The Challenges Before Sprint

Jul.28.11 | About: Sprint Corporation (S)

Sprint (NYSE:S) announced results this morning that were, to put it mildly, disappointing, sending the stock headed for the toilet:

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Opinion on the street is all over the place on this issue. Net postpaid subscriber loss was materially worse than expected (-100k, roughly) but total adds, including prepaids, were up. One of the confounding factors is the deal with Lightsquared, which has deployment problems related to possible GPS interference issues.

That issue is not trivial. I've done a fair bit of reading on it and it's not at all clear who's in the right on this one, but for Lightsquared and its 4G deployment, it doesn't really matter.

This is not to say that there isn't plenty of egg to go around; there is. How Lightsquared managed to get itself a license it can't use, when it disclosed its intent before acquiring it and apparently has primary user access in that band, is an open question. There are potential irregularities in the licensing process that have yet to be exposed and hashed out, and despite looking into it with some diligence, I can't figure out whether ultimate responsibility for this should lie with the company or with the government.

In the end, however, while Lightsqured might get some sort of compensation if sold a pig in the poke, for Sprint and its customer base, it won't matter if Lightsquared gets compensated or not. Therefore, the proper analysis in my view is, "What are the odds this use of spectrum is blocked?" The answer is "Quite high," irrespective of the merits.

A short primer is in order. If you have primary user status you're presumed to have the right to transmit in the spectrum you're licensed for at the power levels you were approved to use. However, there's a catch-all in the form of the "interference" clause.

You clearly cannot intentionally interfere with anyone else. You also can't interfere with a primary user in your band if you're a secondary user. But if you're not "splattering" outside of your allocated band if someone on an adjacent band is interfered with priority becomes a more-sticky issue.

Public-safety, military and similar users "win" these conflicts in the general case. But what if the reason for the interference is that the other folks' radio designers did not bother to put sufficiently-selective filters into their equipment -- some of which is 10 or more years old? In other words, can an industry practice of being cheap screw an allocation made years later to a different company, effectively granting the interfered-with user a blockade on spectrum that he was never licensed and authorized to use?

That's a tougher question. It gets even more interesting when some of the "interfered with" devices are receivers that are designed to receive signals from emitters in other countries that do not follow our band plan. That "dual use" or "international use" design would drive you to use a wider bandpass filter which exposes your device to interference here. Sticky stuff here, especially when one considers that the FCC apparently licensed Lightsquared to use a band that in other nations is under that exact sort of conflicting use without taking this problem into proper account.

Finally, what really doesn't help is that GPS signals are extremely weak. They come from a satellite with a limited power budget and travel a long way. Thus, when they're received at the antenna, there's not a lot of signal there. Lightsquared, for its part, wants to transmit with really high power levels. This makes "front-end" overloading a serious problem, requiring that the GPS receiver have sufficient filtering in front of the first amplifier stage so that the front end doesn't get overloaded by the undesired signal.

But in this case, with GPS being considered an "essential" service, the political considerations may outweigh everything else. While I can argue that it's unacceptable to essentially lock down spectrum not allocated to the GPS system simply as a sop to legacy or international designs that manufacturers intentionally built without the proper filtering (probably for reasons of cost), the fact of the matter is that this is very likely to be the outcome. If it is, Lightsquared will have purchased hardware and designed something it will not be allowed to turn on. This is the uncertainty factor.

Sprint has another problem in that it's making losses. The stock is selling at approximately book value, but beware: There's $18 billion of debt on the balance sheet against $12 billion in market cap. That's a potential problem. Levered free cash flow appears to be adequate at $2.8 billion, but for how long will it remain so?

There are things Sprint could do that might be extraordinarily disruptive to other carriers. Presuming it has the capacity to deal with it, it could allow the activation of any of its post-paid devices on Virgin (NASDAQ:VMED), provided you pay full price for them (or acquire them used on the secondary market.) This would be an absolute destroyer of the postpaid model among the "Big Three To Be Two" (Verizon (NYSE:VZ), AT&T (NYSE:T) and T-Mobile); the question is whether it can be done profitably. It has to be; Sprint can't make losses per-customer with this sort of change, but if it can do it and make money? Oh boy.

The difference here in cost-of-service between Virgin at its $55/all-in-unlimited plan and AT&T's or Verizon's is not small. The biggest problem is that it may cannibalize its own postpaid subscriber base, and there are a lot of people who think prepaid is a rubbish business.

I'm not in that camp. My view is that any business that makes profits is a good one and one that makes losses is a bad line of business irrespective of all other considerations. Therefore, the only question I have is whether such a change would make profits or losses. The potential to literally steal millions of post-paid customers from the other carriers is not to be ignored, although one must balance that against the risk of self-cannibalization or worse, making a move that the other carriers might be able to emulate. Only Sprint knows its internal cost structure and whether this can be done at a profit ... but if it can be, it's a "disruptive" move that could rocket the company and the stock.

Finally there are rumors of some sort of acquisition and they've been around for a while. I discount this, although from an anti-trust perspective it's a cleaner deal than the AT&T/T-Mobile one is. Nonetheless, I don't know that I see the value here for an acquiring company; you're basically buying a customer base, and the only firm with compatible technology is Verizon. The problem with that deal is the same one I foresee with AT&T/T-Mobile: Sprint is materially cheaper to buy service from than Verizon, and trying to force customers to eat a big uptick in price has a history of failing miserably. There's too much risk in that regard for too little likelihood of success.

Down here in the low $4s, a first-blush look at the last year's stock chart renders the company attractive. The problem is that you may be literally buying a zero: Debt coverage could be a problem and if Lightsquared blows up, it won't be good on a forward planning basis, even if Sprint's financial protection against that contingency proves adequate. (There was a rating update just released that essentially said it is.)

On balance, I'd like to see Sprint announce opening up its Virgin service to any Sprint phone. If it did, I'd expect it to result in a monstrous flood of activations, even if they were limited to 3G (and not 4G) speeds on prepaid. Assuming that Virgin is not a loss-maker, this looks like a zero-cost (simply drop the restrictions in the software on its end for the ESNs) option for it that could pay huge, and stick the "big boys" in a corner they would have a lot of trouble defending.

We'll see if someone is thinking "take a head-shot at the leaders" among Sprint's executives.