to Verizon, it is worth noting that Verizon kept its customer base intact during the time period when AT&T had exclusive rights to the iPhone.
Second, Sprint’s Android lineup is improving and many customers actually prefer the open-source Android operating system to Apple’s (NASDAQ:AAPL) closed system. Sprint’s HTC EVO, for example, is very comparable to the iPhone. Some consumers even prefer the EVO because of its larger screen and a higher resolution camera. And, much like desktop computers, laptops, and flip-phones, the trend in the smartphone industry will be towards device commoditization. In that environment, Apple will keep loyal customers but there will be room for other devices.
Third, Sprint will have no trouble attracting a high quality lineup of phones even if the AT&T / T-Mobile acquisition is approved. Android-based smartphones, for example, have low development costs because the operating system is already created by Google (NASDAQ:GOOG). So adding devices for Sprint will remain very profitable for device makers like HTC and Motorola (NYSE:MSI) to make Android-based phones.
Sprint has much lower margins than AT&T and Verizon because the company has two networks. Sprint’s Network Vision project will make the company more competitive over time. Here is a link to an independent assessment of the project.
The plan will cost $4-5 billion and will yield $10 to $11 billion in additional savings over the next 5-7 years. The cost savings are very probable because they are based primarily on removing known costs (like extra towers or based stations). And, as mentioned, the $10 to $11 billion in savings does not include potential inflows from network sharing. Based on my NPV analysis using a 10% discount rate, I calculated that the project adds around $2.50 in value for Sprint.
Clearwire has been a concern for investors because it appeared Clearwire did not have the ability to get outside financing and thus represents a significant incremental cash outflow for Sprint. In December, Clearwire announced a $1.1B private placement. Sprint purchased around $600m of the offering but the debt deal makes it less likely that Clearwire will require additional equity funding in the near term and further reduces the risk that Sprint will be required to consolidate Clearwire.
Also, if the AT&T / T-Mobile deal does go through, the merger makes the pricing dispute with Sprint much easier to resolve by removing any negotiating leverage Clearwire had with Sprint (neither AT&T nor Verizon will bid).
Longer term, the Clearwire picture is much more uncertain. However, Clearwire is unlikely to hurt the long-term position of Sprint, assuming Sprint can gradually shift over to LTE. The Network Vision plan will give the company additional capabilities, providing Sprint much more flexibility on this issue. For example, Sprint will have the capability to stay with Clearwire, to a degree, but still shift gradually towards LTE.
Sprint faces significant near-term headwinds. However, the majority of the value in any perpetual security (stocks) is in the outlying years. In the next 3-5 years, Sprint will likely move from being a low margin provider with a significant competitive disadvantage to a higher margin provider (Network Vision) competing on a more level playing field (iPhone risk reduced or eliminated). Using conservative assumptions to account for the execution risks, I believe Sprint is worth $8 based on the normalized $2.5 billion in free cash flow and the NPV of the Network Vision cost savings.
Key Investment Catalysts
1) Relief, post-iPhone launch
2) Stabilized churn rates over multiple quarters
3) Network Vision Execution
1) Greater than expected subscriber losses due to the Verizon iPhone launch
2) Execution risk with multiple networks and technologies
3) Sprint will eventually need to switch to LTE from WiMax (3-7 years)
Much of the sell side remains focused in near-term challenges and considers the stock “dead money.” Furthermore, some investors hesitate to assign any value to something that occurs in the 3-5 year time frame. As a result, the value Sprint will realize from Network Vision is not priced into the stock.
Potential Verizon Deal
It is worth noting that based on the price AT&T paid for T-Mobile's subscribers, Sprint is worth more than $10 per share. I believe the odds of a Verizon Sprint deal in the next year are less than 20% even though it makes sense from a technological and competitive standpoint. Although if the T-Mobile deal is approved, regulators may reason that having two large competitors versus three is somewhat comparable. And, having two very large carriers as opposed to the current number would lead to better wireless coverage (what customers really want). Eventually, I would expect Verizon to buy Sprint.